Why the prolonged economic slump? Housing.

Economist Dean Baker writes about a recent research paper from the Federal Reserve Bank of Cleveland:

The study goes on to note the extraordinary weakness in housing in this recovery and point out that this weakness could explain much of the weakness of the recovery.

While the study notes that there are questions of causation (a weak recovery could lead to weakness in housing), there can be little doubt that if residential construction had returned to its pre-recession level, as had been the case by this point in all prior post-war recoveries, the economy would be back near full employment.

Of course it is not hard to understand why housing has not recovered. The massive over-building of housing during the bubble years lead to an enormous over-supply of housing, which shows up in the data as a record vacancy rate in the years 2006-10. In the last couple of years the vacancy rate has begun to decline which can explain the recent uptick in housing over the last few quarters.

This housing story explains why we should have expected a long and drawn out recovery. There is no easy way to replace the massive loss in demand associated with the collapse of the housing sector. And, it is hard to blame the collapse on President Obama, since the overbuilding took place in the years 2000-2006 and the collapse was already well underway at the point where he took office. ...

Ultimately we will need an increase in foreign demand, meaning a lower trade deficit, to fill the gap. This will require a lower valued dollar which will make U.S. goods more competitive internationally. Unfortunately, neither candidate seems willing to make the case for a lower valued dollar, which means that we can probably expect a weak economy for many years into the future, regardless of who gets elected.

Unemployment rate drops to 8.6%

The unemployment rate hasn't been dropping steadily, but it has been dropping. Today it was announced that it has fallen to 8.6%, from 9.0% a month earlier.

Economic growth rate climing again!

People fretting about a new recession over the summer were wrong:

The nation's economy gained some much-needed strength in the third quarter, as the pace of growth nearly doubled compared to the previous three months.

The nation's gross domestic product, the broadest measure of its economic health, grew at a 2.5% annual rate in the quarter after adjusting for inflation. That's up from the disappointing 1.3% growth in the second quarter and the anemic 0.4% pace in the first three months of the year.

I was right. Warren Buffett was right. If this continues (and it will) it might barely keep Barack Obama in office for four more years.

Warren Buffett: New recession unlikely

Billionaire investor Warren Buffett thinks the likelihood of a new recession is low:

Warren Buffett says Berkshire Hathaway has been buying stocks at bargain prices, including shares of his own company. ...

The Omaha billionaire isn't worried his new purchases will be caught up in a 'double-dip' for the U.S. economy. He thinks "it's very, very unlikely we'll go back into a recession... We're coming out of a recession."

I agree with him. I track eight specific leading indicators on the St. Louis Federal Reserve website. Of the eight, five are in positive territory, one is negative, and two are borderline. (For most of these indicators, I find the year-over-year percentage change to be a better leading indicator than the current level.)

Positive

• Initial jobless claims (YoY)
• Interest rate spread between 3-month and 10-year Treasuries
• Manufacturer's new orders of capital and durable goods (YoY)
• Money supply growth (YoY)
• New housing permits (YoY)

Negative

• St. Louis & Kansas City financial stress indices

Borderline

• ISM Manufacturing Index
• S&P 500 (YoY)

The two borderline indicators have a history of producing lots of false positives. As the saying goes, "The stock market has predicted nine of the past five recessions." The financial stress indices are probably negative because of what's happening in Europe, rather than because of what's happening here.

This graph shows the Leading Index for the United States through August. Notice that while it normally dips during or prior to recessions, there is no dip this time.

U.S. household incomes fall to 1996 levels

The U.S. Census Bureau reports that median household income has fallen to 1996 levels:

The income of the typical American family—long the envy of much of the world—has dropped for the third year in a row and is now roughly where it was in 1996 when adjusted for inflation.

The income of a household considered to be at the statistical middle fell 2.3% to an inflation-adjusted $49,445 in 2010, which is 7.1% below its 1999 peak, the Census Bureau said.

The Census Bureau's annual snapshot of living standards offered a new set of statistics to show how devastating the recession was and how disappointing the recovery has been. For a huge swath of American families, the gains of the boom of the 2000s have been wiped out.

