Background[1]
Since 1901, short-term interested rates have risen above long-term rages (inverting the “yield curve”). Each time this yield curve inversion lasted longer than 11 months, the US entered a recession. There have been four recessions without an inverted yield curve, typically at the end of a war. Additionally, the policies of the Federal Reserve has, at least, partially caused all major recessions since 1900.
The yield curve was inverted from the middle of 2006 and lasted until August 2007 with the financial panic started. As a result of the panic, during 2007, the Federal Reserve increased assets on its balance sheet (i.e., increased the money supply) from $800 billion to $2.5 trillion.
In 2009, the global poverty level standard is under $1.10 per day. In 2000 it is estimated that 20% of the world population lived below the poverty level, and another 20% lived below $2.00 per day. By 2007, it is estimated that 35% of the world’s population lived below $2.00 per day.
There are two primary classes of tools that the Federal Government can use to combat recession:
- Fiscal Policy – the use of government spending and revenue collection to influence the economy, determined through the legislative process
- Monetary Policy – impacting interest rates and changing the supply of money to influence the economy, primarily at the direction of the Federal Reserve and its Federal Open Market Committee
Note: Fiscal and Monetary policy are independently determined within the same political environment, and can either work in concert or counter-productively.
Housing Bubble[2]
Economic bubbles occur when there is speculation in a market characterized by high transaction volumes at prices that are considerably at variance with the asset’s intrinsic value. It is arguable that there are two primary and interrelated causes for the current recession, a housing bubble that was aggravated by lax credit standards in the mortgage backed securities market. The current housing bubble seems to have started around 1997 with the elimination of capitol gains taxes on the first $500,000 on the sale of a home. Since both the Clinton and Bush administrations aggressively pursued a social/political goal of expanding homeownership, at the time of the 2001 recession, credit standards eroded. Lenders and investment banks that securitized mortgages used rising property prices to justify loans to buyers with limited assets and income. Rating agencies overlooked their fiduciary duties and provided credit reports needed for their clients (the issuers of securitized mortgages) to sell their mortgage backed securities to investors looking for high rates of return.
Housing expenditures in most of the developed world have traditionally taken up about 30% of household income. When the price of housing in the US doubled without a corresponding increase in household income, warning signs of a housing bubble started to emerge, but were largely ignored. Monetary policy, tax-free capital gains, and lax lending standards lead to an average 56% annual increase in loan originations from 2000 to 2003, from $1.05 trillion to $3.95 trillion over those three years.
In 1983 the Bureau of Labor Statistics started using rental equivalence for home-owner-occupied units instead of direct home-ownership costs. That direct home ownership costs were not a factor in the Consumer Price Index added to a false sense of security. For example, in May 2004 the Case-Shiller 20-city composite index of single-family housing prices had increased 15.4% during the previous 12 months, but the related CPI housing component had increased only 2.4%. Estimates are that resulting inflation was underreported by as much as 3%.
To maintain transaction volume in light of higher housing prices, many lenders started issuing subprime loans to people of questionable financial status, and also started issuing interest only and Adjustable Rate Mortgages (ARM). Sometime in 2006 the housing price increased to a point that they were no longer able to sustain the flow of new buyers, and the inevitable crash started.
This Recession Officially began December 2007[3]
- Industrial Production – Recession
The panic started on August 9, 2007, when the French bank BNP Paribas (at the time, with assets in excess of $1.3 trillion, one of the 10 largest in the world) announced that shareholders in three mutual funds that it managed could not redeem their shares because the mutual funds owned bonds based on U.S. subprime mortgages that could not be valued at that time. At the time about 56% of all US debt was held by foreigners.Since February 13, 2008, government policy has committed $8 Trillion in fiscal stimulus.
Lessons learned from Milton Freedman concerning Monetary Policy:
- Inflation is always and everywhere a monetary phenomenon
- Changes in monetary policy are seen in the markets with a varying degree of time lags, never quicker than 1 year nor longer than 3 years, with a 2.5 year average – the current relaxing of monetary policy started in September 2007, which suggests that the impact from lower interest rates and increased money supply will not appear until 2010 to 2011.
