Tuesday, September 29, 2015

Housing, A Series: Part 64 - Price/Rent measures have had an upward bias

Bill McBride shares a recent quote from San Francisco Fed President John Williams:
I am starting to see signs of imbalances emerge in the form of high asset prices, especially in real estate, and that trips the alert system...But I am conscious that today, the house price-to-rent ratio is where it was in 2003, and house prices are rapidly rising. I don’t think we’re at a tipping point yet—but I am looking at the path we’re on and looking out for potential potholes.

On Price-to-Rent Ratios and Inflation Measures

Williams refers to a rising price/rent level.  Bill McBride has this graph of Price/Rent.  This uses Case-Shiller indexes for prices and CPI Owner-Equivalent Rent inflation to adjust rent.  This is reasonable, since both of these measures attempt to measure the change in prices and rents for individual homes.  However, both of these measures are capable of drifting over long periods if there are any measurement biases.

My preferred measure for Price/Rent is to use the measure from the Federal Reserve's Financial Accounts report for the Market Value of Owner Occupied Real Estate for Price and the measure from BEA Table 7.12 for Imputed Rent of Owner Occupiers.  These should represent more of an independent estimate in each period of the aggregate Price/Rent level.  The Case-Shiller index is a value weighted index, and the aggregate Fed/BEA numbers should act like a value weighted index.  The difference between these measures should basically point to measurement drift in the measure that McBride, and presumably Williams, are using.  And, the difference is substantial.

Since 1995, the Case-Shiller/OER ratio has diverged about 23% from the Fed/BEA ratio.  That suggests that either Case-Shiller home prices have been overstated or rent inflation has been understated by more than 1% per year over the past 20 years.  This is surprising, because even as measured, rent inflation has been persistently high throughout this period.  I have used this persistent inflation - centered in the problem metropolitan areas (NY, SF, etc.) - to argue that there has been a persistent housing shortage.

I think what we are seeing here is a form of substitution effect.  There isn't a measurement error, per se, in either the OE rent or the Case-Shiller price measure.  But, what we have been seeing is rent inflation in the problem cities driving up prices with stagnant housing stock.  The prices there are rising due to both the rising rents themselves and due to rising Price/Rent levels, which we can see are especially strong in the Case-Shiller 10 cities, relative to the national level.  So, marginal new homes have to be built outside those cities, and those homes have lower Price/Rent ratios.

Even if rent inflation and price changes of each individual house are accurately tracked over time, the fact that marginal new housing stock tends to have a lower Price/Rent will mean that we have overestimated the price of the home of the typical household.  Measures of real and nominal housing expenditures (rent and imputed rent) would not be biased by this substitution.  And, the Case-Shiller measure of home prices would not be biased regarding the homes.  But, the substitution does mean that Case-Shiller does overstate the cost of homeownership for the typical household over time.

I think this bias in Case-Shiller may be somewhat inevitable, because persistently high rent inflation and the related inflation of Price/Rent will tend to only be sustainable in a supply-constrained environment.  In an unencumbered market, new building would be attracted by the high Price/Rent level.  If high Price/Rent persists, then it seems likely that marginal new building will have to occur in lower Price/Rent locations.

So, while it is accurate to say that the typical house that existed in 2003 has a similar Price/Rent today that it did then, the typical household lives in a house with a Price/Rent ratio similar to 1999.  This is because many households have traded down to homes with lower Price/Rent ratios.  In this Price/Rent graph that goes back to 1950, we can see that aggregate Price/Rent ratios are well within normal long term ranges.  Considering the present very low long term real interest rates, Price/Rent is very conservative.  This is why I claim that home prices are too low.  In the places where we allow homes to be built, homeownership is very affordable.  High income households are bidding up the price of real estate in San Francisco and New York City, but that is a negative supply issue.

In a narrative sense, for every household that remained in a condo in San Jose whose imputed rent rose from $4,000 to $4,200, and whose price rose from $1 million to $1.1 million, there was another family who moved to from San Jose to Phoenix and bought a home with imputed rent of $3,800 that sold for $800,000.  This bias in the Case-Shiller indexes created a false sense of an over-heated housing market in the 2000s in two distinct ways.  Regarding rent, from 1995 to 2006, households spent a stable level of their incomes on housing (rent), about 18%.  But their real housing expenditures over that time declined by about 13%.  Since Case-Shiller tracks homes, not households, it does not reflect this shift to less valuable housing.

Regarding Price/Rent, as mentioned above, there appears to be a bias since 1995 of about 23%.  Together, this means that the typical house, tracked by Case-Shiller, overstates the change in the price of the typical household's home since 1995 by about 39%.  The average household lives in a home with lower imputed rent and a lower Price/Rent ratio because they have been downshifting on their housing consumption.  This was especially the case during the boom.  The divergence between the Case-Shiller Price/Rent ratio and the Fed/BEA ratio mostly happened between 2002 and 2008.  As with so many factors I have considered in this series, this is basically the opposite of what everyone thinks happened during that time.

This chart, from Bill McBride is accurate, that the typical home price, in real terms, is about 40% higher than in the 1990s.  But, since households have been adding marginal new housing stock which has tended to be lower in value - mostly due to being in less valuable locations - the average household lives in a house with a price, in real terms, approximately the same as the average household's home in the 1990s, similar to what we see in the Financial Accounts/BEA measure of Price/Rent above.

Monday, September 28, 2015

Random thoughts about capital income

Apologies in advance if this is just boring nonsense.

I believe that it is fairly universally accepted that speculation is a zero sum game.  Actively managed funds underperform compared to passive funds, after fees.  In the aggregate, it is a mathematical tautology.  For every tactical long position there is a tactical short position.

In all economic activity, there is some allocation of gains between the producer, consumer, and those outside the transaction.  Generally, there is some positive externality from marginal new economic activity simply due to the creation of abundance, increased productivity, etc.  In the end, our claim on production - our ability to earn wages above subsistence - is a product of our available alternative sources of income.  So, generally, economic activity radiates some positive externalities that filter through to incomes in general.

On the one hand, the useful allocation of capital depends entirely on the application of skill and discipline.  Real work, intelligence, and wisdom is required.  It's hard work.  This work occurs within corporations, in private equity markets, among entrepreneurs, and among financial speculators.  If this work was not done, there would be no gains to capital put at risk.  But, on the other hand, the gains from this work are entirely captured by passive investors and consumers.

Ironically, the fact that all of the gains from this work are captured as externalities draws us into taking it for granted.  So, in the places where skilled allocators of capital do capture some of the ensuing gains as income, we see it as an aberration - as a confiscation of what should be ours.  This happens in areas where capital is allocated outside of the liquid marketplaces that modern financial markets have created - in the sphere of high growth start ups, private equity, hedge funds in illiquid markets, etc.

I think it is helpful to think of modern financial markets as an engine of liquidity.  That liquidity lowers the required rate of return on productive assets - it raises their nominal values.  This isn't just a pretend, "paper" increase in value.  It is a mistake to see value from finance as unreal and value from the production itself as real.  The value added by liquidity is real value.  The value is related to the amount of tactical asset allocation that can be captured by passive investors. Liquid valuations rise until the returns reflect the unavoidable risks of the broad basket of at-risk assets.

Before the advent of modern liquid financial markets, tactical allocators of capital captured all of the returns.  In that context, capitalists were all active owners.  They couldn't own a diversified portion of the broad basket of assets.  So, they earned gains above the level a passive investor would require, but they had to earn them through income, because those gains were only available due to the lack of a market through which to monetize them.