Economic podcast

Friday's Wells Fargo weekly economic podcast has a discussion of last week's economic news, including a four-and-a-half minute discussion of construction and housing from 1:38 - 5:58.

America slowly digging out of economic hole

The Aggregate Weekly Hours Index—one of the best measures of employment—shows that the U.S. is very slowly digging its way out of the recession. In the graph below, the blue line shows an index of the total number of hours that Americans are working per week. The red line shows an index of the growth in the civilian non-institutional population (i.e. civilians not in prison). As long as the blue line rises faster than the red line, it means that America's employment situation is improving.

Was it worth it?

Via Paul Krugman, here is the Congressional Budget Office's forecast of the output gap—the difference between potential real GDP and actual real GDP:

That looks to me like seven years of subpar economic performance in exchange for about five or six years of rising housing bubble. But Krugman thinks the seven years may be optimistic:

No, I don’t know where that recovery in 2015 is supposed to come from; my guess is that it’s basically the CBO unwilling to project a depressed economy more or less forever.

He adds:

The CBO also projects unemployment staying above 8 percent until late 2014 — again, with no clear explanation of why it should fall sharply in 2015. This translates into a human catastrophe for the long-term unemployed.

My housing graphs were created to try to warn people of the housing bubble, but many didn't want to listen.

So here's the question: Was the party really worth the hangover?

Is a U.S. debt rating downgrade the end of the world?

The Wall Street Journal cites example of other rich countries that have suffered debt ratings downgrades:

Japan, Canada and Australia, among others, have suffered the ignominy of being downgraded from top credit ratings.

By and large, borrowing costs remained fairly steady and, in some instances, eventually declined. Stock markets wavered but generally rebounded, while the response in currency markets varied widely.

"When [a downgrade] happened in the past, was it the end of the world?" asks Nick Bennenbroek, head of currency strategy at Wells Fargo & Co. "The reaction wasn't positive, but it wasn't extreme."

For the U.S., history suggests the outcome could even be a long-term positive if a downgrade prods policy makers to get the government's fiscal house in order.

While circumstances and economic paths differed, the impacts of the ratings change itself weren't significant, analysts say. One reason is that ratings changes are usually well-advertised in advance, allowing markets to adjust gradually. But more important for the markets than the ratings moves, analysts say, are the country's underlying economic trends.

Economic outlook: blah

Things aren't looking good for the U.S. economy:

Ben Bernanke and the rest of the Federal Reserve have grown more pessimistic about the state of the U.S. economy.

At the conclusion of a two-day policy meeting, the central bank said that while the recovery is continuing at a moderate pace, growth is somewhat slower than expected. It also said the jobs market is "weaker than anticipated."

It also issued new economic projections that call for slower economic growth, higher unemployment and higher inflation in 2011 and 2012 than in its previous forecast. At a press conference Wednesday afternoon, Fed chairman Bernanke referred to the new forecast as a significant revision.

The Fed said in its statement that it believed some of the headwinds would be short-lived, including supply disruptions from the Japanese earthquake, and the "effect of higher food and energy prices on consumer purchasing power."

But Bernanke said he and other Fed policymakers aren't certain how much of the weakness is due to those temporary factors and how much is due to longer-lasting problems.

He said continued problems in the housing market, excess private sector debt and weakness in the financial sector might be more serious than previously thought. And he suggested the labor market is a long way from being healed.

Government confirms weak job market

As a follow up to yesterday's blog post about the interdependency between employment and housing, today's government employment data confirms a weakening job market:

After several months of strong job growth, hiring slowed sharply in May, raising concerns once again about the underlying strength of the economic recovery.

The Labor Department reported on Friday that the United States added 54,000 nonfarm payroll jobs last month, following an increase of 232,000 jobs in April. May’s job gain was about a third of what economists had been forecasting.

The unemployment rate ticked up to 9.1 percent from 9.0 percent in April.

A recovering economy is dependent on a recovering housing market, and vice versa

The economy and the real estate market are caught in a Catch-22 situation:

Home prices won't rebound until jobs come back. But jobs won't come back until the housing mess gets fixed.

