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Oh, the Economics of it All!



February 07, 2008 – Comments (7) | RELATED TICKERS: CFC , C , KBH

So here's a little something I posted on my personal blog that I thought I'd repost here...


In short, for a while, I thought that many were underestimating what was going on for the past few years. The housing market ran up like crazy and it did it on the back of crazy loans that didn't put buyers on the hook for anything.

Today, however, I think we're seeing the opposite happen. Today, it seems as if everyone and their mother is a bear on not only housing, but the stock market, the US economy, the dollar -- you name it. Pessimism isn't completely unfounded, it does appear we're headed towards a growth slowdown, if not a recession. Stocks have declined markedly, especially if you look at certain sectors like financial, technology, or retail. And the Federal Reserve has found it necessary to rapidly cut their target interest rate. In other words, thinks aren't looking all bright and shiny.

Where I differ, though, is when it comes to the people who are calling for a massive economic fall-out and some sort of nuclear winter for financial markets and the US economy.

It's tough for me to pick on a guy like Nouriel Roubini because he's a bona-fide economist (which I am not) and he's probably a heck of a lot smarter than me. All the same, I found myself questioning some of his assumptions in a recent blog post. In short, he claims there is "a rising probability of a 'catastrophic' financial and economic outcome."

He claims specifically that "this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001." His points are below with some comments from me:

1) we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%

I'm going to address US home prices in another post (to come), but let's assume this is true. Let's look at our last major asset bubble and burst (fortunately we don't have to go back too far!). In the Nasdaq market alone there was $3.6 trillion lost as the market plummeted almost 80%. Add in the losses on NYSE-listed stocks and you're talking over $9 trillion. Between peak and trough, Microsoft went from a market cap of roughly $475 billion to one of $240 billion. Intel dropped from $380 billion to under $100 billion. Cisco, from $450B to $90B. JDS Uniphase from $100B to less than $3B. Our good pal Yahoo! from $80B to around $5B... and the list goes on.

Those are real numbers there! And for all the talk today that Americans felt richer when their houses appreciated, you better bet your rear-end that they felt richer when their stock portfolios where going through the roof. Just ask people in San Francisco what the atmosphere was like before the DotCom bust.

The point is, we managed to digest that massive amount of asset devaluation. I have a feeling that, though it won't be fun, we'll manage through this one too.

2) because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch

I think it's questionable how reckless financial innovation and securitization were, particularly outside of the mortgage market. That's not to say that other loan classes won't suffer in an economic downturn, but that's to be expected to some extent.

I think this argument discounts to some extent the credit market participants and the money that's constantly flowing in. There are a lot of buyers of credit that have money that needs to be deployed in interest bearing vehicles (think insurance companies). I'm sure they'll be scrutinize what they're buying more closely going forward, but I just don't think that they can/will turn off the spigot like he is suggesting.

The fact that the Fed has stepped in aggressively and cut rates the way it has also greased the credit system to a large extent.

Don't get me wrong, I think that high quality credit products are going to trump low for a long time, but I think that a severe and extended locking of the markets is unlikely.

3) US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise

I've seen so much said about US consumers, their debt, and its implications. The simple fact is that the situation isn't as cut and dried as it may appear. Some economists argue that with more open and available credit, individuals are now able to smooth their lifetime consumption to a greater extent. This means taking on more debt, though not recklessly. This group has conceded that increased debt loads makes some individuals more susceptible to major financial stress during an income shock, but this is balanced out by the smoothing and stability that credit has offered on a more macro level. Of course, there are those that do overuse credit and use it recklessly, but I have yet to see data that reckless use of credit is widespread.

Demographics also play a role in debt. The Baby Boomer population is now all in the age group of highest home ownership rates and so it's logical that there is going to be more mortgage debt from this group. Similarly, there has been some research that has shown a significant hump in an individual's consumption when they hit middle age (see Baby Boomer age group).

And when it comes to debt, I'll also just throw out there that education debt is far higher than it's ever been. I won't say whether this is right or wrong, but it should be considered. A bullish slant on this is that this is debt that is taken on as an investment in human capital and therefore very beneficial to the economy.

And finally, per the 70% of spending that comes from consumers... first of all, this is not significantly higher than long term averages (mid-to-high 60s). More importantly, consumption spending has been shown to be more stable that business spending, so this could be seen as a stabilizing force going into a downturn.

