Our forecast has not changed over the past six months, so we have not drawn too much attention to it. Today we will, along with an explicit description of the current state of the economy and the obstacles to a complete recovery. Forecast: Stagnation. Currrent State: Failing. Obstacles: Continued Fed Obtusess, Unwillingness to pay bills in cash, and the Meanness that arises from a general Me-ness.

We will expand from these brief descriptions in the forecast section of today's podcast.

Later we will dig a bit deeper into the Fed on Idiot of the Week, and we have comment on the Taylor Rule and other nonsense, taking off from Paul Krugman.

First, though, complete and unedited, the statement by Barack Obama on the Financial Products Safety Commission. We view this new regulatory body as essential to moving out of the current case of market domination by big banks and bad practice.

As we've said before, this is a non-intrusive means of regulation. This has nothing to do with audits, pay restrictions, capital requirements, or any of your back rooms. One must ask Why the big banks have marshaled their money and purchased representatives in opposition to such a bill. As I said, it is not intrusive. One is examining products, not producers. Legitimate real economy firms welcome such consumer safety regulation as a way of weeding out the less competent and presumably less well-funded and at the same time increasing confidence among purchasers.

We suspect that it is precisely because such a financial products safety commission would bring order to the market and prevent exploitation by the well-positioned that it is being resisted by those well-positioned. And we are extremely pleased that Obama has invested political capital in this venture. Here he is, beginning with a calling of the roll.

OBAMA

Barack Obama

If nothing else, the current crisis has demonstrated how thoroughly the financial sector has captured its main regulator, the Fed. This new agency is an important escape from that corrupt arrangement.

Now. The Forecast.

First let's line up the opposition.

The consensus of economists suggests recovery proceed before too long into an equilibrium of high unemployment and lower trend growth, what I will a recovery, that is, slight improvement, into stagnation. Not a V-shaped, not a W-shaped, but a square root shaped -- down, up and out at a lower level.

This is mistaken because of the stable tail.

Another camp, primarily at the Fed, predicts a somewhat stronger rebound and posits a danger, even mortal danger, from an inflation arising from the need to unwind the Fed's injections of liquidity with a fire hose.

These guys have long been clueless and serve only as powerfully placed voices standing ready to sabotage any real recovery in the real economy.

The true context for policy is an economy that is highly fragile and posed for another leg down. The financial sector is a millstone, the zombie banks are hardly rowing, and the prospect of further weakness in residential and commercial real estate and continued negative contributions from derivative and commodity speculation are already on the charts.

Specifically, zombie banks are profitable because they are gouging consumer credit users, playing in commodity and futures casinos, and eating the interest payments from the toxic securities which are still on their balance sheets. The financial sector is not enabling productive investment activity because they don't have to. They have the government. Besides, the prospect of profit from new investment in the context of overcapacity and a retreating consumer is very low.

Aside from propping up the zombie banks and other formerly private sector markets, the Fed's policy has done nothing. There are no more bubbles to blow up, even at zero percent, that will generate private investment. No more high tech booms, no more residential housing booms, no more commercial real estate booms. There are only financial market casinos to play in. Fine if you have the zero percent chips and are playing with the house, but for people looking for productivity in the real economy. Not so much.

The only route to real recovery and a return to strong growth is through the Demand Side. Only with a renewed job market and a recovery of incomes can we escape the blunders of the past few decades. As we've said, this demand side recovery does not need a return to the consumer economy. The consumer economy, after all, was premised on borrowing and the idea of selling houses back and forth to each other. Consumer baubles large and small were the end point of this economy.

The public goods of infrastructure, education, public health and climate change mitigation are ample and productive occupations that can support prosperity. As incomes grow, the overcapacity of the private sector will shrink. But more to the point for private investment, a new emphasis on public goods opens new industries where there is currently NO overcapacity and where new investment would not be redundant. (To be clear for the simple, spending on public goods is income to private economic actors, whether employees or contractors.) These types of industries are very much not currently dominated by foreign industry. Health care, education, domestic infrastructure, energy retrofitting, reengineering transportation and energy and information infrastructure. All domestic activities. All productive activities, in that they generate improvements in the productive framework. These are not BMW's or flat screen tvs or perfume in one hundred dollar bottles.

Three main obstacles are likely overwhelming, however.

1. Fed intransigence in its error.
2. Political opposition to paying cash for public goods, and
3. A social psychology which believes the good of the whole is code for taking away from me.