This is basically still where tactical allocators have excess gains.  I have gone on and on recently lately about how this is available in housing in the US today.  It's another mathematical tautology.  Returns on home ownership are excessive today precisely because homes are selling for less than the risk-adjusted returns should justify.  If constraints in the housing market were sufficiently removed so that it could function as part of the liquid basket of broad assets, prices would converge with other assets and excess returns wouldn't be available any more.

So, speculators and tactical capital allocators gain income in two ways.  First, in illiquid markets - small business owners, favored regulatory arbitrage, etc.- where it is simply earned as income.  Second, by bringing those illiquid assets into liquid markets - private equity, some hedge funds and corporate activist investors, large scale entrepreneurs.  In these cases, since the liquid market allows the value of that future income to be more profitably captured in the present, the gains are registered as capital gains.

With regard to the taxation of capital gains and capital income, then I think there are several categories.  First, there is capital income that is available to the passive investor.  This is mostly a product of deferred consumption and vulnerability to risk.  The general market price of risky assets reflects the cost of that risk, so if we want to avoid taxing deferred consumption, then general, average market gains to stock and bond holders probably don't warrant taxation.  Excess gains to owners of illiquid businesses or other assets (like houses, currently) and the gains to private equity investors and entrepreneurs from bringing assets into liquid markets may represent more than simply deferred consumption.  This income reflects the application of skilled labor.  So, maybe it should be taxed similarly to labor income.

On the other hand, if passive investment income shouldn't be taxed because it simply reflects deferred consumption, and if speculative income within liquid markets would not be taxed because it can't internalize any of the gains from the value it adds, why should these speculators and allocators working outside liquid markets be treated any differently?  In fact, maybe they aren't that different.  Maybe the required return on the market basket of goods tends to be about 10%, but passive investors only tend to earn about 9% because each year, tactical speculative investors and entrepreneurs capture 1% of the market by pulling illiquid assets into the basket of liquid assets.  Thinking of the entire system of productive assets, we might still say that, on net, speculation is a zero sum game, and passive investors are passively making tactical positions by not owning the illiquid portion of the market, and tactically adjusting their positions as those assets become liquid.  Speculators as a whole still don't gain any excess returns, but within that net total, what we call passive investors are really a set of speculative investors who consistently take losses on their tactical positions.

This is ok for them, because the prices of the assets they hold, and the required returns on those assets should still reflect the basic opportunity cost of deferred consumption and risk.  So, the required return on passively owned liquid assets should remain at our hypothetical 9%, but if speculators and entrepreneurs become more skilled or more active, the total return to productive assets might rise to 11%, with passive investors retaining 9% after taking their passively speculative trading loss.  The anchor point for all of these returns should be that passive required return - 9% in my hypothetical.  (Looking at equities - ignoring bonds, etc. - the difference between this hypothetical 9% and 11% gain can be seen, at least partially, in the excess returns of small cap stocks over large caps, over time, or in the difference between total returns as estimated by all US corporations in the Federal Reserve's Financial Accounts vs. total returns to the S&P 500.  It is a difficult thing to measure.  But, I think the large amount of innovation and entrepreneurial activity related to the tech revolution, which is an example of what I am talking about here, explain the broad public sense that there has recently been an unusual amount of capital income given the mediocre returns that traditional equity ownership has actually provided over the past 20 years - even if the 90s boom period is included.)

It seems counterproductive to see the activity that creates liquid productive assets as the one activity that is extractive or especially motivates us to tax it.  On the other hand, one could say this about taxing all value that is created by labor.  So, I think I could agree with some arguments for taxing some of the excess returns to certain kinds of capital income, but I have a reaction against the rhetorical treatment that usually is associated with appeals for this sort of taxation.

Wednesday, September 23, 2015

Housing, A Series: Part 63 - More Evidence that Mortgage Repression is creating a bust, and there was no bubble.

An interesting article from Real Estate Economy Watch (HT: Todd Sullivan).  The gist:
We are deep into the best market for home sales in nearly a decade and the latest hard data shows that it is just as difficult to qualify for a purchase mortgage in July as it was last March–or even in March 2012.
Since the crisis, all-cash buyers, institutional buyers, and investors have pulled up some of the slack in home buying from households who have been pushed out of the credit market.  I think some of the headwinds in housing recovery and the continued excess returns to homeownership are due to organizational limits to how quickly those buyers can expand over large portions of a market that has always been dominated by owner-occupiers.

I have been waiting to see a recovery in mortgage credit markets as a signal that owner-occupiers might begin to return to the market.  There have been faint rays of hope, but generally this proposition has not yet come to pass.  There were signs late last year that regulatory constraints on conventional mortgage standards might loosen.  But, as the article suggests, this just may not be in the cards.  So, I think we will need to see some sort of substitution within the mortgage credit market.

This is why I would have hoped to see more expansion in closed-end real estate loans retained by the banks.  But, this has been disappointing.  There appears to be a burgeoning rent-to-own market, and new single family homes built for renting.  But, I think we also need to see growth in non-bank mortgage lending.  Private securitization markets will probably face many of the same headwinds as conventional securitization markets, so it looks like what needs to develop is non-bank, retained asset mortgage industry.  As with rented single family residence housing, this currently represents a small segment of the market, so, as with all of these residential real estate trends, it looks like there are organizational limits to the amount of growth that is possible in the short term, if it isn't going to come from traditional sources.  In this first graph, we can see that Ginnie Mae loan levels, after many years of stagnation, are the only source of mortgages that has grown since the crisis began, capturing back some of the low down payment market that had been moving into private pools.  All other mortgage holder groups have declined.  So, at least as of 1Q 2015, there had not been a resurgence of mortgage growth outside of federal agencies and banks.

We can see the effect on building by comparing residential and non-residential construction.  I think we can see several patterns here.  First, while non-residential construction has been generally declining as a portion of GDP for a long time, it has recovered to near pre-crisis levels.  (Note, incidentally, the very strong growth in manufacturing construction over the past year. In fact, it looks like manufacturing spending had previously begun to recover from a lull in the 2000s, but was interrupted by the recession.)  Residential construction spending rose to an unusually high level during the 2000s, briefly peaking at the start of 2006 about 50% above the normal level, then falling to about half the normal level from 2009 until today, with a slight upward trend.

I think residential construction spending was inflated in the 2000s, in part, because of the supply constrictions in the major cities, so that we were substituting billions of dollars of lumber and gypsum board in the exurbs for billions of dollars of valuable locations in the air above residential neighborhoods of our high density development-phobic cities.  This caused home sizes and construction spending to increase and productivity to decrease, relative to the alternative.  But, in any case, as with most indicators of residential investment, this appears to show a boom in residential construction in the 2000s followed by a larger bust in the 2010s.

But, was it a bubble, fueled by subprime mortgages and federal home ownership policies, that pushed home prices into unsustainable territory?

CoStar publishes indexes for Commercial Real Estate similar to the Case-Shiller Indexes for Residential Real Estate.  Here, I have graphed two CoStar indexes: Multi-Family Residential Housing and non-residential construction.  And I have compared them to the Case-Shiller National Home Price Index.  All are indexed to 100 at December 2000.

In terms of prices there is very little difference between the Case-Shiller index for single family homes and the CoStar index for multi-family properties.  And non-residential (retail, industrial, and office) prices follow fairly closely, generally rising and peaking about a year after residential prices, but peaking at the same level as residential prices, relative to prices in the 1990s.

After the crisis, single family home prices look like they were probably boosted by temporary homebuyer support programs in 2009 and 2010.  Multi-family and non-residential real estate bottomed in 2010 and have been rising by low double digits annually since then.  In the aggregate, both types of real estate are above pre-crisis price levels - multi-family real estate is much higher.  Meanwhile, single family home price increases are moderate.

