The CERF Blog

The Center for Responsible Lending has published a report “Dreams Deferred: Impacts and Characteristics of the California Foreclosure Crises”. I focus my comments on two of the points made in their report. According to their data and analysis, houses purchased in California from October 2006 to November 2009 were relatively small homes, median size of 1,494 square feet and average size of 1,704 square feet, with a value less than the area median. They also find that about half of all the loans were used to refinance rather than purchase properties.

They write that their findings “challenge the notion that foreclosures are simply the result of people purchasing properties they could not afford”.

However, the data appears to indicate that the household sector took on too much mortgage debt. United States data shows that the ratio of mortgage debt to income climbed from about 55 percent at the end of 2000 to 88 percent in early 2009. While it is subsiding, it is still too high, the early 2010 level was 84 percent. If such data were available for California, it would likely show a more dramatic change from 2000 to 2009, given California’s worse housing market conditions.

The report’s findings do not disprove that some of the households who took on the task of paying a mortgage should not have because of a lack of requisite savings and income. If there was a large share of households who were renters that moved into ownership housing, then I would expect the average home size would be modest.

What do we do now that they are there? We have three options: use government funds to give those households the money they need to stay in those homes, require the mortgage companies to forgive substantial portions of principle, or encourage those households to move back into rental housing. The policy debate should focus on the merits and demerits of these three choices.

Well, this is interesting.  It seems that the Securities and Exchange Commission has filed suit against New Jersey for securities fraud in marketing its debt.  Their problem was that they neglected to report some pension liabilities.

I doubt that California has made that mistake, but State Treasurer, Bill Lockyer, has been very aggressive in attempting to counter any suggestion that California could possibly default on its credit obligations.  I know this from personal experience.  When I first mentioned the possibility of a California default, his office sent out two press releases, the point of which was to highlight my incompetence stupidity and the impossibility of a California default.  While I enjoy rereading the insults once in a while, I’ll stick the claims of financial infallibility today.  Here’s a sample:

“To be crystal clear: The State faces absolutely no danger of defaulting on its bond payments.

My guess is that if a private company made that claim it could be securities fraud.

I was at a meeting this morning with with people from across the economy.  We had a farmer, an accountant, a banker, two city economic development people, a university dean, and more.  While the meeting had another purpose, we ended it by going around the room and having people tell us how things were going in their industry.

I was shocked that almost everyone complained about increased bureaucracy and regulation.  For example, the farmer’s complaints included a “social responsibility” audit.  Even people who worked for quasi-government or government funded enterprises complained about new requirements.  Only the accountant was happy; regulation increases his business.

Complaints about regulation and bureaucracy are common.  I hear them all the time.  However, I’ve never seen such widespread complaints.  In a group of this size, I would expect maybe three people to complain about regulation, but at this meeting, it was practically universal.

This doesn’t bode well for the recovery.  However well intentioned, new broad-based regulatory requirements will serve as sand scattered throughout the gears of economic activity.  It creates additional costs–costs that are likely to exceed the benefits–and uncertainty.  This is exactly the opposite of what we need for robust growth.

It also doesn’t bode well for our forecast.  We have a very difficult time bringing this type of thing into our models.  It probably means that our models are a bit optimistic, and that is a bit scary.

Finally, people are starting to see the problem with the United States economy.  This piece is typical.  For over a year now, we have been warning that the United States could be facing a long period of slow economic growth, similar to what Japan has seen for the past couple of decades.

Seeing a problem and knowing how to solve it are two different things.  So, we’re going to see lots of silly ideas proposed.  We’ll see demands for more government spending.  We’ll see demands for less government spending.  We’ll see demands for higher taxes.  We’ll see demands for lower taxes.  We’ll see demands for more consumer spending.  We’ll see demands for more consumer saving.