The Demand Side way out is really the only way out. And that's why we've outlined it here in the context section. Insofar as the path diverges from this prescription, and by the same dimension, it will be a reduction from the optimal outcome.

The three main obstacles are likely overwhelming, however.

Demand Side is not revolutionary in the sense it is new or complicated, but only because it is fundamentally separate from these errors.

Oh, and four, such a solution likely means inflation in non-core commodities like energy and food. That is because any investment-led growth would mean inflation, as we read Minsky. No less investment-led growth tied to public goods. In the early stages, such inflation would be very mild. In every stage it could be controlled by tax policy -- by reducing inflationary demand via increases in taxes. (This would make sense in that we have bills to pay, but see below.)

But lets go back to one through three.

One, the Fed stands ready to kill any recovery with monetary policy. We have hammered the Fed elsewhere and we have debunked the effectiveness of monetary policy relentlessly. We will do it again next week, but soon we will begin to leave them alone, not because they are unimportant or are gaining a new comprehension, but because they are hopelessly wedded to their doctrines.

Two, Consumer and mortgage credit inflated the housing bubble. It may take public borrowing to create the public goods that can lead us forward. But not because it is necessary or advisable, only because it has been one of the signal successes of the Rovian or Reagan Right to turn the word "taxes" into a synonym for "incest." Since taxes are the way we pay for public goods in the absence of deficit spending, the prospect of paying outright is diminished. One of the continuing marvels of this age is that the non-results from tax cutting fevers have been ignored. The rhetoric continues that cutting taxes will lead us to water even as we go further into the desert.

Three. The Me culture. To some extent "Don't tax me" is a function of this broader "Me" culture. The focus on consumerism and the consumer is also a function of this "Me." And the resistance, as before, to strengthening the whole is very often an affirmation that what is mine is what is most important.

In previous generations, the influence of and dependence on family was felt strongly. Community was essential. "Me" was impolite, at best. The religeon of primitive economics is 180 degrees divergent. Greed is good. Getting what I can is not only all right, it is of positive benefit to everyone. Beliefe that strong community, stable environments, planning, and public goods produce a positive sum game is viewed as dangerously naive. So we keep digging.


All Right. All right. Forecast.

Yes, if you've noticed, we've drawn back in from DemandSide dot net to get more proprietorial. We've decided if we're going to be right, we should look into getting paid for it. Nevertheless, we'll be dropping those charts back onto another vehicle soon, for those of you who have been cribbing off our work.

Forecast continued recession.

The happy talk on Wall Street of recovery is based on a definition of recovery as two successive quarters of positive GDP growth. This is, of course, not a very sophisticated description of the economy, and it is not the formula used by the NBER when they make their official determination. If it were, they wouldn't need twelve months. It is our belief that even considering the strong political winds now blowing in favor of quote recovery unquote and the flimsy increase in activity that is needed to justify such a determination, the NBER will not be persuaded to declare recovery in the same quarter as rising unemployment and continued industrial stagnation.

Our Demand Side descriptions are not recovery and recession, which have peculiar and not well understood technical definitions, but on the three levels of failing, weak and strong economies. The current situation is failing.

We have the stimulus and recovery potential of the Recovery Act on one hand. On the other, we have the negative stimulus of no private investment and contracting state and local governments.

Specifically, real GDP growth will be somewhat volatile around zero. Nominal GDP volatile around 1.5. Unemployment in the narrow measure will continue to trend upward into 2010. Unemployment in the broad U-6 measure will go up less quickly than it has over the past 18 months, but at a steeper slope than the narrow measure.

We have a idiosyncratic measure called Net Real GDP, which is essentially GDP minus the federal deficit needed to make it happen, that will continue to decline. That will likely be our first chart up on the new site.

Demand Side does not see forecasts as a crap shoot, which is the consensus view, but as the evidence of understanding. Neither do we put stock in precision. Better to be approximately right than precisely wrong, as John Maynard Keynes said. Nor do we see economic outcomes as independent of policy choices. All of which creates a different platform than the typical statistical model based forecasts.

(We notice Ellen Zentner, a chief advocate of "The recovery began in June" camp, reserves the right to tweak forecasts up to the day before the next official data come out. This displays sensitivity to statistical trends, but not really forecasts.)

