Peering behind the U.S. economic curtain

Despite the seemingly good news that the U.S. has avoided a technical recession, there's actually a bit more to it than that. From a story by BusinessWeek's Peter Coy:

...the cut in the federal funds rate they announced on Apr. 30—a quarter-point, to 2%— probably won't be enough. Senior U.S. economist Paul Ashworth of London-based Capital Economics predicts the Fed will be forced to cut the funds rate to 1% by summer's end. The U.S. economy remains in dire need of aid, and the financial system, while no longer in flames as it seemed to be a couple months ago, is still smoldering. At the same time, inflation, aside from food and energy, is more a theoretical threat than a real one. Core prices rose just 2% from the first quarter of 2007 through the first quarter of 2008, going by the Fed's own favorite measure of inflation (the personal consumption expenditure deflator, excluding food and energy)...

In fact, though, the U.S. economy is weaker than is apparent from the 0.6% annual rate of growth in gross domestic product, which was reported before the Fed's statement. Much of the growth came from an accumulation of inventories—goods that were put on the shelf rather than sold. Final sales to domestic purchasers, which excludes inventory accumulation, actually fell 0.4%. It was the first such decline since 1991.

Indeed, the U.S. may well be in a recession despite the positive GDP report. First-quarter growth could be revised downward as more data come in. Even if the GDP news doesn't get worse, the business-cycle arbiters of the National Bureau of Economic Research could declare the current mess to be a recession in hindsight based on weakness in income, industrial production, and employment...

...many sectors of the economy are doing fine. By stimulating exports, the weak dollar is giving a lift to farmers, miners, and manufacturers. Procter & Gamble and General Motors both reported strong overseas earnings on Apr. 30. The health-care sector is cruising along as well...

Other sectors, though, are desperately weak, in particular financial services and housing. Residential construction fell at an annual rate of 26.7% in the first quarter, the worst in 27 years. The number of vacant single-family homes and condos rose to nearly 2.3 million in the first quarter, a record. Consumer confidence is in the pits, hurting retailers.

And despite the efforts of Bernanke & Co., there's still plenty of stress in the financial system. Banks are charging one another a big premium over the fed funds rate for loans, reflected in the elevated London interbank offered rate. One reason: They're hoarding cash to guard against incurring more loan losses or being forced to take assets back onto their balance sheets...

The fear of more losses is justified. Contango Capital Advisors CEO George Feiger predicts that losses will soon spread beyond residential mortgages to commercial real-estate loans and then on to weaker parts of the corporate sector, such as companies that have undergone leveraged buyouts. And Feiger notes that banks suffering losses will be forced to cut back on new lending.

That's why the Fed may need to cut more. By reducing the federal funds rate, it can lower banks' borrowing costs so their profit margin on lending goes up. Retained profits will give them the capital base they need to lend more, juicing economic growth.

Inflation hawks worry that rate cuts will cause inflation to become entrenched. But the slow increase in the core rate of inflation over the past year shows that soaring food and energy prices have yet to spill over into the rest of the economy. In the case of energy, there's one obvious reason: Spending on gasoline depresses the economy by taking money out of consumers' wallets and sending it abroad. The same goes for imported food.

Another reason inflation continues to remain under control is that, contrary to appearances, the Fed has not pumped up the money supply to combat economic weakness. It has offset its new kinds of lending to commercial and investment banks by simultaneously draining money from the banking system. The core money supply, known as M1, grew just 0.2% in the year through March. And even at 2%, the fed funds rate is not highly stimulative, given that it's no lower than the year-over-year core inflation rate.

The Fed has quelled the panic that prevailed in the financial markets until recently. But it still has to nurse an economy weighed down by massive bad debts. That is likely to require a period of easier money. Don't put away those fire hoses quite yet.

Owning up to the reality of a recession

It's sometimes hard to avoid being frustrated by the various games played by economists and experts with agendas (and how they tend to color their analysis a la the NAR's David Lereah or now Lawrence Yun) but now that a recession seems a foregone conclusion, Business Week writer Peter Coy provides an overview of what ails the U.S. economy and what we might expect the government to do:

How bad will this downturn get? No one can know because we've never experienced such a headlong slide in the housing market—and this comes at a time when its current value of $20 trillion accounts for the vast majority of most families' wealth. Right now most economists expect the U.S. to experience a mild, short recession in 2008. But there is at least a possibility of a steeper decline that the traditional recession remedies—interest-rate cuts here, deficit spending there—won't be able to handle...

Broadly speaking, policymakers have three options for putting a safety net under the economy. Each has its pros and cons, and the cons become most apparent when the measures are taken to an extreme. That's why a three-pronged approach that uses each option in moderation may be the best way to go.

The first option is to depend mainly on aggressive measures by the Fed to flood the economy with liquidity. That's already under way. On Mar. 11, the central bank announced an innovative program to lend $200 billion in high-grade Treasury securities to big commercial and investment banks. It will allow them to use, as collateral for the loans, valuable but harder-to-trade assets such as AAA-rated mortgage-backed securities. The measure could enable them to start lending and borrowing again. The cons: no direct help for distressed homeowners who don't qualify for refinancing.

A second option would be some sort of a government-led bailout of homeowners, which reduces the burden of looming debt and high interest rates, and limits foreclosures. The third option would be assistance to the lenders and holders of mortgage-backed securities in an effort to thaw the credit markets. The trouble is, both of these options are seen as unfair by those who don't require bailouts. And it's up in the air who would have to bear the biggest share of the housing-related losses: homeowners, investors, or taxpayers.

