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.

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.

Paul Krugman was dead wrong

On Friday, Paul Krugman wrote:

I wish I could believe in this Macroeconomic Advisers claim that there is a zero chance of a double-dip recession. But when they say that this probability

is estimated as a function of the term slope of interest rates, stock prices, payroll employment, personal income, and industrial production

I immediately lose all confidence.

When short-term interest rates are up against the zero lower bound, a positive term spread tells you nothing; as I explained a year and half ago, it’s something that has to happen given the fact that short rates can go up, but not down.

Failure to understand this point led to excess optimism in late 2008. I’m a bit surprised to see Macroeconomic Advisers falling into the same fallacy now.

In the second to last paragraph, he is referring to a previous blog post of his from December 27, 2008, in which he wrote:

I see that economists at the Cleveland Fed are taking some comfort from the positive slope of the yield curve. Long-term interest rates are higher than short-term rates, which is usually a sign that the economy will expand.

Not this time, I’m afraid. It’s all about the zero lower bound.

The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.

But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down. ...

So sad to say, the yield curve doesn’t offer any comfort. It’s only telling us what we already know: that conventional monetary policy has literally hit bottom.

Paul Krugman may have been right in theory, but he was completely wrong in fact. As Frederic Mishkin has pointed out, the yield curve forecasts economic expansion or contraction roughly four quarters advance. Four quarters after Paul Krugman gave his "Not this time, I’m afraid" argument above, Real Gross Domestic Product showed economic expansion as shown here:

So, Paul Krugman was dead wrong. The economy returned to expansion exactly as the yield curve predicted. Furthermore, the yield curve is significantly steeper now than it was in December 2008. That means year-ahead prospects are even brighter now than they were then.

Paul Krugman is a natural economic pessimist. He's such a pessimist that when the economic data shows economic expansion, he tries to confuse his readers by implying that it doesn't.

No matter how Paul Krugman tries to spin it, the yield curve in December 2008 predicted mild economic expansion, and mild economic expansion is what we got. The yield curve is much steeper today.

Economy continues to slowly improve

The economy continues to slowly improve, but today's payroll numbers were not as good as expected:

A flood of temporary Census workers in May led to the biggest jump in jobs in ten years, the government reported Friday.

Employers added 431,000 jobs in the month, up from 290,000 jobs added in April. It was the biggest gain in jobs since March 2000.

But Census hiring was responsible for 411,000 of May's increase in employment. Private sector employers also added 41,000 jobs in the period, well below the 218,000 private sector job gains in April. Government payrolls other than Census declined by 21,000 jobs in May, due largely to job cuts by state and local governments.

It was a disappointing number for private sector hiring, as economists surveyed by Briefing.com had forecast an overall gain of 500,000 in May. U.S. stocks traded sharply lower on the report, with the Dow Jones industrial average down more than 200 points in midday trading. ...

Despite the spike in hiring, the unemployment rate declined only modestly, to 9.7% from 9.9% in April. Economists had forecast it would decline to 9.8%.

Here is the year-over-year percentage change in payrolls:

Here is the year-over-year percentage change in aggregate weekly hours worked:

Here is the year-over-year percentage change in initial jobless claims:

Here is the official unemployment rate:

Warning signs of an economic double-dip

The U.K.'s Telegraph newspaper warns of a possible second recession:

The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history. ...

The M3 figures – which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance – began shrinking last summer. The pace has since quickened.

The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.

"It’s frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said. ...

Larry Summers, President Barack Obama’s top economic adviser, has asked Congress to "grit its teeth" and approve a fresh fiscal boost of $200bn to keep growth on track. "We are nearly 8m jobs short of normal employment. For millions of Americans the economic emergency grinds on," he said.

David Rosenberg from Gluskin Sheff said the White House appears to have reversed course just weeks after Mr Obama vowed to rein in a budget deficit of $1.5 trillion (9.4pc of GDP) this year and set up a commission to target cuts. "You truly cannot make this stuff up. The US governnment is freaked out about the prospect of a double-dip," he said.

The White House request is a tacit admission that the economy is already losing thrust and may stall later this year as stimulus from the original $800bn package starts to fade.

Recent data have been mixed. Durable goods orders jumped 2.9pc in April but house prices have been falling for several months and mortgage applications have dropped to a 13-year low. The ECRI leading index of US economic activity has been sliding continuously since its peak in October, suffering the steepest one-week drop ever recorded in mid-May.

