Economists tend not to be very good at arithmetic. That’s why almost all of them failed to recognize the $8 trillion housing bubble and to understand that it’s collapse would wreck the economy.
Unfortunately their arithmetic (or logic) skills have not improved in the wake of the crash. Hence we have many economists telling us that the economy’s problem is a debt overhang. This gets picked up endlessly (e.g. Joe Nocera’s column today).
Let’s think this one through for a moment. As a result of the ephemeral wealth created by the housing bubble, people ran up far more debt than would have otherwise been the case. This means that people have far less equity in their homes than in a counter-factual where house prices had never diverged from trend.
Let’s say that collective indebtedness is $5 trillion greater than if there had never been a bubble. Now let’s have the great god of economic correctness clap her hands and eliminate the $5 trillion in excessive debt. Do we now see a consumption boom that gets the economy back on course?
If you answered yes, you get a PhD from a prestigious economic department and flunk basic logic. Our god just destroyed $5 trillion in wealth. Any increase in consumption from this act would be the result of the difference in the propensity of the debtors to spend out of wealth as opposed to lenders. If this is even 2 percent, that would be surprising. While $100 billion in additional consumption would be a nice boost to growth, it would still leave us far from full employment. (btw, anyone who bothers to look at the data would know that consumption is still unusually high relative to disposable income, not low.)
The reality is that we need some new source of demand to replace the demand generated by the housing bubble. In the short-run, this can only be the government. This is true regardless of how much we hate or love the government. In the longer run it will have to be net exports. People who know logic and arithmetic understand this fact. Others work as economists.
Addendum:
I thought I would add a bit more on the ownership of mortgage debt. The vast majority of debt is held in mortgage backed securities. The holders of this debt would be comparable to the ownership of government debt, albeit with a somewhat smaller presence of foreign owners. The debt would show up in the portfolios of many individuals with 401(k)s and other retirement accounts. It would also be included in most pension portfolios. Losses in the latter would have to be made up with larger contributions in future years.
On the other side, not all the underwater borrowers should be viewed as low or even middle class. There are plenty of people who bought homes for $600k at the peak of the bubble that are today worth $300k. These people may have substantial other wealth, so they need not have reduced their consumption substantially as a result of the drop in housing values.
And of course our disappearance of $5 trillion in mortgage debt would mostly be for people who are not underwater, since there is only a bit more than $1 trillion in underwater debt. Most of the vanishing debt would be for people who owe $200k on a $300k home. Our god of economic correctness will have reduced this to $100k by extinguishing $5 trillion in mortgage debt.
Again, I would not doubt that the underwater homeowners have a higher average propensity to consume out of wealth than owners of their debt, but there is no reason to believe the latter is close to zero. I think a gap of 2 percentage points would be on the high side of the plausible.
Economists tend not to be very good at arithmetic. That’s why almost all of them failed to recognize the $8 trillion housing bubble and to understand that it’s collapse would wreck the economy.
Unfortunately their arithmetic (or logic) skills have not improved in the wake of the crash. Hence we have many economists telling us that the economy’s problem is a debt overhang. This gets picked up endlessly (e.g. Joe Nocera’s column today).
Let’s think this one through for a moment. As a result of the ephemeral wealth created by the housing bubble, people ran up far more debt than would have otherwise been the case. This means that people have far less equity in their homes than in a counter-factual where house prices had never diverged from trend.
Let’s say that collective indebtedness is $5 trillion greater than if there had never been a bubble. Now let’s have the great god of economic correctness clap her hands and eliminate the $5 trillion in excessive debt. Do we now see a consumption boom that gets the economy back on course?
If you answered yes, you get a PhD from a prestigious economic department and flunk basic logic. Our god just destroyed $5 trillion in wealth. Any increase in consumption from this act would be the result of the difference in the propensity of the debtors to spend out of wealth as opposed to lenders. If this is even 2 percent, that would be surprising. While $100 billion in additional consumption would be a nice boost to growth, it would still leave us far from full employment. (btw, anyone who bothers to look at the data would know that consumption is still unusually high relative to disposable income, not low.)