4) now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted

I don't know that I have much more to add here... per above 1) I'm not sure I'm convinced of the severe credit crunch thesis, and 2) when trillions of dollars were lost in the DotCom bubble bust consumption spending slowed (from 7.3% in 2000 to 4.7% in 2001), but did not fall through the floor.

Another string of reasoning that I've heard floating around that argues for a big turn-down is that we really haven't had a significant recession in quite a long time. This group is arguing that we're "overdue" for a big recession (I actually am hearing Bill Fleckenstein argue almost exactly this on Fast Money right now). While this may seem to make perfect sense since -- as we all know -- recessions are a normal part of the business cycle, I don't think it's supported by data.

Since 1984, economic activity has steadied to a significant extent -- meaning specifically that there has been far less volatility in inflation and economic output (an overview of "The Great Moderation" and some thoughts from Ben Bernanke). What this has meant for our practical purposes right now is that average economic growth has remained roughly the same in the post-'84 period as what it was at in the pre-'84 period. It's the standard deviation of year to year economic growth, the height of the peaks and depth of the troughs, has reduced considerably.

So I find it hard to get on board with the people who say that we're due for a big economic downturn because we haven't had one for a while. Because the peaks haven't been as high as they were in the past, the troughs don't need to be as low to complete a correction and keep the US economy on a steady, and sustainable growth path.

Now there are likely many reading this thinking "oh here's another bull cheerleader." In fact, I have very mixed emotions about what's going on. There are a lot of data that I look at that support a very moderate outcome. On the other hand, I don't know what the X factor of high consumer debt as a percentage of GDP means (it has been steadily growing for decades), and I'm also worried about the high current account deficit that we're running. I'm similarly not crazy about government debt, even if it's not high (as a percentage of GDP) to an unprecedented extent. Although I've taken on some of Roubini's comments above, I don't doubt he is a very fine economist. I likewise have seen some good points on the bearish side from the likes of Barry Ritholtz and Doug Kass and can't get on board at all with a lot of what the ueber-bulls like Ben Stein have to say.

What I am trying to argue here is that the economic consequences of what's going on right now is far more complex than most media outlets and commentators are it giving credit for. I happen to think that we will have a pretty moderate outcome to the current situation. However, the bottom line is that there are many millions of participants in the economic machine and in real life they do not act the way that most economic models expect them to. I have little confidence that anybody can accurately gauge what is going to happen here. Sure, somebody will get it right -- there are enough people making predictions out there that statistically speaking, one of them has to end up hitting it -- but I don't think that person will be right because they are particularly prescient (and hey, that includes me if we do end up having a moderate outcome).

Furthermore, when it comes to getting heard in a crowded media space, it's really tough for anybody to get press time for giving a balanced account of what's going on. Nobody's interested, nobody is pushed into fear or inspired to optimism by somebody saying "well, here are the numbers, but it's not clear what's going to happen." Simplify what's going on, and give an exaggerated account of what could happen and suddenly people's ears perk up.

Now before I wrap this up, I should note that my benign views on recession do not translate to a benign view on the fact that we've had two very massive asset bubbles right on each other's heels. I don't think there's anything that can prevent the psychology of greed from leading to bubblicious asset markets from time to time, but I do think that we need to look at ways that we can identify bubbles sooner and dispense with them quickly before they create a dangerous overhang for the economy. After all, even if this recession isn't that bad, it doesn't make the deflation of housing bubble any less painful for those at or near the epicenter.



7 Comments – Post Your Own

#1) On February 08, 2008 at 12:26 AM, dwot (29.17) wrote:

There you are...  I still have your email.  For some reason it came with that capspitchreplies email address.  Use debwot @  I switched every thing to that address except I've never found where you can change your email on caps.  

First, I was having problems figuring out which post you were talking about for the great moderation...  I'm stuck on dial up speed and it takes time to open all the links, and even though camistocks told us how to search I blogs, I don't know how to search his blog to find the instructions so I can search my blog...

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#2) On February 08, 2008 at 5:49 AM, MakeItSeven (31.80) wrote:

Facts and numbers are similar to assets which are solid and  undisputable.  Opinions are like derivatives which are based on the existing known facts but with some subjective/objective guesses added to predict future facts/events (like "home prices will never go down nationally").

And then we have opinions on top of opinions, far removed from any of the facts/numbers.   That's how we get to all the financial alchemy/analysis that give us some 350-500T worth of derivatives based on just 25T of mortgages, the CDO, CLO, CDS, etc. of the world.

So, I won't add "yet another opinion" to this since everybody has one.  Neither will I try to make an argument based on facts since I can't afford it.