Construction Spending
Many conservatives suggest that the current fiscal policy (the deficit spending) including (HR 1) the $787 billion American Recovery and Reinvestment Act of 2009 (www.recovery.gov) will be inflationary. The package contains $288 billion in tax cuts, including $36 billion to subsidize locally issued bonds for school construction, teacher training, economic development, and infrastructure improvements. There is about $43.6 billion for R&D, and technology upgrades for the Internet and other government and health care information systems. $135.3 billion in spending for construction, deferred maintenance, and energy efficiency. The remaining expenditures (about $320 billion) are in the form of supplemental government operating costs, and social program transfer payments such as income subsidies, and earmarks that are (at this time) difficult to identify.
Total construction spending in the US was $1.08 trillion in 2008, only 5.1% less than the $1.14 trillion spent in 2007. Based on the author’s review of The American Recovery and Reinvestment Act of 2009, the bill contains about $133.8 billion in construction spending including $5.6 billion for military and homeland security projects, $4 billion for health care, $5 billion on energy infrastructure, $27.6 billion in energy efficiency and building deferred maintenance, and $4.8 billion in other government construction. Other additional spending can be seen in the table below, which also contains total construction spending estimates in the US for 2007 and 2008.
| (in Billions) | Total Construction | Residential | Education | Highway | Sewage & Water |
| 2008 | $1,080.0 | $358.4 | $85.5 | $80.7 | $41.4 |
| 2007 | $1,140.0 | $455.8 | $78.8 | $75.5 | $39.3 |
| Reinvestment act of 2009 | $ 135.3 | $ 24.9 | $ 2.9 | $49.6 | $10.9 |
The American Society of Civil Engineers has released a “Report Card for America’s Infrastructure” (http://www.infrastructurereportcard.org) and estimates the need for $2.2 trillion in spending over the next five years to get airports, bridges, dams, highways, schools, etc. up to modern standards.
It is suggested that the spending on infrastructure/construction ($135 billion) and spending on R&D, and information technology ($44 billion) should be treated as investments that will have different multiplier effects on the economy than would Transfer payments ($320 billion) authorized in the appropriation.
What’s Next?[4]
Bubbles are typically followed by Panic. It is arguable that a significant difference in the current recession vis-à-vis other recent recessions is the degree that the declining assets have been leveraged. For example, the dot.Com bubble assets were primarily held by institutional and individual investors that either owned the assets outright, or only a small fraction of the value was purchased on margin, so losses were absorbed by the investor. In this housing bubble, between 90% and 100% of the asset has been mortgaged (purchased on margin). Losses are absorbed not only by the owner (investor) but also the lending institutions (investment banks, investors in mortgage-backed-securities, sellers of credit default swaps), and the issuer of last resort, the US Treasury.
Durable Goods Consumption
In a paper published in 1983, Ben Bernanke, current chair of the Federal Reserve, argues that one of the primary reasons the Great Depression was so “great” was that the financial system failed in its ability to perform its economic role of lending to households for durable goods consumption and to firms for working capitol for production and trade.[5] It is arguable that we are seeing a similar problem with today’s recession. Auto sales have fallen 41% between February 2008 and February 2009. It is also estimated that a significant number of the retail closings before Christmas were a result of not having the working capital to purchase inventory, rather than stores that were not profitable.
Savings Rate
Savings it typically defined as defined as personal disposable income minus personal consumption expenditure. It has also been theorized that savings rate (or spending) is influenced by perceived wealth – the value of a person’s home, for example. In an economy based on consumption, that has seen it savings rate based an increase in the savings rate, there will be a reduced economic activity in the short term, because of reduced consumer goods expenditures, which is typically funded by disposable personal income.
Conclusion
It appears that “a financial crises that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we are witnessing the second great consumer debt crash, [of the past 100 years], the end of a massive consumption binge.”[6]
[1] Smith, James F. “The World Economy is a Mess, But Oklahoma’s OK” Keynote Address at: “CREC Forecast 2009 Conference”, March 3, 2009 Skirvin Hilton, Oklahoma City, OK.
[2] Gjerstad, Steven and Vernon L Smith “From Bubble to Depression?” The Wall Street Journal, April, 6, 2009 p A15
[3] Smith, ibid
[4] Gjerstad, ibid
[5] Bernanke, Ben S, “Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression,” American Economic Review, American Economic Association, vol. 73(3), pages 257-76, June, 1983.
[6] Gjerstad, ibid
April 6th, 2009 at 2:16 pm
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Tom Humes