The reality is that we need some new source of demand to replace the demand generated by the housing bubble. In the short-run, this can only be the government. This is true regardless of how much we hate or love the government. In the longer run it will have to be net exports. People who know logic and arithmetic understand this fact. Others work as economists.
Addendum:
I thought I would add a bit more on the ownership of mortgage debt. The vast majority of debt is held in mortgage backed securities. The holders of this debt would be comparable to the ownership of government debt, albeit with a somewhat smaller presence of foreign owners. The debt would show up in the portfolios of many individuals with 401(k)s and other retirement accounts. It would also be included in most pension portfolios. Losses in the latter would have to be made up with larger contributions in future years.
On the other side, not all the underwater borrowers should be viewed as low or even middle class. There are plenty of people who bought homes for $600k at the peak of the bubble that are today worth $300k. These people may have substantial other wealth, so they need not have reduced their consumption substantially as a result of the drop in housing values.
And of course our disappearance of $5 trillion in mortgage debt would mostly be for people who are not underwater, since there is only a bit more than $1 trillion in underwater debt. Most of the vanishing debt would be for people who owe $200k on a $300k home. Our god of economic correctness will have reduced this to $100k by extinguishing $5 trillion in mortgage debt.
Again, I would not doubt that the underwater homeowners have a higher average propensity to consume out of wealth than owners of their debt, but there is no reason to believe the latter is close to zero. I think a gap of 2 percentage points would be on the high side of the plausible.
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In an article on the Fed’s decision to buy more bonds and to extend its commitment to a low interest rate policy, the Washington Post told readers:
“Fed officials have been sympathetic to concerns about inflation, which would first affect middle-class purchases of necessities such as food and gas.”
Actually, inflation in food and gas prices is of the least concern to the Fed because they are largely out of its control. The price of food and gas are determined in international markets. When these prices have risen it has been primarily because of rapid growth in demand in developing countries like China and India, or reductions in supply due to political disruptions or weather. (In many cases the price rises were amplified by speculation.)
The Fed’s actions will do little to affect worldwide demand for these products and therefore will have little effect on the price of food and gas. This is why the Fed generally looks at the core inflation rate, which excludes food and energy prices, in designing policy. The non-core components are both much more volatile and outside of the Fed’s control.
This piece also inaccurately asserts that the labor market has been worsening over the last three months because the economy has only been generating 100,000 jobs a month. The piece claims that it needs 120,000 jobs a month to keep pace with the growth of the labor market. In fact, the Congressional Budget Office projects labor force growth of 0.7 percent a year. This would imply that a growth rate of 90,000 jobs a month is sufficient to keep pace with the growth of the labor force. By this measure, job growth has just been keeping pace with the rate of growth of the labor force.
In an article on the Fed’s decision to buy more bonds and to extend its commitment to a low interest rate policy, the Washington Post told readers:
“Fed officials have been sympathetic to concerns about inflation, which would first affect middle-class purchases of necessities such as food and gas.”
Actually, inflation in food and gas prices is of the least concern to the Fed because they are largely out of its control. The price of food and gas are determined in international markets. When these prices have risen it has been primarily because of rapid growth in demand in developing countries like China and India, or reductions in supply due to political disruptions or weather. (In many cases the price rises were amplified by speculation.)
The Fed’s actions will do little to affect worldwide demand for these products and therefore will have little effect on the price of food and gas. This is why the Fed generally looks at the core inflation rate, which excludes food and energy prices, in designing policy. The non-core components are both much more volatile and outside of the Fed’s control.
This piece also inaccurately asserts that the labor market has been worsening over the last three months because the economy has only been generating 100,000 jobs a month. The piece claims that it needs 120,000 jobs a month to keep pace with the growth of the labor market. In fact, the Congressional Budget Office projects labor force growth of 0.7 percent a year. This would imply that a growth rate of 90,000 jobs a month is sufficient to keep pace with the growth of the labor force. By this measure, job growth has just been keeping pace with the rate of growth of the labor force.
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A Morning Edition segment on the Fed’s likely actions included a comment from Karen Dynan, the co-director of economic studies at the Brookings Institution saying:
“our housing market remains in very poor shape. It may have turned the corner, but conditions still look pretty bleak.”