All of these recommendations can’t be correct.  In fact, they are all beside the point.  I’m not saying the proposals won’t have any impact.  They will, but the impacts will either be marginal or they will be some time in the future.  Our problem is immediate and very serious.  Here’s what we need to do to avoid a lost decade:

• Fix the financial sector
• Stop paying interest on deposits at the Fed
• Lower effective borrowing costs with an investment tax credit
• Reduce regulatory uncertainty and big-business bias
• Increase immigration

Any vigorous recovery needs a vigorous financial sector, and ours is not.  Fed policy has been ineffective, because the money multiplier has tanked, even as the monetary base soared.  There are two reasons for this: The Fed is paying banks to deposit at the Fed, and the banks–burdened with over-leveraged balance sheets, huge charge-offs, and bad assets–are in no shape to lend.  Fix the banks, and stop encouraging them to park money in Washington, and we’ll have a start on real recovery.

We have an investment problem; there isn’t any.  That’s because, even at zero, borrowing costs exceed expected returns on investments, and the future regulatory environment is extremely uncertain.  We can’t lower interest rates below zero, but an investment tax credit would effectively lower borrowing costs.  Do that and remove regulatory uncertainty, and our businesses will invest.  While we’re at it, let’s reduce big business’ regulatory advantage.

Finally, we don’t have any problems that couldn’t be fixed by a few million new immigrants.  We’d see an immediate increase in housing demand and construction.  Our inner cities would be renewed.  Our economy would see a burst of creativity, energy, and new business formation.

Joel Kotkin has just published the best piece yet written on California and its diminished economic prospects.  Better yet, he used our data to support his work.  It is a relatively long article, but well worth the investment.  Indeed, it should be required reading for voters and policy makers everywhere.  As always, Joel has his own unique way of making a point.  Here’s an example:

‘What went so wrong? The answer lies in a change in the nature of progressive politics in California. During the second half of the twentieth century, the state shifted from an older progressivism, which emphasized infrastructure investment and business growth, to a newer version, which views the private sector much the way the Huns viewed a city—as something to be sacked and plundered. The result is two separate California realities: a lucrative one for the wealthy and for government workers, who are largely insulated from economic decline; and a grim one for the private-sector middle and working classes, who are fleeing the state.”

There is a lot in that paragraph.  The image of Huns at the gates of a city is a striking way of illustrating a fact that Californians, and increasingly residents of other states, often forget: it’s possible to regulate, tax, and harass business too much.  At some point, business heads for the door, taking the prosperity it brings.  When business is gone, prosperity is gone.  No goose; no golden egg.

The private-sector middle and working classes are leaving California, driven away by lack of opportunity and high costs.  Net, domestic migration, people migrating to or from California to other states has been negative for most of the past two decades.  That is, more people are leaving California for other states than are coming in from other states.  This is in stark contrast to most of California’s history.

California’s business and the middle class joint migration is leaving a very strange society.  On the one hand, there is the wealthy, whose income and wealth are largely independent of California’s economy.  On the other hand there is a large, very poor, agricultural sector and a growing sector providing services to the permanent and visiting wealthy.   Consequently, California is likely to see inequality that is unprecedented in  a modern democracy.  It won’t be pretty.

The United States unemployment rate held steady at 9.5 percent, a result of losses in both jobs and the labor force. The job losses occurred in the public sector, the largest component of which was the Census wind-down. While the long-term unemployed slipped a bit from 6.8 million to 6.6 million, 6.6 million remains a very large number that puts a damper on expected household expenditures and hints at the human costs of the recession.

Non-farm jobs fell 131 thousand, driven by a gain of 71 thousand private sector gains and 202 thousand public sector losses. Revisions to the data indicate that last month’s annualized decline of 1.1 percent was revised down to a decline of 2 percent.

Last month I wrote about the United States employment situation:

Our back-of-the-envelope July job change projection would be driven by a presumed Census worker contraction of 230,000 that would be offset by private-sector gains of 80,000 resulting in an overall 150,000 non-farm job drop. If the employment survey drop matched the job drop and the labor force contracted by 300,000 then the unemployment rate would be a bit over 9.4 percent in July.

We ended up with an unemployment rate of 9.5 percent, a non-farm job drop of 131,000, driven by a 70,000 private-sector job gain, and a 202,000 public sector job drop. The 202 thousand public sector jobs lost were compositionally different than I expected last month: only 143 thousand were Census workers. The remainder included 10 thousand Federal-non-Census workers, 10 thousand state workers, and 38 thousand local government employees. The lack of revenues and balanced-budget requirements of the states and localities are starting to show more seriously in the public sector jobs data.