That's a problem because both the housing market and the broader economy are having trouble getting back in gear. Hiring is losing steam, and after home values hit a post-boom low, many are projecting further price declines.

"The economy can move forward without housing," said Mark Zandi, chief economist with Moody's Analytics. "But I don't think it can flourish and create enough jobs to bring down unemployment in a significant way without a revival of the housing market." ...

Housing typically helps lead the way in an economic recovery not only through a surge of construction and the hiring that goes with it, but though demand for goods and services that go into forming a new household. ...

Doug Duncan, chief economist of mortgage finance giant Fannie Mae, is focused on the impact of jobs on housing — and vice versa.

"Our mantra all along has been employment, employment, employment," Duncan said. "Until you see employment growth and then income growth and then household formation, you don't get to the bottom of this." ...

On Wednesday, payroll processor ADP reported that hiring by businesses ground to a halt in May, raising concerns about the recovery in employment.

Here's more on the weak job market:

"The ADP Employment report coughed up a hairball in May," Robert Dye, senior economist with the PNC Financial Services Group, said in a research note, referring to a report by payroll processing company ADP released Wednesday.

That report showed private sector employers added only 38,000 workers in May, far lower than the revised 177,000 jobs added in April and much weaker than economists had expected.

That level of job growth is the weakest number since September. ...

The ADP report followed on the heels of an already disappointing jobs number released by outplacement consulting firm Challenger, Gray & Christmas on Wednesday morning.

According to that report, the pace of planned job cuts edged higher in May, as 37,135 jobs went on the chopping block — a 1.8% increase from April's planned job cuts.

But government sector layoff announcements dominating those numbers.

How to fix the American economy

The Economist lays out America's systemic economic problems, which politicians and the public ignore:

PESSIMISM about the United States rarely pays off in the long run. Time and again, when Americans have felt particularly glum, their economy has been on the brink of a revival. ...

On the plus side, it is hard to think of any large country with as many inherent long-term advantages as America: what would China give to have a Silicon Valley? Or Germany an Ivy League? But it is also plain that the United States does indeed have long-term economic weaknesses—and ones that will take time to fix. The real worry for Americans should be that their politicians, not least their president, are doing so little to tackle these underlying problems. ...

Of course, plenty more could be done to spur innovation. The system of corporate taxation is a mess and deters domestic investment. Mr Obama is right that America’s infrastructure is creaking. But the solution there has as much to do with reforming Neanderthal funding systems as it does with the greater public spending he advocates. Too much of the “competitiveness” talk is a canard—one that justifies misguided policies, such as subsidies for green technology, and diverts attention from the country’s real to-do list.

High on that list is sorting out America’s public finances. The budget deficit is huge and public debt, at over 90% of GDP when measured in an internationally comparable manner, is high and rising fast. ... Neither party is prepared to make the basic compromises that are essential to a deal. Republicans refuse to accept that taxes will have to rise, Democrats that spending on “entitlements” such as health care and pensions must fall. ...

Below the radar screen, America had employment problems long before the recession, particularly for lesser-skilled men. These were caused not only by sweeping changes from technology and globalisation, which affect all countries, but also by America’s habit of locking up large numbers of young black men, which drastically diminishes their future employment prospects. ...

All this means that grappling with entrenched joblessness deserves to be far higher on America’s policy agenda. Unfortunately, the few (leftish) politicians who acknowledge the problem tend to have misguided solutions, such as trade barriers or industrial policy to prop up yesterday’s jobs or to spot tomorrow’s. That won’t work: government has a terrible record at picking winners. ... Stemming the decline in low-skilled men’s work will also demand more education reform to boost skills, as well as a saner approach to drugs and imprisonment.

The fear over inflation is stupid

Right now we hear lots of worries in the financial press about high inflation. We've heard these worries throughout the financial crisis, which is stupid because inflation barely even exists. This graph shows that inflation is below the Fed's target rate of 2.0-2.5%.