So, having been right, we will continue to tell you about it until we are wrong. Not a V. Not a W. Not a square root. There is upside, but not until the employment situation has been fully addressed and the drag from the financial sector's systemic meltdown is cut away. There are upturns on the charts, and strong ones, but these depend on policy choices not yet made. Until then, it is the Great Stagnation, with a distinct risk of another leg down.

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Forecast charts and assumptions

The Pessimist Scenario assumes:

• No change in the Big Banks First policy regarding the financial sector.


• The commodities bubble now underway is not met at the pass by government countermeasures.


• Health care reform is passed, but without the public option.


• No new or significant fiscal stimulus.
  

The Baseline Scenario assumptions we've already gone over:

• New significant stimulus, including help to states and localities


• A viable public option in the health care reform package


• Oil prices moderate, and the commodities bubble is short-lived
  

The Optimistic Scenario:

• A full public option included in health care


• Commodities bubble is short-lived


• Full reform of the banking sector, including structuring markets to exclude government guarantees of derivatives and breaking up the big banks


• Fiscal stimulus is paired with climate change alarm


• Revenue is enhanced with carbon taxes and higher rates on the wealthy
  

All assume

• The consumer economy is buried under the rubble of the crash of the financial markets.


• An end to the Great Recession has to come on the back of public goods

Of no concern to us is:

• Strength or weakness in financial markets. Lower stocks will lower effective borrowing rates. Strength in stocks will gin up confidence.


• Dollar weakness or strength. Dollar weakness mirrors strength in the price of commodities, particularly oil. Although we have argued for a decade that the trade imbalance eventually means a weaker dollar, that is not so true in the short term in an economic crisis.


• Budget deficit. The larger the deficit the more fiscal stimulus is likely to have been administered, but also the more pressure builds to raise interest rates and resist needed reforms.

Forecast I -- We begin the extension of the Demand Side forecast

The low-tech forecast from Demand Side

All the high-flying forecast models have broken down. The Demand Side forecast does better than the Bull Chips.

Not by brilliance, but because we are looking in the right direction.

It is not that there is any particular sophistication in our forecast that it has done so well in difficult times, it is just that the forecast adopts the demand side perspective.

We'll get to the details on the next podcast. Today the theory.

Waiting for profits to increase before the economy can turn around, a canard repeated by last week's Idiot of the Week, is ass-backwards. The prospect of profit must increase, not the fact of profit.

The difference is the crucial difference.

Prospect is forward-looking and involves investment. Entrepreneurs identify a need and fill it. The investment is important. it is the beginning of the business cycle, such as it exists.

The fact of profit means the investment is paying off, not that any new investment is required. In fact, companies habitually maintain this profit by discouraging investment from competitors by one means or another. Continued profits may mean a good investment has been made in the past, but it may equally mean a protected industry or the aging of the business cycle.

When we use the word investment, we are not referring to buying stocks, but in real investment. Equities and debt issues from companies do not necessarily mean a new plant or better mousetrap -- or more jobs. They are purchases of existing investment and may very well be made for defensive purposes or to take advantage of a market advantage or some other reason. Financial investments, in particular, are -- as we have discovered to our dismay -- not jobs-producing investment.

We use the concept of business cycle not because we put much stock in it as a prime descriptor of what is going on, but because it is familiar. The concept is much more useful when applied to segments of the economy, the sectors, than it is when applied to the economy as a whole. The entrepreneur is always looking forward, hence there is no particular reason for demand to fade unless the profits portion is too large or concentrated in cohorts that do not spend or invest. Such unbalanced profits distribution simply drains the multiplier.

The past two recessions, for example, were brought on by speculative financial bubbles. This is not a business cycle. It is demand alternately stimulated and crushed by perceptions of wealth, as paper values of stocks and houses rise and fall. It may stimulate investment, but because these perceptions are in a bubble, that investment is inevitably distorted.

One might argue that the investment boom of the late 1990s actually ameliorated the downturn in the 2000's. The real improvements in productivity reducing, perhaps, the decline in perceived wealth. Be that as it may, and it is only speculation:

Demand creates the prospect of profit. But what creates demand? One might foresee that a water shortage will increase the demand for water, and so invest in that commodity. But it must be effective demand. You will not make a profit if people cannot create effective market demand by having the income to purchase.

In our current case, what creates demand is government spending and investment, and its translation into private investment.