Source : accuracy of real rate, from most to least is: green, red, purple.
Subprime loans and federal homeownership programs weren't pushing prices of commercial real estate up.  Given the parallel behavior of these real estate classes, there is no reason to believe they pushed up single family home prices either.  The main place on this graph where mortgage markets appear to have an effect is since 2011, where a lack of mortgage access is preventing single family home prices from recovering to normal levels.  (Here is a graph that shows the divergence after 2007 between real long term yields and implied yields on homes.)

Non-residential real estate has continued to rise, reflecting low real interest rates and general inflation over time.  Multi-family residential real estate prices are probably rising even faster than non-residential prices because the decade-long supply depression has created significant rent inflation and expected future rent inflation, and the foreclosure crisis pushed many families into rental housing, pushing up rents.  Also, multi-family housing, as a class, is especially exposed to the high rents from the dysfunctional cities.  Rents on single family homes are rising, too, but the difference is that multi-family housing owners have access to credit outside the single-family mortgage market.  So, those properties can be bid up to their reasonable market prices.

Single family homes may need to appreciate another 30% to trigger the complex set of market reactions that will lead to the robust new building that we desperately need.  Commercial real estate prices have risen that much more already because developers can usually charge market rents on commercial real estate in the big cities (Who is going to complain that rents on corporate offices are too high?), nobody frets about affordability indexes for corporations, and nobody demands that we fine or jail bankers for making "predatory" loans to commercial borrowers.  Single family homes face all of these obstacles.  In modern America, maybe the best you can hope for is that populists hate you enough that they stop coming up with imaginary problems that they have to fix for you.

Tuesday, September 22, 2015

More Signs of Life in the Treasury/Homebuilder Position?

Closed-end real estate loans at commercial banks remain flat, after showing some life early in the year.  There have been a few other signs of life, though.

Friday, the Fed published the Financial Accounts report for 2015 2Q, which is slower than the weekly and monthly bank reports, but more comprehensive.  Finally, we are seeing an increase in mortgage levels.  Maybe non-bank alternatives to housing funding are finally filling in the housing gap for owner-occupier households.  It's only 1.6% annualized growth, but at least it is strong movement in the right direction.  After a few years of mortgage growth at the top end of the 5% to 15% historical range, we have had a decade of negative mortgage growth.  And practically everyone I talk to believes that high rents and high home prices are a demand problem.  This suggests that the Great Recession created a mental virus that may infect our national psyche for years.  But, at some point, if building a reasonable number of houses doesn't cause Armageddon to arrive, maybe everyone will tip-toe back from crazy land and believe it's ok again.

The recovery of homeowners' equity has continued, after a brief rest in 2014.  I think we may have reached the tipping point where mortgage growth and equity recovery create a virtuous cycle of new activity that helps prices and building to recover more, although homeownership continued to decline sharply in 2015 2Q.  At the current pace, we will be back to pre-bust equity levels by mid-2016.

Mortgage growth probably needs to get back above 5% to really gather enough demand to push homebuilding back to normal ranges.  I recently posted a graph about housing starts.  Here is a graph of private fixed investment.  It tells a similar story.  As of the end of 2003, private investment in structures, as a portion of GDP, was moving along within historical ranges.  Then, there was a brief jump slightly above historical ranges, followed by a decade long depression where investment in structures has been below all post WW II recessionary contractions.  A decade.  As with housing starts, this suggests that building could grow quickly until it is back to 2005 levels, and would need to continue at that level until after 2020 just to make up for the lost decade.  If we will allow it, homebuilder revenues should eventually run at double today's revenues for some time.

In total, the 2004-2005 boom together with the drop below trend in private residential structural investment is responsible for a net 6% gap in GDP.  Residential recovery could add 1% to real GDP growth for 3 full years.  But, this is investment, so the investment will add persistent value.  Currently residential real estate annual gross value added is about 7% of home values.  So, if we can build that missing housing stock, real GDP will have a persistent annual boost of nearly 0.5%.

In this graph, we can also see the tremendous drop in multi-family structural investments.  In the 1960s, this ran at about 1% of GDP.  Now, at what many consider to be an expansionary point in the cycle, multi-family structural investments are not even 0.3% of GDP.  Most of those cranes that are populating American cities are building commercial space, because nobody ever protested a developer's public meeting in order to demand below market rents for corporate offices and chain stores.

The treasury side of the position is still questionable.  If the Fed continues to be hawkish, it may be a long time before bonds have a 2%+ inflation premium.  Real rates should climb as housing expands.  But, if we don't let housing expand, then the divergence between returns to housing and real treasury returns will remain.  Over the long term, the only real way to enforce this divergence as home equity builds is to induce a recession.  Allowing housing to recover might solve most of our supposed stagnation problems.  If we don't allow it, income based residential investment trusts could provide excess returns for some time, while the rest of us muddle along wondering what is wrong with the American economy.

Right now, we could really benefit from more money, more houses, more bankers, more immigrants, and a higher trade deficit (by which I mean more capital inflows).  You know, just like all the presidential candidates have been saying....

Monday, September 21, 2015

Housing Tax Policy, A Series: Part 62 - Inflation, real incomes, and home prices

This is probably ground I have treaded through already, a time or two.  Timothy Taylor had a post recently that reflected his typical level-headed and reasonable approach.  In the post, he is defending the Fed's role in the crisis, as having plausibly prevented some version of another Great Depression.  I think he is correct, as far as it goes.  I would say that, while the Fed threw us a life preserver, it may happen to have been the one who pushed us off the boat.

In any case, his post is a nice review of some of the economic dislocations that occurred after the recession bottomed.  The most striking graph may be this one:

Over four years, home values pushed about 25% above the historical range, relative to GDP.  Then, in three years, dropped by 50% to a point below the historical range, and have now recovered back to historically typical values.

He includes the next graph, though, that relates to the rent inflation topics I have been studying.  He compares home prices to CPI inflation:

Theoretically, this should be coherent.  Various arbitrage tendencies should work to keep rent and home prices growing at the general rate of inflation over time.  The problem is that limits to housing expansion - largely regulatory in nature - cause prime real estate to be bid up, as incomes grow and the real housing stock stagnates.  So, in practice, shelter inflation and comprehensive inflation have diverged.  Given this divergence, it seems clear to me that the proper comparison is home prices and shelter inflation.

In the next graph, I have added some additional measures to Taylor's graph, and I have indexed them to 1975 values instead of 2000 values.  The blue line is the Case-Shiller national home price index.  The dark green line is CPI inflation, the higher light green line is Shelter CPI inflation and the low medium green line is a very rough approximation of Core CPI excluding Shelter.  The red line is average hourly earnings and the orange line is median household income.

We can see that home prices are generally tracking with shelter inflation with a sharp rise above trend in the past 15 years.  I think we need one more adjustment, which is to use a log scale, which in Taylor's defense is sometimes difficult in Fred.  Here I have downloaded the data from Fred and charted it in log scale.  There is still a bump in the 2000s, but the linear scale exaggerated recent proportions relative to previous levels.  Also, this makes it easier to see how much the growth of price levels across the board have leveled off compared to the 1970s, and current home price levels don't look as far from the long-term rent trend as they do in the linear scale.  Relative to rents indexed to 1975, home prices are about 15% above the rent trend level and are still about 30% below the relative top price levels of the mid 2000s.

Even if we conclude that home price levels should be back to the trend measured by rent inflation (and I don't think we should, given low secular real long term interest rates and building constraints), we can see how monetary policy that led to 3-4% inflation, similar to the 1990s, would have been capable of helping to pull home prices back close to trend without creating a nominal crisis.  This is basically what did happen in the early 1990s.  We seem to have come to a consensus that stability is not a universally applicable policy goal.