Actually house prices are pretty much back on their long-term trend path. The current sales rate is also at or above its trend level. It is true that house prices are still well below their bubble peaks, but that should be expected. It would be unreasonable to expect the Nasdaq to return to the prices it reached at the peak of the stock bubble. Similarly, there is no reason to expect (or want) house prices to return to their bubble peak.
A Morning Edition segment on the Fed’s likely actions included a comment from Karen Dynan, the co-director of economic studies at the Brookings Institution saying:
“our housing market remains in very poor shape. It may have turned the corner, but conditions still look pretty bleak.”
Actually house prices are pretty much back on their long-term trend path. The current sales rate is also at or above its trend level. It is true that house prices are still well below their bubble peaks, but that should be expected. It would be unreasonable to expect the Nasdaq to return to the prices it reached at the peak of the stock bubble. Similarly, there is no reason to expect (or want) house prices to return to their bubble peak.
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A NYT article reports that one of the background issues in the strike of Chicago public school teachers is the increased use of charter schools, which is advocated by Chicago Mayor Rahm Emanuel. It would have been worth reminding readers that charter schools do not on average outperform the public schools they replace. If Emanuel is advocating increased use of charter schools he is either unfamiliar with recent research in education or has some motive other than improving student performance.
A NYT article reports that one of the background issues in the strike of Chicago public school teachers is the increased use of charter schools, which is advocated by Chicago Mayor Rahm Emanuel. It would have been worth reminding readers that charter schools do not on average outperform the public schools they replace. If Emanuel is advocating increased use of charter schools he is either unfamiliar with recent research in education or has some motive other than improving student performance.
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In his column today George Will notes the Fed’s responsibility to maintain price stability and high employment and tells readers:
“Achieving the former is the best thing the Fed can do for the latter.”
Apparently Will has not been following what has happened in the economy recently. While inflation has remained low and relatively stable, unemployment has soared. He also apparently does not recognize how the Fed hopes to boost economic growth through quantitative easing.
The biggest impact from lower interest rates is probably from mortgage refinancing. This both directly generates economic activity through people employed in the process (e.g. banking staff, appraisers etc.) and indirectly by reducing payments and freeing up money for other consumption.
The second biggest impact is on lowering the value of the dollar relative to other currencies, which will reduce the trade deficit. Anyone who does not want a large budget deficit and/or negative private savings (like we had at the peak of the housing bubble) must want to see the trade deficit move closer to balance. This is an accounting identity — there is no way around it. And, there is no plausible mechanism to get the trade deficit closer to balance except by reducing the value of the dollar.
For some reason Will fails to mention either the impact of quantitative easing on mortgage refinancing or the impact on the trade deficit. There is also zero evidence of the hyper-inflation that he and other opponents of more aggressive Fed actions have been warning about for years.
In his column today George Will notes the Fed’s responsibility to maintain price stability and high employment and tells readers:
“Achieving the former is the best thing the Fed can do for the latter.”
Apparently Will has not been following what has happened in the economy recently. While inflation has remained low and relatively stable, unemployment has soared. He also apparently does not recognize how the Fed hopes to boost economic growth through quantitative easing.
The biggest impact from lower interest rates is probably from mortgage refinancing. This both directly generates economic activity through people employed in the process (e.g. banking staff, appraisers etc.) and indirectly by reducing payments and freeing up money for other consumption.
The second biggest impact is on lowering the value of the dollar relative to other currencies, which will reduce the trade deficit. Anyone who does not want a large budget deficit and/or negative private savings (like we had at the peak of the housing bubble) must want to see the trade deficit move closer to balance. This is an accounting identity — there is no way around it. And, there is no plausible mechanism to get the trade deficit closer to balance except by reducing the value of the dollar.
For some reason Will fails to mention either the impact of quantitative easing on mortgage refinancing or the impact on the trade deficit. There is also zero evidence of the hyper-inflation that he and other opponents of more aggressive Fed actions have been warning about for years.
