Friday, October 19, 2007


The 2007 Nobel Prize in the Economic Sciences was just awarded to three U.S. economists, all mathematicians, in what is part of a watershed movement to bring back economics that benefits public institutions, as well as private individuals. Their research into “mechanical design theory” has made financial markets more workable for the many, rather than leave them to the devices of the “invisible hand” of Adam Smith, our first free market economist.

Also, major banks have agreed to set up a $200B fund to increase liquidity in non-subprime commercial paper markets. Why? The credit crunch is caused by mortgage lenders unable to sell their non-conforming, jumbo loans into the secondary market. And so by providing liquidity to the short end of the secondary market (i.e., 90-day commercial paper has the cheapest rate.) that buys shorter-term consumer loans, it should ease the credit crunch and make more money available.

What is the real cause of the credit crunch? Fed Chairman Bernanke claimed in his most recent speech it was the fault of sloppy underwriting of subprime loans: “The rate of serious delinquencies has risen notably for subprime mortgages with adjustable rates, reaching nearly 16 percent in August, roughly triple the recent low in mid-2005. Subprime mortgages originated in late 2005 and 2006 have performed especially poorly, in part because of a deterioration in underwriting standards.”

Yet the Fed has raised short-term interest rates 4.25 percent over that time in chasing the phantom of inflation. This in fact has doubled mortgage payments in many cases; something that no borrower (or maybe lender) could have anticipated—whether prime or subprime loan. Therefore, the Fed should be shouldering much of the blame. It created the problem, not faulty underwriting.

The economics prize Nobel press release stated that “Whether one considers auctions, elections or the taxes we pay, our lives are governed by mechanisms which make collective decisions, while attempting to take account of individual preferences. Such mechanisms are designed to deliver the greatest social good despite the fact that individual participants may act for their own gain, rather than for the general well-being of society.”

This is bringing us back to a form of Keynesian economics that sees a role for government and regulation. The latest research is moving economics away from libertarian or so-called supply-side economics, in a word, which had enshrined unregulated, free markets that tended to cause greater income inequality.

What is the research? It is a branch of Game Theory (remember the film, “A Beautiful Mind”?) that helps to determine the best market outcomes for the “general well-being of society”, in the words of the Nobel committee.

Markets do not do this automatically. For example, those with insider information tend to profit more from market information that is not readily accessible to all. So government regulation does not have to be a bad thing. That is why we have the Federal Reserve, whose charge is to regulate banks and the money supply. Without the Fed, recessions would be deeper and inflation swings more volatile. Hence one of its mandates is to “manage” inflation.

Copyright © 2007


We know that third quarter economic growth will be good to very good, in spite of the credit crunch. Why? Prices are still rising at a healthy rate. And some inflation is good for economic growth, contrary to what the Federal Reserve may say.

The September Producer Price index for wholesale goods and services rose 1.1 percent, but most of the increase was in food and energy—no surprise in a growing economy. The so-called core rate without food and energy prices rose just 0.1 percent and is up just 2 percent in 12 months. This means that the extreme fluctuations in energy and food prices (due to seasonal demand factors) are not being passed on to other goods and services. What would happen if prices actually began to fall? That is one of the official definitions of a recession!

Here are some reasons we will see good growth for the rest of this year. The September employment report showed 110,000 jobs added to private and government payrolls, while another 118,000 jobs were added in revisions to prior months’ estimated job growth by the Labor Dept. The 4.7 percent unemployment rate means the U.S. economy is still at full employment.

Then retail sales, the main indicator of consumer spending, continue to be healthy. Overall consumer spending is averaging 3 percent and retail sales, its main component, soared 5 percent annualized in September, the strongest showing in at least 2 years. The biggest spending was in health care, as well as catalogs and online sales, each up 1 percent.

In spite of this, growth could be slowing in Q4. Third quarter job growth was half that of 2006, and private sector payrolls are growing at slowest pace in three and one-half years. This alone should keep another interest rate cut on the table at the Fed’s October meeting, says CBS Marketwatch economist Irwin Kellner.

Interest rates have barely budged since the Fed’s September rate cut. ARM indexes, such as the Cost of Funds, or Treasury, or LIBOR indexes are still hovering around 5 percent, which means it could be months before holders of adjustable rate mortgage will see any payment relief. Why? Investors are asking for higher returns until the extent of ARM defaults is known. Most of the negatively amortized Option ARMs were issued in the past 2 years, and so they won’t reach their full payment for at least another year. It is that uncertainty that is keeping short-term interest rates high.

How do we know when property valuations return to more normal levels? A measure of housing value used by economist Robert Shiller of Irrational Exuberance fame, is the growth of median incomes. Housing prices over the long term tend to approximate the average increase in household incomes. No surprise, since that is what determines affordability.

Household incomes have increased 5.6 percent per year over the past 35 years.

Yet average home prices have risen more than 50 percent just over the past 6 years, according to the National Association of Realtors. This means housing values have risen 15-20 percent over the historical norm in those years, and so must fall by that amount to return to the historical norms.

Copyright © 2007


The key to a recovery from the subprime debacle is the health of consumers. And so consumer spending is the most closely watched indicator at present, with the Federal Reserve now waiting to see whether its one-half percent rate cut will keep consumers, and so the economy, humming. Surprise, surprise. August consumer spending is the highest in 2 years; probably because the labor market is still creating jobs.

It is a pleasant surprise, given all the bad news in August. It means the Fed has room to cut rates further at its October 31 FOMC meeting should real estate sales continue to decline. August new and existing-home sales dropped 8.3 and 4.3 percent, respectively, and for sale inventories are up to a 10-month supply. Another surprise is that median prices are still holding, as higher-end homes continue to sell.

The drop in the Prime Rate that determines most credit card rates could also spur more consumer spending over the holidays. August credit card debt rose a whopping 8.1 percent, or $6.1 billion, according to the Federal Reserve.

September’s unemployment report also generated optimism. Though the jobless rate rose from 4.6 to 4.7 percent, 110,000 new payroll jobs were created and past months’ employment was revised upward. Health care and food services are responsible for one-half of all payroll jobs created this year, according to the Labor Department. Mortgage lending, its related services, and construction continue to lose jobs, however.

The good jobs picture is encouraging consumers to continue to shop. Real consumer spending increased a large 0.6 percent, while the inflation rate is back down to early 2004 levels. The Personal Consumption Expenditure index, the major inflation indicator, is up just 1.8 percent in 12 months. Average hourly earnings are rising 4.1 percent—double the inflation rate. The fact that incomes are rising faster than inflation has to make consumers feel more secure.

"Consumers -- so far -- are taking the recent financial turbulence in stride," said economists for Credit Suisse in their weekly outlook. They look for a 0.4 percent increase in September sales, boosted by moderate growth in general merchandise sales, and sales growth in restaurants, building materials and apparel.

But others think the retail numbers won't be so rosy. "Sluggish chain-store suggest that September was a disappointing month for retailers," wrote economists for Global Insight, who expect only a 0.1 percent gain in sales. "Consumers have become more cautious and resistant to outlays on big-ticket items," such as building materials and durable household goods.

For the third quarter as a whole, consumer spending increased at a 3 percent annual rate, double the growth recorded in the second quarter, economists said. This could mean that third quarter economic growth will exceed 3 percent, following the 3.8 percent Q2 final estimate of GDP growth, since consumer spending accounts for two-thirds of economic growth.

Copyright 2007