It's indisputable, though, what policy changes cannot accomplish. There's no way to stop home prices from falling; they got way too high, and the current crisis won't end until they get back to what the market concludes is a sustainable level. It's not reasonable to try to avoid a recession, either. When a sector as huge as housing goes into a deep dive, it's pretty much inevitable that the rest of the economy will be affected...

Policymakers have an obligation to make sure the downturn doesn't gather speed and turn into something along the lines of the long and deep 1973-75 recession. It is extremely dangerous for there to be millions of homeowners who have a clear financial incentive to abandon their homes because they are worth less than the mortgages on them. Already there are signs that the stigma of abandoning a home is fading, as desperate homeowners flock to Web sites with names like walkawayplan.com and youwalkaway.com...

The entire capital of the U.S. banking system would be wiped out many times over if everyone who was underwater on a mortgage turned the keys over to their lenders...

There's a social aspect, too. Concentrated foreclosures, voluntary and otherwise, can destroy neighborhoods because abandonment increases decay and crime. And the housing crash undermines the social compact...

The most urgent task is making sure that the financial system isn't so crippled by losses that it ceases to perform its critical function of moving capital from those who have it to those who need it. Asset deflations can damage the financial system. Further complicating matters is that securitization and derivatives make it nearly impossible to figure out who's vulnerable to a big loss until things blow up...

The Fed's approach is double-barreled. Since last summer it has cut the federal funds rate from 5.25% to 3%, and markets are forecasting the central bank will cut to around 2% before it finishes. The Fed may need to go even lower, though, perhaps to 1.5% or even back to its 2003-04 level of 1%...

The Fed's second tactic is to ease the credit crunch by convincing market players that suspect assets really are worth something. It's doing that by giving commercial and investment banks new options for backing up their loans. The Fed's Mar. 11 move is designed to help its primary dealers—20 huge firms at the core of the financial system. They will be able to pledge a wider variety of collateral—including AAA-rated private label mortgage-backed securities—in exchange for top-quality Treasuries. And the loans will be for 28 days instead of just overnight...

But the Fed can't do it alone. Lower rates don't help homeowners who can't qualify for a new mortgage because their homes have lost too much value. Also, massive cuts raise the risk of inflation, which in turn pushes up long-term interest rates, partially neutralizing the Fed's efforts. The Bush Administration's $152 billion economic-stimulus package will help a bit, but economists expect the lift to fade by the end of 2008, not long after the November elections...

But one person's "necessary intervention" is another's "outrageous bailout."

When the government steps in, that's when the battle starts about who wins and who loses. Home mortgages account for 44% of private nonfinancial debt, making them one of the main pillars of the debt market. If the value of household real estate falls by 25%—an amount many economists consider plausible—it would be a $5 trillion loss of wealth. Any type of government bailout plan will alter the eventual distribution of losses between homeowners and investors...

The purest form of bailing out homeowners would be forcing lenders to reduce the amounts borrowers owe. Such a "cramdown" could be accomplished by legislative fiat or, more likely, by changing the federal bankruptcy law to allow judges to reduce mortgage debt in a Chapter 13 reorganization the same way they're allowed to reduce other debts...

The downside: In the short run, lenders might face even bigger losses. In the long run, they would charge higher interest rates for fear of future cramdowns...

At the other extreme are ideas that would bail out the lenders without trying to prop up prices. Harvard's Feldstein, who publicized his plan in a Wall Street Journal op-ed piece on Mar. 7, would have the federal government make low-cost personal loans to families equaling 20% of their mortgage debt. The homeowners who took the offer would have to use all of the money to pay down their mortgages.

That would give a huge shot of cash to lenders and would reduce the likelihood that borrowers would walk away from their homes since the remaining mortgage debt would be well under the home's value. But it would expose taxpayers to risk while doing nothing to reduce the total indebtedness of households. And by letting lenders off easy, it would embolden them to think they could lend irresponsibly again with impunity...

In the Presidential race, Republican Senator John McCain doesn't want to bail out either side, favoring private workouts between borrowers and lenders. Here's how he summed up his feelings on Mar.11: "It is not the government's role to bail out investors...or lending institutions who didn't do their job."

Democratic Senators Barack Obama and Hillary Clinton both tilt toward homeowners, but Clinton is more aggressive, calling for a voluntary 5-year freeze on subprime mortgage rates and a 90-day moratorium on foreclosures...

One idea that's gaining support from some liberals and conservatives alike is the creation of a modern-day version of the Home Owners' Loan Corp., a Depression-era agency that bought mortgages at a discount and issued new, more affordable ones...

Even if the warring parties agreed to such a plan, there would still be plenty of scope for conflict...Each side, naturally, would cloak its arguments in the public interest. Lenders would try to dump the worst-performing loans on the government and retain the healthy ones, notes Elmendorf. And any wide-ranging program would inevitably help many undeserving borrowers and lenders.

One danger is that political brawling will lead the debate away from what's best for the economy as a whole. There are many ways to get this wrong. In Japan in the 1990s, for example, insolvent but politically powerful companies got their banks to keep them alive with low-cost loans, which meant that the banks had no money left over to fund new businesses. That led to Japan's infamous Lost Decade of slow growth.

All that said, some inefficiency and political conflict may be an acceptable price to pay for programs that lessen the very real risk of a systemic financial meltdown.

In other words, there will be plenty of angry renters who sat out this entire boom-and-bust phase waiting for the typical fundamentals to return to the markeplace. But it's not just about them and their dreams for affordable homes, anymore. As part of a society, we sometimes have to hold our noses when we bailout those seen as undeserving.