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I’ve heard many folks complain that Chicago’s teachers are only concerned about their wages and benefits and not over the education received by the children. As my friend Larry Mishel reminds me, there is an important reason that the teachers’ union is only talking about wages and benefits in the context of the strike: it’s the law.
These are mandatory topics for negotiation under U.S. labor law. Issues about how the schools are run fall under management prerogatives. While the union and management are free to discuss these issues, the union cannot legally strike over them. Therefore if the union were to explicitly put forward conditions that directly related to the quality of education as a reason for the strike, the city could pursue legal action against the union and its officers for conducting an illegal strike.
It would be appropriate for reporters to point out this fact in discussing the strike. Those unhappy that the union is not making demands on behalf of students should be complaining about labor law, not the teachers’ union.
Those interested in how Chicago’s teachers envision ways to improve the quality of education might look at this pamphlet they published earlier this year, as cited in a blogpost by Dylan Matthews. Matthews acknowledges that the measures listed are backed up by research showing their effectiveness, but notes that the plan comes with a $713 million price tag.
That’s not trivial, but if we assume that Chicago’s per capita GDP is equal to the national average, then it amounts to less than 0.5 percent of its annual income. The union also proposed ways to raise the money, all of which focus on getting more money from the wealthy.
My personal favorite is a tax on financial transactions. The Chicago Mercantile Exchange is the largest exchange for commodities and futures trading in the country. The union proposed a tax of 6 cents per transactions, which they calculate would raise about $110 million a year.
Matthews seems to view this tax as impractical suggesting that trading would just move to New York. He cites the example of a tax on stock trades in Sweden which led trading volume to quickly migrate to London.
This is an especially inappropriate example. The tax in Sweden was large (1.0 percent of the value of the trade) and almost seems to have been designed to be evaded. Brokerage houses could open up shops in Sweden for trades done in the U.K.. It is a bit more difficult to imagine all of Chicago’s traders shutting down over a tax of 6 cents per transactions.
This is not the way I would impose the tax (I would take it as a percent of the trade), but based on past calculations, this tax rate would correspond to roughly one hundredth of a basis point (0.0001 percent) of the nominal value of trades. It’s hard to envision the Chicago market shutting down over a tax of this magnitude.
As with the other tax proposals, Matthews is quite right that there will be enormous political obstacles. But if we have a plan on the table that we have good reason to believe will improve the education of our children, and the people with money and power in Chicago don’t want to foot the tab, why are we blaming the teachers for the poor educational outcomes?
I’ve heard many folks complain that Chicago’s teachers are only concerned about their wages and benefits and not over the education received by the children. As my friend Larry Mishel reminds me, there is an important reason that the teachers’ union is only talking about wages and benefits in the context of the strike: it’s the law.
These are mandatory topics for negotiation under U.S. labor law. Issues about how the schools are run fall under management prerogatives. While the union and management are free to discuss these issues, the union cannot legally strike over them. Therefore if the union were to explicitly put forward conditions that directly related to the quality of education as a reason for the strike, the city could pursue legal action against the union and its officers for conducting an illegal strike.
It would be appropriate for reporters to point out this fact in discussing the strike. Those unhappy that the union is not making demands on behalf of students should be complaining about labor law, not the teachers’ union.
Those interested in how Chicago’s teachers envision ways to improve the quality of education might look at this pamphlet they published earlier this year, as cited in a blogpost by Dylan Matthews. Matthews acknowledges that the measures listed are backed up by research showing their effectiveness, but notes that the plan comes with a $713 million price tag.
That’s not trivial, but if we assume that Chicago’s per capita GDP is equal to the national average, then it amounts to less than 0.5 percent of its annual income. The union also proposed ways to raise the money, all of which focus on getting more money from the wealthy.
My personal favorite is a tax on financial transactions. The Chicago Mercantile Exchange is the largest exchange for commodities and futures trading in the country. The union proposed a tax of 6 cents per transactions, which they calculate would raise about $110 million a year.
Matthews seems to view this tax as impractical suggesting that trading would just move to New York. He cites the example of a tax on stock trades in Sweden which led trading volume to quickly migrate to London.