The red line shows core PCE inflation, the measure of inflation tracked by the Fed due to its relatively low volatility. The blue line shows the GDP Deflator, the best measure of inflation affected by monetary policy. Is inflation currently something to worry about? Not by a long shot!

Warren Buffett on the U.S. economy

As always, Warren Buffett—the most successful investor alive—is optimistic about the long-term future of the United States economy:

Money will always flow toward opportunity, and there is an abundance of that in America. Commentators today often talk of “great uncertainty.” But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.

Don’t let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.

We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.

Shadow Stats

From Paul Krugman, Nobel-laureate in economics:

An interesting exchange between John Quiggin and Jonathan Chait on right-wing agnotology — that is, culturally-induced ignorance or doubt. ...

I mean, I see it all the time on economic statistics: point out that inflation remains fairly low, that the Fed isn’t really printing money, whatever, and you get accusations that the data are being falsified, that you yourself are cherry-picking by using the same measures you’ve always used, whatever. There really is epistemic closure: if the facts don’t support certain prejudices, that’s because They are hiding the truth, which we true believers know.

Here Paul Krugman is talking about the right wing in general, especially Tea Party types, but the paragraph on economic statistics could easily be applied to the Shadow Stats website and its cult members followers.

Why do economists put price on the vertical axis?

I see over on Paul Krugman's blog that several readers are complaining about the drawing of supply and demand curves. According to them, it is wrong to put price on the vertical axis and quantity on the horizontal axis, as economists typically do:

Why do economists break the standard math rules regarding the placement of independent and dependent variables?

First, I'm not sure they do. In microeconomics, changes in production capacity shift the supply curve and changes in tastes shift the demand curve. These are effectively quantity changes that subsequently affect prices. This makes quantity the independent variable and price the dependent variable. From this perspective, price should be on the vertical axis. If you insist that price determines quantity, but not the other way around, then you obviously don't understand the effect of weather on agricultural output.

Second, my guess is that economists measure so much stuff in terms of price, that it is convenient to always have price on the same axis. Would you really prefer price on the horizontal axis like this?

Price appears on lots of economics graphs. By always putting price on the vertical axis, economists don't have to repeatedly swap which axis is the price axis from one graph to another.

Update: I decided to ask "The Google." In an old post, here's what Harvard's Greg Mankiw had to say on the issue:

On the axis question: The instructor is right that, given the way we now teach supply and demand, it makes more sense to have price on the horizontal axis. The price is viewed as the variable that determines quantity supplied and quantity demanded, and we usually put the dependent variable (which here is quantity) on the vertical axis.

So why is it switched? Here is a guess. The early economists may have been imagining that, in the very short run, a given quantity of goods was supplied to the market (an agricultural harvest, for example). The supply curve is then vertical, and the price adjusts to ensure that quantity demanded equals this exogenous quantity supplied. So, in this very short run, the price seems more like the dependent variable. Now, however, the choice of axes is based more on historical convention than logic.

I am not an historian of economic thought, so these answers may be off base.

In the same post, Mankiw also adds the input of Robert Barro:

As I recall, Hicks in Value and Capital thought in terms of demand price and supply price. The demand price is how much a person was willing to pay for an additional unit of goods (starting from some initial quantity, Q). The supply price is how much a producer would have to be paid to provide an additional unit of goods. This construction—which I think comes from Marshall—makes it natural to have P on the vertical axis and Q on the horizontal.

And finally, Wikipedia points me to this from An Introduction to Positive Economics, 7th ed. by Richard G. Lipsey:

Readers trained in other disciplines often wonder why economists plot demand curves with price on the vertical axis. The normal convention is to put the independent variable on the X axis and the dependent variable on the Y axis. This convention calls for price to be plotted on the horizontal axis and quantity on the vertical axis.

The axis reversal — now enshrined by nearly a century of usage — arose as follows. The analysis of the competitive market that we use today stems from Leon Walras, in whose theory quantity was the dependent variable. Graphical analysis in economics, however, was popularized by Alfred Marshall, in whose theory price was the dependent variable. Economists continue to use Walras' theory and Marshall's graphical representation and thus draw the diagram with the independent and dependent variables reversed — to the everlasting confusion of readers trained in other disciplines. In virtually every other graph in economics the axes are labelled conventionally, with the dependent variable on the vertical axis.