Looking back at the previous graph, I think we can see the effect the housing constriction has had on real incomes.  Median real incomes and wages have grown somewhat over the past 30 years, but rising rents have eaten up the real growth.  So, if we adjust nominal incomes with CPI, median real incomes look stagnant, but if we adjust with CPI ex. Shelter, there has been some growth.

Given that there has been some additional growth among high income labor, the use of more aggressive inflation adjustments exaggerates the amount of inequality.  And, I think that is the proper way to describe this.  Given that shelter expenditures have been level for about 40 years, in nominal terms (as a proportion of total spending), but real shelter expenditures have fallen sharply, it appears that, in the aggregate, the elasticity of demand for housing is roughly unitary.  Considering the wide range of housing investment over this time, and the substantial drop in real housing consumption (as a proportion of total spending), the trend of nominal shelter expenditures running flat for the period at about 18% of total PCE is striking.  This suggests that the excess inflation related to shelter is related to supply, not monetary policy, and that we might be better off conceiving of real adjustments to income by using CPI ex. Shelter.  The additional real income that goes toward bidding up the shrinking relative housing stock is a consumption choice.

Of course, the aggregates hide a lot of individual idiosyncrasies.  The constraints on housing create a lot of movement within the economy as households realign themselves with changing reality.  We can see this in dramatic fashion in the most constrained cities where longstanding tenants complain about gentrification and rising rents.  The problem is sharp enough that it has begun to define political movements.

Normally, a family who are long-term tenants in a house gather consumer surplus from their extended tenure.  The value they receive from the property increases as their relationship with the local community deepens.  When developers purchase entire neighborhoods for new development, we can see this play out when some households refuse to sell their properties, even at values well above market rates.  Those values don't reach their substantial level of consumer surplus.  In the cities today, we are seeing the opposite.  Rents have risen so high because of supply constraints that market rates have risen above the level of consumer surplus gained by longstanding residents.  They are being forced out of neighborhoods that, to their senses, have not changed.  Rent as a proportion of income in these neighborhoods has increased over time, to a point that is no longer sustainable.

The problem is that this problem has festered for so long that if the cities with those neighborhoods did allow supply to grow, there would still be a long period of adjustment before rents declined enough for the influx of households would reflect the socio-economic norms of the long-term residents.  So, those residents fight new supply, because it appears to only worsen their situation, because they associate the new housing units with rising rents.

But, these residents are only one side of the coin.  Many families, faced with the supply constraints of the high rent areas choose to move to lower cost cities.  This movement aligns costs with incomes, but gets lost in aggregate numbers.  State-level cost of living adjustments raise the level of measured poverty in places like California, New York, and Washington, DC.  At the top of the income distribution, households are bidding up rents in order to gain access to high income labor markets.  At the bottom of the income distribution, households accept a high cost of living until they can't manage to any more, and then move to lower cost areas.  (Actually, even relatively high income households are being forced out of the worst cities.)  There is probably a bifurcation of individual outcomes here.  High income households moving into these cities claim a higher portion of compensation because of the limited access to those markets.  Relative to aggregate measures, low income households who lived in those cities but moved should tend to have seen higher real income growth than their raw incomes would suggest due to their reduced cost of living.  Low income households who have remained in those cities should tend to have seen lower real income growth due to the excess increase in their cost of living.

In the meantime, regarding the labor/capital split, higher rents (and imputed rents to homeowners) would cause capital income to rise, and for measures that include capital gains, the associated rise in real estate values would also cause capital incomes to rise, and would create very large reported incomes for households who have sold a property.

This graph, from some recent work by Josh Bivens and Lawrence Mishel at Economic Policy Institute, does a great job of helping to consider the different aspects of recent wage divergence.  The top line estimates the growth in productivity since 1973 and the bottom line estimates the growth in real median compensation.  I am not going to try to engage in detailed statistics here.  There has been a lot of conversation about this graph, and I think others have debated the details well.  But, I would like to conceptually consider the effect of a supply constraint on these numbers.

The difference between the top line and the next line is the amount of marginal production since 1973 claimed by capital as opposed to labor.  Labor has seen a growth of 63% in real compensation while productivity has risen by 72%.  This next graph estimates the portion of domestic income captured by residential real estate owners, after depreciation and expenses.  This reached a low point in the mid 1970s   Since then, it has grown from about 3% of GDI to about 5% of GDI.  I estimate that this accounts for roughly half of the difference between compensation and productivity growth.  Note that most wage-earners are homeowners, households are divided between those who are simply earning rents on the supply constraint outside measured wages and those who must pay rents to a landlord.  But, in any case, this has more to do with land-use policies than it does with the distribution of productive output or the negotiating power balance between workers and employers.

The next gap is the difference between real compensation adjusted with consumer inflation versus producer inflation.  Here is a graph comparing CPI for all items, CPI for all items except Shelter, and the GDP Deflator, all indexed to 1973.  Here, again, we can see that nearly half of the gap is explained by housing inflation.  So, we have the same issue as with the labor/capital split, regarding total incomes, cash and imputed, for homeowners vs. renters.  (Also, we can see how sensitive these long-term measures are to the deflator.  In the comparison between nominal 2014 activity adjusted for population, and nominal 1973 activity, the deflator accounts for more than 80% of the difference.)

If we use price measures as a proxy for demand-side inflation, but the shelter component is the result of a supply issue, then using an inflation proxy that includes shelter inflation is double counting, I think.  Housing is unique in this way, in that the marginal cost from inflating rent goes to land, which is fixed in quantity.  If inflation is high because bananas have been especially costly over time, this is mostly a reflection of higher costs, and would be embedded in a net of opportunity costs and tradeoffs that would be difficult to disentwine from monetary inflation.  But, the consistency of nominal housing expenditures, and the inevitable capture of excess expenditures by land owners as unusual capital income, means that this sort of inflation reflects the transfer of income to rentiers instead of costs.  (The existence of natural arbitrage tendencies that would tether long term home values to general inflation levels seems to be generally accepted, leading to the use of CPI inflation as a trend input for home prices, as Timothy Taylor did in the post that started me off here.  But, oddly, this assumption is used in spite of the clear divergence of shelter inflation from general inflation.  This seems to lead to demand-side arguments about housing bubbles, whereas it seems to me that the acknowledgement of this long term divergence should lead us to supply-side explanations.  In other words, it seems that almost everyone models home prices as if that arbitrage has happened without bothering to notice that it hasn't.  We should all be in agreement that that arbitrage should happen.  Cutting off housing supply through credit and monetary tightening is just making matters worse.)  If we agree that the increased rents reflect a transfer of economic rents from tenants to landlords, then I think we must agree that the excess shelter inflation reflects this transfer rather than a change in the relative value of the dollar.  That being the case, I think that some of the "Terms of Trade" gap is due to a flawed inflation measurement.

And, I think, even within the "Inequality of Compensation" gap, some will be explained by the rents that are captured by high productivity workers who live in the housing constrained cities and by the various movements in and out of those cities as workers align their income potential with the cost of living in various locations.  If a worker making $150,000 in Austin can move to San Francisco and make $200,000, but they have $25,000 additional rent expense, then their real income has only increased by $25,000, not $50,000.  Using nationally aggregated inflation adjustments will exaggerate the level of income inequality in this case.  As Hsieh and Moretti point out, both the $25,000 in additional rent and some of the rest of the additional $25,000 in income can be attributed to the effect of housing constraints on incomes and rents in San Francisco, so there are several subtle ways that this problem leads to more income inequality as it is generally measured.  This effect is far too complicated for me to estimate here.

At the risk of being that guy that's always obsessing about housing, I agree with those who note that this is much more of a wage distribution story than a wage vs. profit story, and I think a good portion of these wage distribution issues are related to housing.