This is an especially inappropriate example. The tax in Sweden was large (1.0 percent of the value of the trade) and almost seems to have been designed to be evaded. Brokerage houses could open up shops in Sweden for trades done in the U.K.. It is a bit more difficult to imagine all of Chicago’s traders shutting down over a tax of 6 cents per transactions.
This is not the way I would impose the tax (I would take it as a percent of the trade), but based on past calculations, this tax rate would correspond to roughly one hundredth of a basis point (0.0001 percent) of the nominal value of trades. It’s hard to envision the Chicago market shutting down over a tax of this magnitude.
As with the other tax proposals, Matthews is quite right that there will be enormous political obstacles. But if we have a plan on the table that we have good reason to believe will improve the education of our children, and the people with money and power in Chicago don’t want to foot the tab, why are we blaming the teachers for the poor educational outcomes?
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As the Fed has attempted to push interest rates down with the purpose of boosting the economy, there have been numerous stories mourning the situation of savers who see little return on their money. The NYT gave us such a piece on Tuesday.
While those who have all their savings in short-term assets like savings accounts and money market funds are seeing low returns, the low return story does not apply to all savers. Of course those who have money in the stock market have done quite well, with prices nearly double their lows from 2009.
However, even people who do not have money in the stock market would have done well if they had put money in long-term bonds. The graph below shows the price of a 30-year bond that comes due in 2037, assuming that it was bought in 2007 with a 5 percent yield (roughly the interest rate at the time).
Source: Smart Money Bond Calculator.
The bond that our troubled saver purchased in 2007 for $10,000 would be worth a bit more than $14,000 in today’s low interest rate environment. That isn’t exactly the sort of situation that would normally call for violin music.
As a practical matter, there are people who are losing in this story, but realistically there are not a lot of people who both have substantial savings (enough that the interest makes up a big share of their income) and who kept it exclusively in short-term assets.
There are no policies to increase growth that leave no one harmed. (If you think you know of one, then you haven’t thought through the implications of the policy carefully enough.) The winners from a policy to boost growth through lower interest rates vastly outnumber the losers. The biggest grounds for complaint is that the Fed did not go far enough.
As the Fed has attempted to push interest rates down with the purpose of boosting the economy, there have been numerous stories mourning the situation of savers who see little return on their money. The NYT gave us such a piece on Tuesday.
While those who have all their savings in short-term assets like savings accounts and money market funds are seeing low returns, the low return story does not apply to all savers. Of course those who have money in the stock market have done quite well, with prices nearly double their lows from 2009.
However, even people who do not have money in the stock market would have done well if they had put money in long-term bonds. The graph below shows the price of a 30-year bond that comes due in 2037, assuming that it was bought in 2007 with a 5 percent yield (roughly the interest rate at the time).
Source: Smart Money Bond Calculator.
The bond that our troubled saver purchased in 2007 for $10,000 would be worth a bit more than $14,000 in today’s low interest rate environment. That isn’t exactly the sort of situation that would normally call for violin music.
As a practical matter, there are people who are losing in this story, but realistically there are not a lot of people who both have substantial savings (enough that the interest makes up a big share of their income) and who kept it exclusively in short-term assets.
There are no policies to increase growth that leave no one harmed. (If you think you know of one, then you haven’t thought through the implications of the policy carefully enough.) The winners from a policy to boost growth through lower interest rates vastly outnumber the losers. The biggest grounds for complaint is that the Fed did not go far enough.
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Since the Chicago school teachers went out on strike Monday, many political figures have tried to convince the public that their $70,000 average annual pay is excessive. This is peculiar, since many of the same people had been arguing that the families earning over $250,000, who would be subject to higher tax rates under President Obama’s tax proposal, are actually part of the struggling middle class. They now want to convince us that a household with two Chicago public school teachers, who together earn less than 60 percent of President Obama’s cutoff, have more money than they should.
Anyhow, if we want to assess whether someone is getting too much money, we always have to ask the follow-up question, compared to what? Here are a few comparisons that I have found useful.
Source: Author’s calculations, see text.
