Nothing is better for the mind of an economist than a vacation. It reminds them to not focus so much on the day-to-day economic data, but instead to keep their eye on the big picture and ongoing evolution of the economy.
Not a lot has changed in the two weeks I've been gone. Alan Greenspan testified last week and said he was still concerned about cutting interest rates to prevent deflation. Many business economists were still predicting a imminent recovery based not on profitability or business capital investment, but on consumer confidence, a regional manufacturing index, and home building. New unemployment claims remained above 400,000 for the 22nd consecutive week. Personal bankruptcies are still rising around 10% year-over-year. The NBER finally got around to saying the last recession was over 20 months ago, but said little as to what state the economy was currently in (recovery? stagnation? both?).
The one big recent development was a big reversal in treasury bond rates. In just over two weeks, the 10-year treasury bond yield has bounced from an intraday low of 3.07% (a 40-year low) to Friday's close at 4%. Given the price of these bonds moves inversely with the yield, whoever was long treasuries has seen their capital whacked by around 20-30% in a fortnight.
In addition, since the 10-year treasury is the benchmark for many public and private interest rates, these have backed up by roughly the same proportion. Thirty-year mortgage rates have jumped nearly a half point to 5.67% in the last three weeks, according to Freddie Mac. The "prime" 30-year rate listed by BankRate has backed up from 4.88% to 5.5% in the past four weeks.
As of yet, our economy has not been stress-tested over a prolonged backup in interest rates. There was a short period of rising interest rates at the end of the previous boom, but that undoubtedly will have a much different effect on today's economy as in the past. In 2000, we actually had capital investment that could be discouraged by higher interest rates. Today, most lending is in corporate and consumer debt, particularly mortgage debt; not to mention new supplies of state and Federal debts shipping fresh daily.
The vacation has not tempered my pessimism, particularly since it was taken in San Diego where the median home price is nearly $389,000 and the median income for a family of four is $63,800. Around $200 billion of home equity was extracted in 2002 thanks to record low mortgage rates and record high home prices. Lower rates keep refinancing profitable and make the marginal home more affordable and can keep prices increasing despite higher unemployment and relatively smaller incomes. We'll be seeing first-hand over the next several months whether the economy really can recover in a rising interest rate environment, as the slug of extra consumption afforded by refinancing is taken away. My guess is that it can't, and even lower interest rates will be needed soon, if the Fed can make that possible.
There have already been four instances where Treasury and mortgage interest rates have backed up by 1/2 point. All coincided with stock market rallies and expectations of an imminent economic recovery that ultimately failed. The conspicuous absence from my answering machine messages were the weekly calls from mortgage brokers asking me to refinance.
Of course, my revisit to my usual websites yielded some interesting facts.
This mortgage-refinancing binge has had two effects. One is the change in net new borrowing by the consumer, which rose by a record amount of $768 billion during 2002. The other effect is the amount 'saved' by private households through the refinancing of existing mortgages on their interest payments. Considering that 30-year fixed rates for mortgages have plunged by more than two percentage points over the past 12 months, from well over 7% to almost 5%, these savings have played an important role in bolstering disposable consumer incomes.
Pondering where all this money went, we took a look at the pattern of consumer spending from 2002’s first quarter to 2003’s first quarter. What we found greatly surprised us.
Apart from a temporary, minor surge in the sale of motor vehicles, expenditures on consumer durables were flat over the year. Among nondurable goods, the major increases in spending were on food, gasoline and fuel. Actually, 63% of the higher consumer spending was on services, and mainly on housing and medical care.
It was a discovery that has shocked us - because we learned that the American consumer’s heavy borrowing is largely financing expenditures on essentials.