Saturday, September 19, 2015

More Perspective on Housing Starts

Average Annual Housing Starts, 1959-Aug. 2000:

3 Worst 5-Year Periods for Housing Starts from 1959 to 2000:
Sept. 1965 - Aug. 1970:  1,365,000
Jan. 1979 - Dec. 1983:  1,375,000
Mar. 1989 - Feb. 1994:  1,210,000

Average Annual Housing Starts, Sept. 2000-Aug. 2015 - a 15 year period which includes the housing "bubble":

So, the worst 5 year period for housing starts in the modern era was followed by a 6 year period with average housing starts (1,517,000 from 1994 to 2000).  This was followed by a 15 year period that has had lower housing starts than any of the other 5 year periods in the modern era.

Yet, practically everyone I speak to says home prices and rents are going up because we have a too much money!

Apparently, there is nothing too outrageous for there to be a national consensus about it.  There are arguments about efficient markets, which have not been settled.  But, is there any question about what would happen if we had stable regulatory and institutional foundations that weren't bent on adjusting market conditions?  We'd be building houses!  And all the people complaining about demand and bubbles would be buying them.  Because we are only insane in the abstract.  We are usually sane in practice.

The problem isn't market efficiency.  The problem is that consensus leads to policy, and policy has a real effect on the market.  We can argue about whether, on a scale of 1 to 10, market efficiency is a 7 or a 9.  But, public policy can go off the rails.  It is capable to getting pinned down at 1.

Group beliefs are strange.  They say you can't reason someone out of something they weren't reasoned into.  But, we all think we were reasoned into our beliefs.  When consensus beliefs reach a certain level of absurdity, strange group behaviors begin to take shape.  There is some tipping point, where the absurdity of the belief itself creates a barrier against accepting rational, disciplining information, because it becomes difficult for the group to correct in a face-saving way.  We naturally rationalize the delusion.  We are now engaged in a subconscious national Ptolemaic drama.  The problem is that this process is unpredictable because it is not constrained by reason.

This particular issue is not even moderated by arbitrary bipartisanship, because the absurdity has captured virtually the entire spectrum of political viewpoints.  Antipathy to finance is a useful unifying device.  But, the worse things get, the harder the face-saving becomes.  I don't have a confident image of how the American populace will be able to allow housing to normalize.  The mechanisms that trigger new housing will probably lead to recovering prices before they lead to a supply response that will be strong enough to eventually lower rents, and therefore eventually prices.  Can we get there?

Wednesday, September 16, 2015

August 2015 Inflation

It looks like we have more of the same.....

Both Core minus Shelter and Shelter inflation moved down on a month to month basis.  Year over Year rates continue to be just over 3% for shelter inflation and just under 1% for core minus shelter, adding up to Core CPI inflation of about 1.8%.

Core minus Shelter inflation has been running close to 1% for about 2 years now.  Except for a few months at the end of 2003 and beginning of 2004, Core minus Shelter inflation hasn't been this low since before the high inflation period of the 1970s.

On a month over month basis, Core minus Shelter inflation has now fallen for 4 straight months.

Considering the supply influence on shelter inflation, together with the very low levels and negative momentum in non-shelter inflation, I assume there will be a lot of conversation at this week's FOMC meeting about lowering interest rates in order to boost nominal activity.  It is times like these that I am thankful we have decided to manage the quantity of money through a committee of experts instead of exposing ourselves to the whims of market forces.  For all we know, without the direction of these wise people, natural forces would just be pushing us deeper into nominal stagnation....

Tuesday, September 15, 2015

Housing Tax Policy, A Series: Part 61 - Strong prejudices and imposed malaise

A few days ago, I happened to be listening to NPR's "Morning Edition".  The show's introduction was:
Here are two major effects from California's long-running drought.  If you work on a California farm, you are making less money.  If you own a California farm, you may be making more.  We'll report both sides of the equation this morning......
What followed were two stories.  One from a farm with limited access to water, and one from a farm with access to water.

In the first story, they describe the consequences that having a limited harvest has on the workers.  Many acres weren't planted, and those that were have smaller fruits because of the lack of water.  The reason workers are making less money is that there is less fruit.  Though this work is usually paid piecemeal, some farms are paying higher piecemeal rates to help counteract the effect of the poor harvest for the workers who remain.  Nevertheless, these workers live lives on the margin, and they have few resources at their disposal to survive during these challenging times.

In the second story, which directly followed the first story, they describe operations at the farm with water access.  We learn that prices rising due to falling production are helping, though there are signs that they will not remain high.  Further:
While prolonged drought has strained California agriculture, most of the state's farms, it seems, aren't just surviving it: They are prospering. 
The environment, though, that's another story. We'll get to that.... 
farmers in 2014 replaced about 75 percent of their surface water deficit by draining their groundwater reserves.
James McFarlane, who grows almonds and citrus near Fresno, is one of those farmers. He says that drought has been "beyond terrible" for some farmers. But for him personally? "It's been a good year. We've been able to make some money, and you have to just count your blessings and call that a good year," he says.... 
Howitt says that there are two contrasting realities in California agriculture these days. "Some people just don't have the underground water. You meet these people and they really are in poor shape," he says. But where there is water, "you have investors pouring money into planting these almond trees at a rate that they've never seen before." 
But this is also where the environmental damage comes in.

The interesting thing about deeply ingrained prejudice is that it comes from perceptual blinders we don't realize we are wearing.  The prejudice that has the strongest hold on us is the one we wear on our sleeve.  So, the story presents the facts that belie NPR's framing without hesitation.  These stories and the way they were framed are a textbook example of how our biases can control our perceptions so strongly that our perceptions become our biases.  Uncritical listeners will come away from the presentation of these stories with some caustic new perceptions.  Workers are damned if they do and damned if they don't while big-agribusiness gets by just fine, even if they have to destroy the environment to do it.  But, the preconceptions are doing all the work here.

In any volatile economic situation, owners accept the most exposure to that volatility, by design.  Of course, low income workers may be less able to weather volatile conditions, but, for instance, at the water-deprived farms, where workers have less work, the farms will be losing money.  Even in the face of the economic disruption, NPR tells us that some of those farms are raising their piecemeal rates to help workers get by.  In other narrative contexts, where farmers are seen as salt-of-the-earth families, the volatile nature of farming is easy for us to notice.  That story is an archetypal narrative in American culture.  The farms in these stories are only different from those farms in that they may be better capitalized to survive a temporary problem, but they are just as exposed to the vagaries of nature and markets.

So, what we have here is a volatile situation, where at some farms the workers and the farmers are not doing well and at some farms the workers and farmers are doing quite well.  And, in dollar terms, the farmers have both the worst and the best of it, because they accept more of both the downside and upside risk.  NPR sends reporters in to the poor farms and notes the woes of the workers and sends reporters in to the prospering farms to note the success of the farmers. "If you work on a California farm, you are making less money.  If you own a California farm, you may be making more."

The condition I describe is not complicated, nor hidden from plain view.  And, I would believe that the reporters and producers involved in this story had every intention of conveying an honest account of these settings.  I suspect that the self-editing of perception is so strong on this topic that they simply did not notice half of the reality that was staring them in the face.  It's like they were wearing eyeglasses with polarized lenses that filtered out prospering workers and failing owners.

This selective perception creates a motivating set of apparent facts.  For instance, the possible mismanagement of groundwater looks like it is simply in service of speculative gains by corporate farmers.  How differently would we think about the environmental issue if the stories were framed around failing farmers that didn't have water and prospering workers who were working at farms that did?

We have an understandable bias to believe that the cost of labor is always too low and the returns to capital are always too high.  Ironically, it is specifically returns to risk-taking that we tend to deem too high.