Meanwhile, The Economist sees the glass half full (but only half full):

The American economy has now expanded for three consecutive quarters, as of March of 2010. New reports on durable goods orders and manufacturing activity show continued growth in April. This will slowly but surely translate into rising employment, which will ultimately feed back to rising spending and investment.

America's recovery remains young and fragile. Still, many developed nations would be happy to have a nine-month performance like the one the American economy has managed since returning to growth.

Economic outlook good

The National Association for Business Economics sees good economic growth ahead:

The U.S. economy should expand at a solid pace this year and next as consumers increase spending, confident the recession is behind them, a panel of economists said in a survey released Monday.

The 46 economists surveyed in the National Association for Business Economics report between April 27 and May 7 predicted U.S. gross domestic product would expand by 3.2% in 2010 and 2011.

That is a touch higher than the 3.1% growth predicted for both years in the last survey, released Feb. 10.

"Although risks involving Europe have recently escalated, the outlook in this country has improved in most respects," said NABE President Lynn Reaser, chief economist at Point Loma Nazarene University.

"Growth prospects are stronger, unemployment and inflation are lower, and worries relating to consumer retrenchment and domestic financial headwinds have diminished," she said.

Judging by the slope of the Treasury yield curve, I too expect decent economic growth over the coming year. That said, the economy fell so far during this recession that it will take a long time to get back to potential GDP.

To put things in perspective, here's a graph of real GDP vs. potential real GDP:

Luckily, real GDP is currently growing faster than potential real GDP, which is needed if we want the economy to get back to normal.

January 2010 unemployment statistics

The official unemployment rate declined in January. It's still too early to tell for sure, but so far it looks like we're seeing the declining unemployment that occurs after a typical recession, rather than the "jobless recovery" of the previous two recessions. (The typical pattern after a recession is for the unemployment rate to decline. That pattern was broken by the previous two recessions when the unemployment rate rose for quite a while after the recession had ended.)


Payroll numbers suggest we lost 20,000 jobs in January. That's far better than the pace a year ago, but we need 100,000-200,000 job gains just to keep up with population growth. This graph shows the month-over-month change in payrolls as measured by the U.S. Bureau of Labor Statistics:


Here is the month-over-month change in payrolls as measured by Automatic Data Processing, a private payroll-processing company. I'm starting to favor the ADP data over the BLS data due to lower month-to-month volatility. As a reminder for conspiracy theorists, the ADP data does not come from the government.


Some economists consider aggregate weekly hours worked as the best measure of both unemployment and underemployment. For those of you who favor the U6 measure of the unemployment rate over the official rate because it takes underemployment into account, you should love the Aggregate Weekly Hours Index. Here we see that the pace of average weekly hours worked is showing continuing improvement, but it's still below zero:


Finally, some economists like to look at weekly initial unemployment claims because it is updated more frequently than the monthly statistics above. This graph shows the year-over-year percentage change. Notice it's currently below zero, which is a good sign.


For those of you on the east coast, enjoy the snow this weekend.

Is the economic stimulus effective?

Comparing the Obama administration's projections for unemployment when President Obama proposed the stimulus bill with the unemployment rate we have actually experienced, it's hard to say definitively that the economic stimulus package has "saved or created jobs."

Dark blue: projected unemployment rate with stimulus.
Light blue: projected unemployment rate without stimulus.
Red: actual unemployment rate.

Graph source.

December 2009 jobs data

Pundits are making a fuss about the fact that official December job losses increased from November's unbelievable numbers. Monthly job losses still show a longer-term gradual decline. (Source.)


Perhaps looking at ADP's private job loss numbers does a better job of putting the trend in perspective:


The official unemployment rate remained unchanged at 10.0% in December:


The year-over-year percent change in aggregate weekly hours worked shows an upward trend, although it's still below zero:


The year-over-year percent change in initial unemployment claims is below zero and continuing to improve:


So, while the widely-reported official data didn't look so good in December, other data shows the recovery is continuing.

A reminder for conspiracy theorists: The ADP data (i.e. the second graph) does not come from the government.

November 2009 monthly job loss numbers from ADP

According to the ADP Employment Report, the month over month rate of job losses continued to decline in November. This graph shows the number of job losses in thousands:


Here are ADP's comments on the numbers:

Nonfarm private employment decreased 169,000 from October to November 2009 on a seasonally adjusted basis, according to the ADP National Employment Report®. ...

November was the eighth consecutive month during which the decline in employment was less than in the previous month. Although overall economic activity is stabilizing, employment usually trails economic activity, so it is likely to decline for at least a few more months.