With that caveat of time and lucidity limitation spelled out, here are some of my random and hopefully relevant observations:

- In the dotcom bust, some people argued that since all technology stocks comprised of only 25% of the valuation of the stock market, so even if all of them (including MSFT, IBM, CSCO, INTC, EMC, EBAY, AMZN, etc) went down to zero, that would only make a 25% drop in the valuation of the stock market.  The argument seemed to make sense since, after all, what do companies like WMT, HD, MCD have anything to do with the dotcom companies ?   It turned out that the problem was not "contained" as those people argued.

This time, it's most likely that home prices will go down about 25% from the top, making it a 4.7T loss in valuation based on the total mortgages of 25T.  That is for the perfectly "contained" scenario without considering the roughly 400T of mortgage-based derivatives and any ripple effects.

- The "resilient" consumers of recent years have been hogging on their Mortgage Equity Withdrawal for their lifestyles.  It's almost 100% certain that the extra MEW in recent years will be turned off when home prices go down.  That will take over 400B out of the economy (a lot more if you count the ripple effect of such spendings on the GDP).  See October 2007 article, chart 9).  On top of that, those super-resilient consumers who spent with no consideration for their reducing incomes will now have to pay back the 2+T in MEWs.  So roughly 200B a year will be used in debt repayment instead of spendings.

- Considering the declining real incomes and the extra debt, the drop of consumer spendings will not be just back to the norm of 66% but will be significantly below it.  See Chart 12 Jan/Feb 2008.  BTW, I see some other accounts which claim that the current consumer spendings is 72% of GDP.

- Chart 10 Jan/Feb 2008    is pretty interesting and shows some dynamic relationship between sales of equity assets and household borrowings.  This is all Paul Kasriel says about it: 

Chart 10 shows that household borrowing relative to DPI hit a postwar record in 2006. Household deficits also can be funded by the sale of assets to other sectors. Chart 10 shows that households were big net sellers of corporate equities in 2001, 2006 and 2007. By the way, principal net buyers of these corporate equities were corporations themselves.

We all know what happened after 2001.  It was 2002 and the SP500 went down yet another 25% or so.  Also, at the end of 6/2007, corporations had spent over one trillion dollars in stock buybacks in 10 quarters, the biggest in history at the same time households are selling equities at a record high.  Again, the market went down in the second half of 2007.

What does that mean ?  Does it mean that the average households are smarter than the CEOs or does it mean that they feel the pain (and the need for cash from their savings) long before the executives realize what's going on ? 

BTW, this is the most interesting chart to me and seems to be the best indication of the stock market direction than anything else I've seen.  Hopefully, Dr. Kasriel will produce this chart every month.

Anyway, both borrowings and equity sales are going down from a record peak (due to exhaustion of MEWs and 401K ?) so there will be much less money for household spendings.  We have not seen any extreme unravelling like this since WW2.  The closest (but far below) peaks were in the mid 80s and when the unravellings were done, we ended up with the 1990 recession.

In short, I think the argument that the 2008 recession will be worse than in 1990 is supportable from currently available data.  The "Damn the torpedo, full speed ahead" resiliency from the consumers is gone.  We have to understand why it existed before and why it is gone now.  The government won't be able to give them some 500B a year every year to replace what they can no longer access.

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#3) On February 08, 2008 at 9:21 AM, redearth329 (99.64) wrote:

I say 20 months, care to make it interesting?

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#4) On February 08, 2008 at 12:24 PM, TMFKopp (97.81) wrote:

MakeItSeven -- Interesting stuff, and I appreciate the links. One thing I noticed reading through all that, though, is that they claim that the 1990 downturn is a good model for what's currently going on. If that's the case I think we're talking about a relatively benign outcome. I'm not saying no pain, I'm just saying we're not looking at the kind of economic meltdown that the Roubini's of the world are talking about.

redearth -- If there's one thing that I'm not going to bet on it's whether I'm right on the economy... per my post above, there are so many variables, I'm impressed with anybody that can make sense of it all (and I've yet to see anybody that does it to my satisfaction!)

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#5) On February 08, 2008 at 3:41 PM, redearth329 (99.64) wrote:

Darn, I was hoping for a hedge in case it did drag on that long!

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#6) On February 08, 2008 at 4:22 PM, TMFKopp (97.81) wrote:

haha... if you find somebody that will take you up on that, let me know!

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#7) On February 08, 2008 at 5:56 PM, TMFKopp (97.81) wrote:

haha... if you find somebody that will take you up on that, let me know!

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