These biases play out starkly in the way we conceive of national economic management.  We have few misgivings about creating an upward biased safety net under aggregate wages.  This is effectively the justification for a slightly positive inflation target.  And, it is a good justification. Money illusion is real.  There is no point in fighting it when we have fairly straightforward ways of mitigating it.  So, there is general agreement that polices which keep nominal wage growth safely above zero are probably helpful.  They probably help to minimize unnecessary frictions that would keep labor markets from functioning healthily.

But, these same issues are factors in capital markets, too - especially among low risk asset classes or assets where we have policies that encourage high leverage.  These factors may even be more important when applied to capital, in terms of creating a stable economic atmosphere.  The aggregate nominal value of collateral has its own zero bound problem.  When there is a systemic collapse of nominal collateral values, all sorts of financial transactions and relationships break down.  As with wages, there is an easy solution - manage nominal values with a bias toward slight inflation.

Let's just sit and notice our feelings about that for a second.  Think about your feelings regarding inflation meant to keep many workers employed, who for one reason or another, find themselves with sticky nominal wages that are above the current market clearing wage level.  Now, think about your feelings regarding inflation meant to keep many investors solvent, who for one reason or another, find themselves with collateral valued at less than the debt it is securing.

I submit that, especially if we are talking about a condition where these nominal declines in value are widespread, there is very little difference between those two scenarios.  The main difference comes from our biases about them and our deep, subconscious moral reactions to wage labor vs. capital income.

Imagine if the biases were reversed.  Would we argue that countercyclical monetary policy was dangerous because workers who were routinely rescued from unemployment would become soft and entitled?  Would we argue that workers who are spared the fear of mass unemployment will become irresponsible in their wage negotiations?  Would we complain that 3% inflation was just a bailout of workers?

At the base of the causes of our recent malaise, I lay this bias.  In hindsight and in foresight, monetary and regulatory policy built around the goal of stability would have allowed us to avoid an enormous amount of damage.  Yet, even having seen the damage, can we even suggest in louder than an uncertain whisper that, maybe, just maybe, it would make sense to err on the side of liquidity when aggregate, national home price levels were down 5%, 10%, even 15%?

It is striking to me how much this anti-capital attitude resonates - how much of our peripheral vision is blackened by our moral pique.  Thinking again of farmers, would we feel any moral ambiguity over some historical episode where farmers were losing their land as values declined by 5% or 15% or 25%?  Would there be any doubt about their role as victims in that narrative?

Yet, were homeowners in the recent disturbance qualitatively different than the archetypal farmer in that story?  But, we became so convinced by the path of nominal values (a path that, frankly, was not particularly out of line in our post-WW II experience, even in terms of unsophisticated nominal measures of valuation) that this belonged in the category of "speculation" that we demanded comeuppance and lesson-learning over stability.  The crisis was simply a playing-out of our moral demands over time.  We imposed damage on nominal capital until the damage was so great that it led to damage on nominal wages, and only then could we give ourselves permission to manage for stability.

Our moral demands meant that homeowners, who were mostly middle class families, took a massive hit to our net worths.  We try to substitute "predatory lenders" into the narrative, in order to keep the moral cast of characters coherent, and many find it easy to make this substitution.  But, if we think about this for a minute, it's not a very satisfying substitution.  In effect, it says, it's the lenders' fault that we had to impose this nominal instability on innocent households because if we had managed nominal stability, the lenders would have kept preying on us.

Maybe I am wrong about all the pesky details surrounding the housing boom.  But, I think pointing out that home prices were justified by the present value of future rents, that incomes of new homebuyers weren't unusually low, that the levels of down payments and monthly payments weren't unusual, that defaults seem to have come from price declines instead of from poor credit characteristics of home buyers, and that all of these points continue to be confirmed by rising rents and home prices that are rising with no help from mortgage markets, is sort of like pointing out that a military conquest was ill-advised after thousands of soldiers have died in its cause.  Social reexamination is a long and unlikely process.  This perspective I am laying out may be wrong or right, but in either case it will appear to be antagonistic.

In the meantime, we will continue to notice always that labor is too cheap and capital is too rich.  Those California farms contain either undercompensated labor or overcompensated owners.  This is the complete set of available observations.  Opinions on the Fed appear to come in four categories these days.  Either the Fed is too tight because Wall Street wants to keep wages low, or it is too loose and the de facto cost of living is eating away at wages.  Either the Fed is too loose because Wall Street loves rising asset prices or it is too tight because bankers hate to see the present value of those interest payments eaten away by inflation.  What we all know to be the case is that the Fed is under the thumb of moneyed interests.  We can disagree about the facts that confirm it.

Likewise, either home prices and stock indexes are too high or rents and profits are too high.  Too high.  Always too high.  There will always be a bubble in capital asset markets, the question is only whether the bubble is in their numerators or their denominators.

The alternative might have been to hold the Federal Funds rate at 4% or so back in 2005 and to provide regulatory support for mortgage originations.  Maybe we would have seen inflation reach 3% or 4% while home prices fell slowly in real terms over several years as supply continued to expand.  I fear that a plurality of Americans, even knowing the pain we have endured and even accepting my counterfactual, would choose the path we took - would say that accommodating the continued expansion of homebuilding would have been unacceptable relative to the path we took.

The one complaint about crisis policy that is a guaranteed applause line is to complain that after September 2008, we bailed out Wall Street while Main Street suffered.  Why shouldn't they applaud?  After all, I think I heard on NPR that, even while unemployment remains elevated, many corporations have been reporting record profits.  Ain't that always the way it is, fella?  Ain't that always the way it is?

Monday, September 14, 2015

Housing Tax Policy, A Series: Part 60 - Financial Engineering for Insurance & Speculation

I have sided with defenders of the GSE's.  Fannie & Freddie portfolios sharply leveled off at the end of 2003, and the Ginnie Mae portfolio was as small, in nominal terms, in 2005 as it had been in 1990.  The private mortgage pools were largely filling the gap left by the GSE's.

If private pools hadn't filled the gap, 2004 would have seen a contraction on the order of 1980 or 1990.  It looks to me like a good deal of the new private pool and subprime loans were replacing Ginnie Mae loans.  And, Ginnie Mae loans have long been a source of low down payment mortgage options.  So, to a great extent, low down payment subprime options were simply providing a similar service to what Ginnie Mae had been doing for decades.

Here is a graph of issuances, by pool type.  Here, we can see how private pools grew before 2004 while Ginnie Mae issuances remained low, and then from 2004 until the collapse, private pools barely made up for the sudden drop in Fannie & Freddie issues.

Proportion of total $ outstanding.  Source
And, I think this third graph is striking.  This is a graph showing the proportion of all loans outstanding, by holder type.  Here we can see in sharp relief how the rise in subprime and private pool loans was almost completely in response to the decline of Ginnie Mae loans.  The proportion of loans securitized leveled out in the early 1990s, before home prices began to rise.  Then, from 1998 to 2003, the combined level of Ginnie Mae and private pool loans actually declined.  And, when the combined proportion of Ginnie Mae and private pool loans did grow after 2003, as we see from this graph and from the graphs above, it was making up for the sudden sharp drop in Fanny and Freddie loans.

Part of the Ginnie Mae package of requirements, together with low down payments, is mortgage insurance.  This provides protection to the investor, in case of default, but tends to be somewhat expensive.  I wonder if the expansion in the late 1990s and early 2000s of subprime and low down payment mortgage options came about because private alternatives developed that created less expensive forms of mortgage insurance.  This graph suggests that there wasn't a change in the prominence of low down payment mortgage options; there was just a shift from Ginnie Mae to private loans.  This explains why survey and loan level data for the period doesn't appear to back up the broadly held belief that down payments were unusually low during the boom.  One oddity for me has been that people who worked in the mortgage business tend to agree with the consensus that there was a rise in low down payment loans.  But, if the reality is that those loans were being funded in private pools instead of through the channels that would have facilitated Ginnie Mae funding, then they would have that impression, and all of these apparently contradictory pieces of evidence would be true.