Our back-of-the-envelope August job change projection consists of a presumed Census worker contraction of 80,000 that would be roughly offset with private-sector job gains. However, a reasonable State and Local government job loss rate would be 40,000 jobs. These changes along with a 100 thousand person contraction in the labor force (due to the Census and State/Local government wind-downs) would imply the August unemployment rate would hold steady at 9.5 percent. The implied annualized non-farm jobs growth rate would be minus 0.3 percent.

Have you heard of the new plan to close California’s $19 billion budget shortfall?  If not, here is a link to a nonpartisan report by a public radio station, 89.3 KPCC.  Here are the basics of the new plan: 1) increase income taxes 1 percent for all Californians, except for those in the highest income brackets; 2) increase vehicle fees by 0.5 percent.  To offset these increases the state’s sales tax would be lowered by 1.75 percent and Californians would be able to deduct the new taxes from their federal taxes.

Ladies and gentlemen, this plan makes no sense!!  Raising taxes during a period of weak economic growth is poor policy.  Approximately 70 percent of our economy is driven by consumption.  Increasing our income taxes will only lead to less consumption.  The offset in sales taxes will not incentivize consumers to spend more when their incomes have fallen.  Further, economic theory is clear: income taxes are more harmful to the economy than consumption (sales) taxes, so this plan is backwards in that sense.

The same argument applies to the vehicle taxes.  Car sales in California are weak.  Job losses, stagnant incomes, and concerns about future economic prosperity have lead consumers away from making big ticket purchases.  It makes no sense to increase the price of vehicles when sales are low.

Here is some food for thought.  Why is California considering raising taxes on everyone but the rich, while the Federal government is considering raising taxes for only the rich?  In this case the Feds are correct.  By definition the wealthy can afford the increase.  There may be incentive problems, but they can afford the taxes.  California should not be raising taxes on the middle class.  Instead the State should find ways to encourage the middle class to spend money.  This would best be done by increasing economic activity, opportunity, and consequently, income security.

Who comes up with these ideas?  In what universe does this make sense?  I wonder if ideas like this are responsible for our current budget crisis.  In any event, hold on to your seats.  It is going to be a bumpy ride in California, and we won’t need any earthquakes to shake things up.

We are just wrapping up our first year of the CLU MS Econ program.  In fact, my students are taking their final as I write this.

On a personal level, it’s been very rewarding.  When we started the program, some people outside of CLU claimed we couldn’t get the program up, running, and accredited in our time frame.  We did though, with a lot of help from the University.  Three months after Dan, Kirk, and I came here, we had a program, accreditation, and students.  Our accreditation came with commendations and no criticisms or recommendations.

Watching the students has been far more rewarding.  They have learned a lot.  They can now do advanced econometric analysis and forecasting.  They can competently analyze economic proposals and discussions. They can write policy briefs.  The can formulate and defend an economic argument.

For me, it has been a huge pleasure to get to know and work with these bright young people, and to see them gain in capability and confidence.

Being an economist, I have to ask myself if the students received their money’s worth.  I think so.  On a strict accounting basis, the question is: Did the change in the expected present value of their future income stream exceed the costs of the program?  Probably.  The MS provides a signal to potential employers that should result in higher income, and these students can meet any reasonable employer’s expectations.

On the cost side, the weak economy likely means that the students’ opportunity costs were relatively low.  Direct costs were not too high, probably less than $30,000 including books and such.  So, it wouldn’t take much of an incremental income increase to make the year they spent studying economics pay for them.

I hope the value of the year was much more than an increase in the net present value of the students’ lifetime income.  I hope the program was fun for them, that they enjoyed the discovery that comes with a year studying one subject at the MS level.  Perhaps most importantly, I hope they find their world a bit easier to understand.