The racist origins of the Davis-Bacon Act

From an interview and biography of George Mason University economics professor Walter Williams:

Mr. Williams distinguished himself in the mid-1970s through his research on the effects of the Davis-Bacon Act of 1931—which got the government involved in setting wage levels—and on the impact of minimum-wage law on youth and minority unemployment. He concluded that minimum wages caused high rates of teenage unemployment, particularly among minority teenagers. His research also showed that Davis-Bacon, which requires high prevailing (read: union) wages on federally financed or assisted construction projects, was the product of lawmakers with explicitly racist motivations.

One of Congress's goals at the time was to stop black laborers from displacing whites by working for less money. Missouri Rep. John Cochran said that he had "received numerous complaints in recent months about Southern contractors employing low-paid colored mechanics." And Alabama Rep. Clayton Allgood fretted about contractors with "cheap colored labor . . . of the sort that is in competition with white labor throughout the country."

Today just 17% of construction workers are unionized, but Democratic politicians, in deference to the AFL-CIO, have kept Davis-Bacon in place to protect them. Because most black construction workers aren't union members, however, the law has the effect of freezing them out of jobs. It also serves to significantly increase the costs of government projects, since there are fewer contractors to bid on them than there would be without Davis-Bacon.

Wikipedia has more on the Davis-Bacon Act here.

Green jobs training: The road to unemployment

Green jobs are political marketing, not reality. Workers who believed the hype and retrained for these largely non-existent jobs are finding themselves unemployable:

After losing his way in the old economy, Laurance Anton tried to assure his place in the new one by signing up for green jobs training earlier this year at his local community college.

Anton has been out of work since 2008, when his job as a surveyor vanished with Florida's once-sizzling housing market. After a futile search, at age 56 he reluctantly returned to school to learn the kind of job skills the Obama administration is wagering will soon fuel an employment boom: solar installation, sustainable landscape design, recycling and green demolition.

Anton said the classes, funded with a $2.9 million federal grant to Ocala's workforce development organization, have taught him a lot. He's learned how to apply Ohm's law, how to solder tiny components on circuit boards and how to disassemble rather than demolish a building.

The only problem is that his new skills have not resulted in a single job offer. Officials who run Ocala's green jobs training program say the same is true for three-quarters of their first 100 graduates.

"I think I have put in 200 applications," said Anton, who exhausted his unemployment benefits months ago and now relies on food stamps and his dwindling savings to survive. "I'm long past the point where I need some regular income." ...

The industry's growth has been undercut by the simple economic fact that fossil fuels remain cheaper than renewables.

If you don't substantially raise the price of carbon, people will continue to get the vast majority of their energy from fossil fuels. Even if you do substantially raise the cost of fossil fuels, the "green jobs" created will likely be less than the "black jobs" lost.* That's because energy conservation—using less energy—is an essential part of reducing carbon emissions. Using less energy means that the energy industry must shrink as a percentage of GDP, while other industries grow as a percentage of GDP. The "black jobs" lost would be completely offset by more jobs elsewhere in the economy, but it is a mistake to assume that they would all be in green jobs. Many of them will be in other industries entirely.

The Obama administration has completely missed its opportunity to raise the price of carbon. If it didn't happen when Democrats controlled the House of Representatives, it won't happen with Republicans in control. Democrats seem to think that reducing carbon emissions, fighting global warming, creating "green jobs," and promoting "energy independence" can occur completely through wishful thinking. It cannot. The price of carbon must go up.

Hat tip: Jeffrey Miron

* Since oil, coal, and soot are black, I figure "black jobs" is the best complementary term to "green jobs."

CNBC housing debate

In the video, Susan Wachter is misleading. Price-to-rent ratios are out of line, not just by 1890 levels, but also by 1970-1999 levels—basically all of the pre-bubble period. From 2007-2008, prices were falling rapidly until the Federal government stepped in to prop them up.