Let's think about what would happen with a Ginnie Mae mortgage.  The mortgage would be issued, and the mortgage borrower would buy mortgage insurance.  A mortgage insurance firm would accept monthly payments from the borrower, which they would pool and invest as a safety net for investors who could then treat pools of Ginnie Mae mortgages as safe securities.

The mortgage insurer sounds a lot like the lower tranches of a private MBS to me.

These are really just two different forms of financial engineering.  Are they that different?

Mortgage insurance seems to me like a sort of equity tranche that is required to keep its income in reserves for the other tranches.  It seems possible that MBSs could be designed to mimic this risk profile.  On the other hand, an MBS without deferred payments on the bottom tranches and with a broader range of lower rated tranches as a result is sharing risk more broadly, in a way that might even be more robust than a traditional mortgage insurer.

And, aren't investors in CDOs constructed from the original pools of securities sort of the equivalent of investors or re-insurers involved with a mortgage insurer?

It seems to me that the greatest difference may be in the market exposure.  On the borrowers side, this might have allowed the cost of these functions to fluctuate more efficiently with changing risk aversion and financial innovation so that the cost of these functions reflected market conditions.  I wonder how much this difference led to the stagnation of Ginnie Mae activity.  The market for MBS investors is much more efficient than the market for mortgage insurers.  Were private MBSs simply outbidding mortgage insurers in the competition for non-conventional mortgages?  I know that one reaction to that statement is that they were outbidding mortgage insurers and Ginnie Mae by offering gross yields that were too low for the risk involved.  But, I don't see how a mispricing would lead to a price collapse followed by a default crisis and a collapse of credit markets.  Why wouldn't that just lead to a shift in yields?  Shifts back and forth in yield spreads happen all the time.  This seems like a problem that normally fluctuating financial markets would be able to handle without a crisis.

On the lenders' end, this efficiency led to more volatility.  A mortgage insurer has natural exposure to a range of cohorts.  The lack of competitive efficiency that kept mortgage insurance costs high also led to a natural sort of diversification.  The millions of pre-2006 mortgages paying fees to the insurer would help buffer the large losses on the 2006 and 2007 cohorts.  In the private MBS market, there might be pockets of funds or investors with focused exposure on the troubled cohorts.  This was especially the case, in practice, since the switch from GSEs to private pools was recent, and young cohorts made up a large fraction of the available pools.  In this way, the sharp pullback in the GSE pools after 2003 increased systemic risk by creating an unavoidable anti-diversification of investment exposure in the private pools.

But, even more importantly, while a mortgage insurer would be treated as a constant in a Ginnie Mae pool, in the private pool, where the insurance was bundled with the investments themselves, the cost of the insurance fluctuated with market prices.  In a way, the advantage of the insurance model here is an accounting fiction.  In a market collapse like we saw in 2006-2008, the health of mortgage insurers will fluctuate, and mortgage insurers have had problems, as have most firms in the mortgage industry over the past decade.  But the opacity of their form of intermediation allows their clients to ignore those fluctuations until they become imminently problematic.

So, in 2007, when defaults were really only beginning to climb, house prices were collapsing in an unprecedented way, and the Fed was making it clear that they were going to do little to stop it, investors in private pools were left holding securities whose prices could collapse as much from falling expectations as from falling current incomes.  That's what functioning financial markets do.  They bring information back in time.

While MBS investors in that context were the first to find themselves in a liquidity crisis, a mortgage insurer in that context would not find meeting their short-term cash needs that difficult.  And, the lack of competitive efficiency might even allow them to raise rates temporarily above competitive levels in anticipation of coming defaults.

In the end, if our consensus public credit and currency policy is to allow a 25% drop in nominal house prices, it probably doesn't matter that much.  I doubt that any realistic credit system with low down payments would withstand that sort of volatility.  But, were the risk profiles of the private pools really that different than the Ginnie Mae pools we had been using for decades?

Thursday, September 10, 2015

August JOLTS news not so great

The August JOLTS report adds further concern about the strength of the economy.  I think the Openings measure is an outlier.  I think it might be signaling both cyclical strength and secular weakness.  The increase in Openings without similar movements in the other measures suggests a rightward move in the Beveridge Curve, which coincided in the 1970s and early 1980s with possible frictions in the labor market and rising secular unemployment levels.

While Layoffs remain very low, Hires and Quits have leveled off.  This could be an early sign of a cyclical top.  There is no reason why we can't coast along a high growth trajectory for many years, like we did in the late 1990s, but this would require a willingness to allow expansion.  In the current regulatory and technological context, that probably means rising wages, rising inequality, rising home prices, rising building, and rising debt.  A plurality of the country appears to be generally against the realistic achievement of growth that includes these properties, so I am just hoping we can have as much growth as we can get until that plurality pushes us into an unnecessary cyclical contraction.  Some forbearance from the Fed would be a nice step in the direction of allowing some reasonable growth.

Quits and hires are starting to look like the late 2005-2006 period, where the yield curve and JOLTS data both flattened.  These were early signs of a downturn.  I don't think a downturn is inevitable.  If the Fed raises rates and the yield curve flattens as a result, the danger of a downturn is high.  If we allow it, we could see expansion for years with relatively flat behavior among the JOLTS indicators.  But both hires and quits have been level for nearly a year, now.  This is beginning to be a pretty strong indicator of a maturing recovery phase.

Wednesday, September 9, 2015

Real Wage Growth and Tight Labor Markets

The Atlanta Fed publishes a lot of great stuff on their blog.  This is a recent post about Quits and wage growth.  What they find is that while wage growth does correlate strongly with Quit rates, wage growth rises most strongly, and more in line with quits, among job quitters.

From the Atlanta Fed post
This is why the relationship between real wage growth and inflation is not strong.  In the aggregate, employers and workers aren't locked into some ongoing negotiating drama.  It seems like they are, and this fits with our us vs. them narratives about fighting over income shares.  But, in the aggregate, there just isn't that much to fight over.

Profits, as a proportion of national income fluctuate by around 1% to 3% through business cycles.  Most of this is due to shocks that move profits out of equilibrium and labor out of full employment.  It seems that less than 1% of national income at any given time is available due to some sort of cyclical negotiating power.


The reason wages grow during expansions, when unemployment is low, is because of the quits.  The growth doesn't come from capturing more production from existing employers.  The growth comes from finding a job where you can be more productive.  The reduced frictions and risks of shopping your skills mean that you can match your skills better.  Laborers are becoming more productive, not simply because of the application of capital, but because capital is complementing their labor more efficiently, because small disloyalties can be committed by employees and employers without undue damage.  There are many more separations during expansions than there are during contractions.  It's just hard to remember that because the separations that happen during contractions are so painful.

It seems like this can't be the case.  In every workplace, there are individuals who provide value to the firm with sharp variance to their compensation.  And, between firms, there can be tremendous differences of returns to invested capital.  But, these represent inefficiencies that must play out within the realm of either labor or capital compensation.  There are too many interdependent variables and actors to remotely comprehend, but that mass of unpredictable, untrackable activity creates an aggregate result that contains very little systematically tradable income.