The Bureau of Economic Analysis released its first estimate of the United States 2010 second quarter Gross Domestic product growth rate today. Their estimated 2.4 percent growth rate was below most economists’ expectations, ours included. They estimate that consumption expenditures grew very mildly at 1.6 percent, investment expenditures grew massively at 29 percent, government expenditures grew very rapidly at 4.4 percent while trade detracted from the overall GDP growth rate by 2.8 percent. In other words, if export growth were balanced with import growth then GDP growth would have been about 5.2 percent. The Bureau also revised previous quarters’ data beginning with the first quarter of 2008, where these revisions imply slower growth in 2008 and 2009, see the table below.

The growth decomposition is very interesting. Total household consuming, which is imports plus consumption grew very rapidly (6 percent) in quarter 2. It is hard to imagine that households can continue to spend this rapidly given their debt levels and the unemployment rate. The strength of investment, which grew 29 percent, was also interesting. All investment components were positive, including real estate. However, by many other indicators, real estate markets are nowhere near normal. Residential real estate investment grew 29 percent, and commercial real estate investment grew 5.2 percent. These numbers are striking, given the underlying weakness in this economy. I believe that they are driven, at least in part, by government stimulus programs. They are reversals from the prior quarter, where residential fell 12.3 percent and commercial fell 18 percent. As well, government spending grew at what I consider to be a fantastic rate, 4.4 percent. The federal spending numbers are strong, as I suspected they would be: defense at 7.4 percent and non-defense at 13 percent. The state and local government spending increased to 1.3 percent which was not what I expected given their lifeless revenues and budget constraints.

As CERF bloggers have stated many times in the past year, the economy still has weak fundamentals. As can be seen from our forecast included in the table below, we forecasted about 1.5 percent growth in the second half of 2010 using the old data. The revised data would not change our forecast significantly.

The government’s home purchase program ended in the second quarter, and as long as it is not reinstated, the strongly positive real estate investment numbers that we experienced in quarter 2 will not materialize in quarters 3 and 4. Regarding the government expenditure strength, perhaps the Federal government can continue to pump up state and local government spending. Sometimes the government expenditure components are revised significantly, so we will watch for that at the end of August.

That leaves trade. Will imports continue to grow with such strength in the remainder of 2010? This leads to a broader question about how households will behave in the next 6 months. We hope they spend less and continue to rebalance their assets and liabilities. But, they might not. If they spend now, near-term GDP will benefit, but long-term GDP will suffer due to poor net household wealth accumulation. If they save, the remainder of 2010 will be weak but long-term GDP growth will benefit.

United States Economic Growth Rates:
CERF forecast vs. Old GDP vs. GDP revisions
2008 Quarter 1 – 2010 quarter 4

2008                          | Qtr 1 |          | Qtr 2 |            | Qtr 3 |              | Qtr 4 |
     Old GDP                  -0.7                1.5                  -2.7                   -5.4
     New GDP                 -0.7                0.6                  -4.0                   -6.8

2009                          | Qtr 1 |          | Qtr 2 |            | Qtr 3 |              | Qtr 4 |
     Old GDP                  -6.4               -0.7                  2.2                     5.6
     New GDP                 -4.9               -0.7                  1.6                     5.0

2010                           | Qtr 1 |          | Qtr 2 |            | Qtr 3 |             | Qtr 4 |
     Old GDP                   2.7                 n/a                  n/a                    n/a
     New GDP                  3.7                 2.4                  n/a                    n/a

     CERF (6/24)             2.7                 3.0                  1.5                    1.5

Units: seasonally-adjusted annualized growth rates
CERF: Center for Economic Research & Forecasting, CLU
Old GDP: published June 25, 2010
New GDP: published July 30, 2010

Bloomberg has a report on an IMF study.  Here is the key sentence:

“The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the results of International Monetary Fund stress tests.”

We at CERF have been long concerned about the strength of our financial sector.  In fact I suspect that the IMF study may be understating the severity of the situation.  That would be a problem.  Ask the Japanese what a weak banking sector can do to an economy.  The weakness of their financial sector, and their failure to correct those weaknesses, were a significant contributor to their 20 years of economic malaise.

Failure to promptly deal with our weak financial sector can have similar consequences for us.  You may think the new financial regulation fixes our banks.  It doesn’t.  It creates a new regulatory environment but it does nothing to address the problems that are keeping our banks from fully participating in our economy, inadequate capital and bad assets on their books.