Keep in mind that we need 100,000-200,000 job gains each month just to keep up with population growth.

U.S. economy in sustained, gradual recovery

Don't believe the impatient fear mongers. A slow, but steady, recovery is in process. From Bloomberg:

The U.S. economic recovery will extend into next year as manufacturing expands and the pace of firings abates, reports today indicated.

The Conference Board’s index of leading indicators, a gauge of the outlook for the next three to six months, rose 0.3 percent in October, preserving a string of gains that began in April. Other reports showed claims for jobless benefits held at a 10-month low and Philadelphia-area manufacturing accelerated.

The rally in stock prices, low short-term interest rates and slowing job losses that propelled the leading index signal consumer confidence and spending are likely to stabilize, limiting the risk the economy will retrench. The data supported Treasury Secretary Timothy Geithner’s forecast today that the emerging expansion will be sustained into 2010.

“It’s very clear that the economy is now expanding, but I don’t see it being a vigorous expansion,” said Michael Moran, chief economist at Daiwa Securities America Inc. in New York, who correctly forecast the leading index. “We are seeing a gradual improvement, but the key word is ‘gradual.’”

How the crisis could change economic theory

Here's an interesting look at how the housing bubble may change macroeconomic theory.

The crisis exposed the inadequacy of economists' traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles. ...

"We could be looking at a paradigm shift," says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.

That shift could change the way central bankers do their job, possibly leading them to wade more deeply into markets. They could, for example, place greater emphasis on the amount of borrowing in the economy, rather than just the interest rates at which borrowing is done. In boom times, that could lead them to restrict how much money various players, ranging from hedge funds to home buyers, can borrow.

October 2009 unemployment and jobless numbers

The unemployment rate has reached the highest level since the early 1980s, rising to 10.2% in October 2009. The last time the U3 (official) unemployment rate was this high was April, 1983. (As a kid back then, it really didn't seem that bad—although I'm doing well now, too.)


Initial weekly unemployment insurance claims continue to improve—or more precisely, they are getting worse at a slower rate. This graph shows year-over-year numbers. Ideally, we'd like the YoY numbers to be below zero for an extended period of time.


The government's job loss numbers show a continuing, but slowing, contraction in the job market. Remember, we need monthly job gains of 100,000-200,000 just to keep up with population growth.


For conspiracy theorists who don't believe the government's numbers, here are the monthly job loss numbers as measured by Automatic Data Processing, Inc.

Cash for Clunkers cost $24,000 per car

Edmunds.com has analyzed the car sales numbers during the Cash for Clunkers program and estimated that the marginal cost was $24,000 of our tax dollars for each new car sold:

A total of 690,000 new vehicles were sold under the Cash for Clunkers program last summer, but only 125,000 of those were vehicles that would not have been sold anyway, according to an analysis released Wednesday by the automotive Web site Edmunds.com. ...

The Cash for Clunkers program gave car buyers rebates of up to $4,500 if they traded in less fuel-efficient vehicles for new vehicles that met certain fuel economy requirements. A total of $3 billion was allotted for those rebates.

The average rebate was $4,000. But the overwhelming majority of sales would have taken place anyway at some time in the last half of 2009, according to Edmunds.com. That means the government ended up spending about $24,000 each for those 125,000 additional vehicle sales.

The average rebate value mentioned above seems like bad rounding. It appears the average rebate was closer to $4,348. Here's the math:

$3 billion overall cost ÷ 690,000 cars sold = $4,348 per car total cost

(690,000 / 125,000) × $4,348 = $24,000 per car marginal cost

In an example of regulatory capture (government regulators protecting the industry they are supposed to regulate), the Department of Transportation is defending Cash for Clunkers (i.e. "Car Allowance Rebate System") by saying that it was good for the auto industry:

"It is unfortunate that Edmunds.com has had nothing but negative things to say about a wildly successful program that sold nearly 250,000 cars in its first four days alone," said Bill Adams, spokesman for the Department of Transportation. "There can be no doubt that CARS drummed up more business for car dealers at a time when they needed help the most."

Note that what's good for car dealers is not necessarily what's good for the overall economy, just as what's good for Realtors is not necessarily what's good for the overall economy. Like the first-time home buyer tax credit, Cash for Clunkers is nothing more than wasteful corporate welfare.