The other, equally important conclusion to be drawn from these facts is that consumer spending, despite ever-new records in borrowing, is not able to lead a sustained recovery. So far, it has prevented a deepening recession, but it is much too weak for more than that. - (Kurt Richebacher)
Example: Not once, but more than several times we have run across instances of home-owners falling in arrears, which would have resulted in summary foreclosure. In this “kinder, gentler” world, they are contacted by the lender for a “re-finance”. The appraisal shows sufficient equity to bring payments current, escrow several months into the future and handle taxes and insurance as well as all the substantial requisite fees for the lender. Future ability to service is not of interest to the lender as there is now way this sucker is staying on the balance sheet. For those of you who have not been there, I commend the Appraisersforum.com. Some of the chat on pressure from lenders to over-appraise is startling. The mortgage inception process also has devolved into a situation without a responsible adult in the origination process. The anecdotal we are receiving may explain why recent statistics released show delinquencies down while ultimate foreclosures are up to a record. “Refi until it gets impossible and then shut down.” Tangentially, bankruptcies continue to hit new records. As long as the bubble in residential is provided some of that 16% growth aforementioned the dance can go on. By the way, each appraisal obviously affects all the “comparables”. Is there any wonder we have double-digit growth in prices. Is it any wonder that the buyer (previously the ultimate check on prices) cares less or is motivated to “BUY BEFORE THE PRICE GOES UP AGAIN, NOW!? - Edmund McCarthy.
We may be getting close to the time when the Fed may either have to put up or shut up. The warning shot in the bond market of the last few weeks just may be the market's way of suggesting to the Fed that they get on with supposed unconventional action as opposed to continued promises, threats and jawboning. And if a scenario like this comes to pass, monitoring foreign flows of capital may be more critical than ever since potential change at the margin in the buying habits of the single largest buyer of US debt instruments over the last few years would be more than meaningful. Unconventional Fed monetary warfare would necessarily mean a big expansion in the monetary aggregates (M3, M2, MZM, etc.). In essence, this type of activity would be an open and outright "dilution" of the dollar, especially in the eyes of foreign holders of dollar denominated assets. Would foreign money continue to be lavished so generously upon the US fixed income markets if a scenario like this were to occur? It may be well worth pondering because if the economy does not experience the fables second half recovery, election concerns on the part of the Administration may mean that the Fed is allowed leeway to move on to Plan B in relatively short order - the unconventional weaponry espoused by Greenspan, Bernanke, et al.
Alternatively, if some type of recovery does transpire, the talk of deflation will have proven to be an illusion. Either way, we have a lot of long bond players potentially looking to be less long in simultaneous fashion. As per the 1Q Flow of Funds data, the foreign community just may be leading the pack of big US debt holders pondering asset allocation, in spite of the fact that US trade related dollars continue to swell their holdings of foreign reserves. Remember, we're not suggesting that foreigners will sell their dollar denominated financial assets en masse. That's probably not realistic under any scenario except an outright panic. It's the potential slowing of foreign purchases of US fixed income assets that carries the most weight with us. Especially because it would probably occur within the context of the leveraged speculating community being forced into a bit of liquidation. - Contrary Investor
With the dollar remaining strong while the bond market implodes, the cause is most likely "a bit of liquidation" and foreign money being reallocated but not removed from U.S. assets, which would explain a little of the stock market's resilience of the past month. While reallocation of assets is fine and to be expected, the drain on incomes - alternatively the loss of refinancing gains - will be the $64,000 question as to whether the long awaited "second half recovery" materializes. With consumers being so heavily overindebted, forced to spend more just to afford necessities (and economists forced with a straight face to say there is no inflation), it's hard to see a recovery led by the consumer. So who steps up to the plate?
Tom DeLay says spending is causing the deficit. Is he right? What's really causing the deficit? War? Recession? Spending? Tax Cuts? Some of each? If the latter, how much of each?
To take a quick look at some of these issues, I grabbed data on Federal Revenue, Spending, and GDP from 1992-2004E. First, the Revenue and Spending Numbers. Note that the Bush budgets and tax plans were in effect from roughly 2002 onward (Spending in 2001 was authored by Clinton; Bush's 2001 rebate did cut into what 2001 revenue was under Clinton's budget).