I believe some of the reduction in profit as a share of national income which we do see late in some of the longer expansions may be the result of lower risk premiums and more forward looking corporate capital allocation.  The effects of this tend to be overwhelmed by real shocks to the economy that happen subsequently, so it doesn't seem to carry on into long term growth rates.  For instance, growth rates are low now even though the late 1990s were a period of transformative corporate investment.  Maybe the effects just aren't measured well. Both the late 1990s and the late 1960s were at the tail end of especially stable periods where profits declined relative to compensation during healthy recoveries and both periods are known for creating a new wave of frontier firms.

In any case, it seems as though the overwhelming factor for positive outcomes is stability.  That seems to be associated with inflation rates in the 2% to 4% range.  Stability will be related to low unemployment and low risk premiums.  The risk to our economy of wage growth, if there is any risk at all, seems greatly overshadowed by the risk of business cycle instability.  If we are managing the economy as if low risk premiums and tight labor markets are problems to be avoided, then we are  doing it wrong.

PS.  Evan Soltas has an interesting post on this issue.  I'm still wrapping my head around all the ramifications, but he finds that while some sectors have increased their productivity over this period than other sectors, compensation within each sector has basically grown in line with productivity.  At the least, it suggests that average compensation tracks productivity at the sector level.  Evan argues that the standard intuition that compensation tends to track productivity seems to be a better explanation of changing distribution of compensation than changes in labor market institutions.

At least the Bivens and Mishel report from EPI seems to be moving toward defining the issue as about distribution of income within labor rather than about the split between capital and labor.  Their headline graph lends itself to unhelpful labor vs.capital narratives, but almost all of the differences between median compensation and average productivity, as presented in the graph, are happening within compensation and the cost of housing.  Maybe the conversation can move to productive grounds.  Confiscatory or obstructive policies toward capital income would be deeply unhelpful.  Evan's post, I think, is actually a good argument for pro-growth, pro-capital policies.  There would be great benefits to creating more opportunities for workers to move into the more productive sectors.  That could be accomplished through domestic capital formation and through more aggressive international trade.

Tuesday, September 8, 2015

Odds of Deflation

The Atlanta Fed posts some great stuff at their "macroblog".

Friday, they posted about a measure of expected 5 year cumulative deflation that can be estimated by comparing the yields of new 5 year TIPS bonds with the yields of off-the-run 10 year TIPS bonds that have the same maturity date.  Since past inflation on the 10 year bonds can be clawed back, but the new 5 year bonds can't have a maturity value less than the original value, the difference in their yields can be used to estimate the expected probability that there will be net deflation over the next 5 years.

Here is the graph from the post.

150904aThis probability has been negligible since late 2013, but it has re-appeared in the past couple of weeks.

You can see the shadow of monetary policy here.  The probability of deflation hit 30% after the end of QE1.  Then it dropped with QE2, and rose again after QE2 ended.  Then it dropped after QE3 began, returned briefly during the "taper tantrum", and subsided after the Fed signaled that it would be patient about tapering QE3.  Since then, the market appears to have seen no risk of deflation until now.

It seems to me that the natural interest rate has been tickling something above the zero lower bound, but recent turmoil has pushed it slightly back down.  It will probably continue to move up with the economy's natural recovery if we let it.  A rate hike now risks getting ahead of it.

While nobody on the FOMC seems to take responsibility for the discretionary tightening that culminated in the late 2008 collapse, it does seem as though the FOMC has made the right moves when they have had to, since then, even if they have been a little premature about withdrawing accommodation.  Let's hope they acquiesce to all of the signs one more time.  I suspect that within a few months, we will have seen some more recovery in the natural rate, and a rate hike won't be as much of a risk.

In the meantime, Friday's employment report coincided with a drop in equities and a drop in long term yields.  My Eurodollar model says the mean expected rate hike moved back about 1 month Friday, from early February to early January.  The market clearly thinks the risk of a September hike is high.

Stock valuations are based on real growth rates.  Expected real returns on equities are stable over time and have little relation to bond rates within normal operating dimensions.  Equities don't benefit from inflation.  They can be hurt, along with all of us, by shocks to real economic activity that can be set off by nominal shocks.  The Fed can't help equities by being too loose, but it can hurt it by being too tight (or too loose).  The idea that equity markets are helped by over-accommodation is fallacious.

Aswath Damodaran had a good post Friday touching on some of these issues.  My only quarrel is that he believes we are wrong to focus so much on the Fed.  I agree that the Fed shouldn't have to be our focus.  But it has to be our focus when Fed policy moves outside reasonable bounds and deflation or hyperinflation become palpable.  The Fed has been outside reasonable bounds since 2006.  A rate hike in September increases the chances of that context continuing.

Monday, September 7, 2015

Trust and the Sustainability of Free Economies

Here is an interesting article on trust and prosperity (HT: EV)  They describe the various ways in which broader social trust and expanding circles of expected fair treatment correlates with prosperity, with causation running in several paths.  This suggests that prosperity does not rest on a stable equilibrium.  Low trust leads to poor policies and illiberal behaviors.  Poor outcomes will lead to poor policies.

This reminds me of the Robin Hanson idea (which I can't find a good link to, but I will try to paraphrase).  Human progress continued to be delineated by the Malthusian context for foragers and farmers, even though there was some economic and technological progress because our ability to reproduce could outpace our economic growth.  But, the industrial age brought economic growth rates that were higher than our ability to reproduce.  This created a regime shift where capital accumulation was a better strategy for laying claim to future production than fertility was.  So, fertility rates decline substantially when cultures transition to capitalism and industrialism.

Possibly, the sustainability of liberal economies is a product of their ability to naturally recover from cyclical downturns.  Sort of like healthcare in the age of bloodletting.  The body's ability to heal itself is usually stronger than the doctor's inadvertent attempt at killing it.  Maybe free economies can heal themselves faster than we can kill them.

This is probably more tenuous than we would like to believe.

This article, also via Economists View, is probably related to this topic.  It describes a positive relationship between payday loans and liquor sales.  From the article's conclusion: "heterogeneity likely exists within the pool of payday loan users, and external factors will influence the ratio of `productive and counter-productive borrowers.' Lending restrictions can seek to reduce the proportion of counterproductive borrowers through the prohibition of practices known to harm consumers, including those that rely upon leveraging behavioral responses such as addiction and impulsivity."

I tend to want to come down in favor of freedom to contract in these cases, because I see a lot of anti-market bias in political activities, and most of the reaction against payday lenders seems to come from factions that don't acknowledge that heterogeneity.  But, there is probably some set of contract characteristics that becomes a signal, itself, of that contract's tendency to enable destructive behavior.

While it seems generally true that the twin pillars of trust and prosperity in our most vulnerable neighborhoods will rise with economic liberalism, which means the expansion of allowable activities, the relationship of these activities with a level of trust in the community is vital.  The delicate balance, however, is between encouraging a tableau of trust building activity and trusting our fellow citizens to make their own decisions, even when those decisions don't seem optimal to us.  The relation between trust and freedom is unstable, so freedom in a marginalized community can be destabilizing.  Yet, prohibition can become much more destructive than freedom.

How many of the seemingly endless stream of bad encounters with police officers are the result of the police enforcing petty crimes (not to mention the Drug War) or involve resisting or running because of past petty crimes, or possession of unlicensed or illegal firearms or substances?  So, on the one hand, it does seem defensible that marginalized neighborhoods might be better off, on net, with fewer payday loan stores.  On the other hand, it seems like the last thing those neighborhoods need is yet another normal, consensual, non-violent behavior to be driven in lawless black markets - yet one more behavior that is disallowed or used as a means for the state to prey on its citizens.  Could we  regulate payday loan stores more strictly while taking 20 other petty crimes off the books?

On that topic, the recent development of "Campaign Zero" coming out of "Black Lives Matter" seems like a surprisingly constructive turn, based generally on unifying and liberalizing ideas.  There are details I know people could debate, but the tone and direction seem positive.