The White House has come out with a weak, short-term-oriented defense of the program. Notice, however, that for the most part the left-wing economics bloggers who are usually quick to defend the White House against faulty economic reasoning (e.g. Paul Krugman, Mark Thoma, Calculated Risk) are remaining silent on this one. In fact, left-leaning economist Jeffrey Sachs is out with his own criticism of Cash for Clunkers' supposed climate benefits. Sachs actually makes the mistake of measuring total cost, rather than marginal cost, so the program is actually 5.5 times more wasteful than the numbers he complains about.

Just like the first-time home buyer tax credit, Cash for Clunkers is a handout of our tax money to the special interests who lobby Congress.

My thoughts on a second economic stimulus package

Some economists and politicians are advocating a second economic stimulus package. Here are my thoughts on a second stimulus.

State governments likely have better ideas than Congress regarding what are high value spending projects within each state. On the whole, pre-existing state spending was likely already going to the highest-value projects available. Since state governments are now being forced by circumstances to drastically cut back at a time when Congress's stimulus package is in effect, this suggests that Congress massively misallocated capital with the first stimulus.

If Congress creates a second economic stimulus package, it should only consist of more aid to the states and extended unemployment benefits. Congress should avoid a bunch of bells, whistles, and pet projects. Stuff like cash for clunkers and subsidies to transfer existing homes from one person to another are just real-life examples of the broken window fallacy.

Wasteful spending harms long-term economic growth just to avoid short-term pain. On the other hand, when states are forced to cut useful investment spending (e.g. education and infrastructure), then it harms the economy in both the short-term and the long-term.

Warren Buffett described the first stimulus package as a mix of Viagra and candy. Aid to the states and extended unemployment benefits would be pure Viagra. Most other spending options would be candy.

Recession may not be over

Last month, as the unemployment rate took a reprieve from its upward spike, I speculated that the recession might be over. Friday's release of the August unemployment rate showed a resumption of the upward spike, suggesting that the end of the recession may be yet to come.

Here's a graph of the official unemployment rate over the past ten years. Gray bars indicate recessions:


Here's a graph of the official monthly job loss numbers during this recession:


For conspiracy theorists who don't trust the government, here are the job loss numbers from the private ADP Employment Report. Notice that ADP measures job losses in August as being roughly 50% higher than the BLS numbers:

An economic recovery forecast

The Economist makes its prediction for the shape of the economic recovery:

A gloomy U with a long, flat bottom of weak growth is the likeliest shape of the next few years.

They also have a discussion about the housing market here.

Recession is ending; may be over

The number of new job losses continues to decline. Compare these U.S. Bureau of Labor Statistics job loss numbers with the numbers from Automatic Data Processing, which I published on Wednesday.


The unemployment rate is no longer spiking. It may drift upward at a slower pace if we have a jobless recovery, but the end of a sharp upward spike has historically been a sure sign of the end of a recession.


Weekly initial unemployment insurance claims peaked about a month ago. This graph shows the year-over-year percentage change for emphasis.


Finally, the bulk of the economic stimulus package is yet to be spent. That's a lot of money that will be dumped into the economy over the next year or two.

July 2009 ADP employment report numbers

Source: Automatic Data Processing, Inc.

It looks like the recession is slowly ending, but it will still take a while. Note that job gains need to be positive just to keep up with population growth. The government's numbers come out on Friday.

Do the leading economic indicators suggest a recovery?

Here is a look a several important leading and coincident economic indicators. Leading indicators help forecast the future of the economy several months in advance. Coincident indicators reflect the current state of the economy.

Leading Indicators

The most reliable leading indicator is the slope of the Treasury yield curve. The slope is typically measured by the spread between the 10-year Treasury bond yield and the 3-month Treasury bill yield. An inverted yield curve (long-term rates lower than short-term rates) suggests a recession within the next year. Meanwhile, an upward sloping yield curve (long-term rates perhaps 1.0% or more higher than short-term rates) suggests a growing economy within the next year. I don't have a graph of the yield curve, but the spread is currently 3.33%, which suggests we are headed for a recovery.

New capital goods orders are a sign of a near-term recovery or decline. Here is the year-over-year percent change.


New building permits are another leading indicator. Due to the fact that we still have a housing bubble, I don't expect permits to turn around before the recession ends. Expecting housing to lead us out of this recession is like expecting technology to lead us out of the 2001 recession.


Coincident Indicators

While leading indicators forecast the future of the economy and thus tick up before a recovery, coincident indicators reflect the current state and thus should not tick up until the economy is actually recovering.

Year-over-year non-farm payrolls are still dropping like flies.


Year-over-year industrial production is still plunging.


Yet the year-over-year change in consumer sentiment is surprisingly strong, probably caused by the recently rising stock market (or vice-versa).