First, in raw numbers (inflation has been modest, so while these are not inflation-adjusted, doing so would only have a minor effect). Under Bush, Federal Spending has skyrocketed. It was $1.86 trillion under Clinton's last budget but 2.01 trillion under Bush's first budget. Under Bush's third budget (authored with a Republican House, Republican Senate, and Republican White House), spending will be $2.27 trillion. That's a 22% increase over Clinton's last year, at most 3-5% of which is due to inflation. Now that's big government. How to pay for all of this?
Certainly not with tax revenue. That's down from $2 trillion in 2001 to $1.8 trillion in 2004. But that must be the fault of the recession, right? Wrong. Here are the GDP numbers:
So while slow and accompanied by rising unemployment, growth is still positive, meaning the tax base of national income increased. The only mechanism by which terrorism could affect revenue, as opposed to spending, is by reducing GDP, and that just hasn't happened. The only explanation is the Bush Tax Cuts. If we're not paying for the Bush spending now, when do we pay? Later, starting right around when the Baby Boomers retire.
But maybe our ability to pay is also increasing, so that as a percent of GDP, the increased spending and deficit are not so bad? Wrong. Bush increased spending as a percent of GDP from about 18.5% to over 20% (and inflation affects both the numerator and denominator equally and so is not a factor). But he did get the tax burden way down, from over 20% to 16%. But there are no free lunches. If spending is over 20% of GDP and revenue is 16% of GDP, that gap has to be paid at some point. But the bill will come after the 2004 election, and Bush is hoping you are too stupid to realize that (click to enlarge).
Back to the original issue of what caused the deficit, it's not the recession because the tax base has not fallen. The Wars on Terror and Iraq amount to at most $100b per year, so that without them, spending in 2003 might have been 19.63% of GDP instead of 20.56%--still well above the 18.6% mark in Clinton's last budget. So at most 20% of the deficit can be tied to terrorism (and that's just the sort of unforseen need Democrats were referring to when arguing, in vain, against Bush's tax cut). And that's perhaps generous, since it increasingly appears that the War on Iraq was discretionary spending by the Bush administration, rather than anti-terrorism spending. Of the 80% of the deficit not related to terrorism, roughly 1/3 of the blame goes to increased spending and 2/3 to the Bush tax cuts, resulting in this approximate allocation of responsibility (click to enlarge):
The White House is expected Tuesday to forecast record budget deficits in excess of $400 billion this fiscal year and next with little hope of a turnaround anytime soon.
The simultaneous operations in Afghanistan and Iraq are running around $60b per year, so we can forgive the administration that. On the other hand, income and GDP are actually rising, so it's hard to blame the economy for the deficit. Sure, unemployment is up, but that's a burden that falls disproportionately on the poor, who as Republicans love to remind us, pay little or no income taxes. (Of course they pay payroll taxes, which the Administration has busted out of the lockbox and comingled with general revenue).
What does this mean for you? Higher taxes and reduced services in the future, higher interest rates, and increases in the Federal Government's cost of debt service.
But surely, as a percentage of GDP, this is not so bad? So says incoming OMB Director Josh Bolten"
"Furthermore, the current deficit -- as a percentage of GDP -- is not large by historical standards and manageable within the overall context of our economy."
The CBO projects next year's GDP at $11.7 trillion, meaning that a $450 billion dollar deficit would represent 3.85% of GDP. Bolten is right that 3.8% is not high by historical standards, as long as you use the right history: the Reagan and Bush I years. On the other hand, Clinton inherited a deficit at 4% and got it down to 3% within a year. So perhaps Bolten should say that the deficit is not large by Republican historical standards. Just to make things clear, I've bracketed the years under budgets written by Clinton (1994-2001) in blue:
UPDATE: The projected deficits for 2003 and beyond in the graph are, of course, way too low now--they should look roughly like the Bush I deficits.
UPDATE: It doesn't happen often, and I had to be awake at 4:30 in the morning to do it, but I beat Atrios on this subject by almost two hours. But he's got a better graph.