The first comparison number is the annualized pay that Chicago Mayor Rahm Emanuel got for a 14-month stint as a director at Freddie Mac. President Clinton appointed him as a director shortly after he left the administration. It’s not clear exactly what Mr. Emanuel did as a director, he was not appointed to any board committees. While Emanuel’s stint ended just as the housing bubble was building up steam, Freddie Mac was involved in an accounting scandal during this period for which it was forced to pay several million dollars in fines.
The second comparison is the compensation that Emanuel received for his day job after leaving the White House, working for Wasserstein Perella, an investment bank. According to Wikipedia, he earned $16.5 million for two and a half years of work.
The third comparison is the compensation that Erskine Bowles received as a director of Morgan Stanley, the huge Wall Street investment bank in 2008. Erskine Bowles has been mentioned in the news frequently as the co-chair of President Obama’s deficit commission. The plan that he co-authored with former Senator Alan Simpson, the other co-chair, is often held up as providing a basis for a “grand bargain” on the budget.
The year 2008 is noteworthy because this was the year that the bank was driven to the edge of bankruptcy. It was saved from imminent bankruptcy by a bailout from the Federal Reserve Board, which allowed it to change its status to become a bank holding company on an emergency basis. This gave it the protection of the Federal Reserve Board and the FDIC. Morgan Stanley also received tens of billions of dollars in below market loans and guarantees from the government. (Bowles continues to serve as a director of Morgan Stanley as well as several other companies. Here is a fuller discussion of his record as a director.)
These pay packages might be useful information for those trying to decide whether $70,000 a year is too much to pay a teacher working in inner city schools in Chicago. On the same topic, Catherine Rampell provides a useful comparison of the pay of teachers in the United States relative to the pay of teachers in other countries, most of which have better student performance on standardized exams.
Since the Chicago school teachers went out on strike Monday, many political figures have tried to convince the public that their $70,000 average annual pay is excessive. This is peculiar, since many of the same people had been arguing that the families earning over $250,000, who would be subject to higher tax rates under President Obama’s tax proposal, are actually part of the struggling middle class. They now want to convince us that a household with two Chicago public school teachers, who together earn less than 60 percent of President Obama’s cutoff, have more money than they should.
Anyhow, if we want to assess whether someone is getting too much money, we always have to ask the follow-up question, compared to what? Here are a few comparisons that I have found useful.
Source: Author’s calculations, see text.
The first comparison number is the annualized pay that Chicago Mayor Rahm Emanuel got for a 14-month stint as a director at Freddie Mac. President Clinton appointed him as a director shortly after he left the administration. It’s not clear exactly what Mr. Emanuel did as a director, he was not appointed to any board committees. While Emanuel’s stint ended just as the housing bubble was building up steam, Freddie Mac was involved in an accounting scandal during this period for which it was forced to pay several million dollars in fines.
The second comparison is the compensation that Emanuel received for his day job after leaving the White House, working for Wasserstein Perella, an investment bank. According to Wikipedia, he earned $16.5 million for two and a half years of work.
The third comparison is the compensation that Erskine Bowles received as a director of Morgan Stanley, the huge Wall Street investment bank in 2008. Erskine Bowles has been mentioned in the news frequently as the co-chair of President Obama’s deficit commission. The plan that he co-authored with former Senator Alan Simpson, the other co-chair, is often held up as providing a basis for a “grand bargain” on the budget.
The year 2008 is noteworthy because this was the year that the bank was driven to the edge of bankruptcy. It was saved from imminent bankruptcy by a bailout from the Federal Reserve Board, which allowed it to change its status to become a bank holding company on an emergency basis. This gave it the protection of the Federal Reserve Board and the FDIC. Morgan Stanley also received tens of billions of dollars in below market loans and guarantees from the government. (Bowles continues to serve as a director of Morgan Stanley as well as several other companies. Here is a fuller discussion of his record as a director.)
These pay packages might be useful information for those trying to decide whether $70,000 a year is too much to pay a teacher working in inner city schools in Chicago. On the same topic, Catherine Rampell provides a useful comparison of the pay of teachers in the United States relative to the pay of teachers in other countries, most of which have better student performance on standardized exams.
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