One of the great calamities afflicting young economists is segregating C + I + G + NX. Consumption plus investment plus government spending plus net exports. On one hand, it is an accurate description of output, since it covers all the bases. On the other hand, it is simply a labeling exercise which often gets its tags wrong. C includes consumer durables, some education and health care. G includes a lot of education, health care, infrastructure spending and activities such as national defense. All of this might be better thought of as investment in a real form. The I includes only investment by businesses and residential housing. Business inventory may include chewing gum.

Not to beat this horse too long, but the return on education per dollar is about six times that of residential investment,

What creates demand? Investment. Government spending. But it is also released by economic security.

You heard our simple modeling of the various stimulus packages where we highlighted the falling consumption function. The consumption function is the proportion of new income that is spent. In good times, with stable prospects, more of one's income may be spent. In bad times, with uncertain prospects, the tendency is to save. You can see the savings rate spiking right now. Private pullback has more than offset public stimulus. We'll have a comment on the savings rate and the flagellation of the American consumer in an upcoming podcast.

But let's walk around this point a bit.

What is so important economically about the health care fix? It will create security and return confidence in consumers. So serious has been the body blow to the balance sheet of households that confidence will not return without a tangible reason. Universal health care can be one reason. Secondarily it will reduce the many types of burdens of profit-first health care delivery on the budgets of households, government and business.

What destroys demand? Withdrawal of investment and government spending -- and a falling consumption function.

All other things equal, one would use government spending to balance a drop in investment spending such as we have seen since 2007 with the drop in residential and business investment. This has not happened. Not only has there been the pull-back in the household and business sector we noted above, but the contraction in state and local government spending has also offset much of the federal expansion. The financial collapse and credit crunch piled on an enormous subtraction in investment and employment far above what might have occurred in the expiration of a housing bubble absent the blunders in securitization, mortgage innovation and derivatives.

We could go on.

But to the forecast.

As we've said, our baseline forecast assumes policy advances at the federal level in three areas:

(a) Removing the zombie banks from the economic field and reforming the financial sector,

(b) Fiscal stimulus, and

(c) Improvements in social insurance and homeowners' assistance.

We did not mention homeowners assistance this time, until now, but it is important not only to stabilize the consumption function but also to stabilize the housing market. These clearly are not in place to the level we imagined, but neither have policymakers exhausted their allotment of time. The response may come as the facts make themselves more clear.

Prospects going forward are uncertain to the degree that we are going to break out the forecast into optimistic, baseline, and pessimistic scenarios. The differences are based entirely on government policy choices. We recognize that economics is a science of human behavior. The behavior of millions aggregated is, however, more predictable than that of a few in government or powerful corporations that may have idiosyncratic incentives.

You've heard some of the assumptions for the baseline. We'll go into the details, including the numbers in the next podcast.

House price decline may not be abating

One of the recent claims is that house prices are falling less rapidly than they were before. Declining at a slower pace, is the term. We believe this is wrong. Even in the math. If zero were the base, it would be conceivable. But house prices are not going to fall to zero. They have some positive value. If this positive value is in any way significant, then the denominator of the percentage fall gets smaller faster than in the case of a zero base.

It's too damn bad the solution chosen was not an effective Home Owner's Loan Corporation or effective protection in bankruptcy. Instead it is the supply side of the market that is being salted with free money from the Fed to bring down mortgage rates. This may help those in good shape to refinance and generate some better cash flow, but that is going directly into the savings account and is not going to help demand.

Here is housing expert and noted economist Robert Shiller's take. This is the Shiller of the Case-Shiller Home Price Index.

Why Home Prices May Keep Falling,
by Robert Shiller,
Commentary, NY Times:

Home prices in the United States have been falling for nearly three years, and the decline may well continue for some time.

Even the federal government has projected price decreases through 2010.

...

Such long, steady housing price declines seem to defy both common sense and the traditional laws of economics, which assume that people act rationally and that markets are efficient. ... If people acted as the efficient-market theory says they should, prices would come down right away, not gradually over years, and these cycles would be much shorter.

But something is definitely different about real estate. Long declines do happen with some regularity. And ... we still appear to be in a continuing price decline. ... One could easily believe that people are a little slower to sell their homes than, say, their stocks. But years slower?

Several factors can explain the snail-like behavior of the real estate market. An important one is that sales of existing homes are mainly by people who are planning to buy other homes. So even if sellers ... have no reason to hurry because they are not really leaving the market.

Furthermore, few homeowners consider exiting the housing market for purely speculative reasons. ... And they don’t like shifting from being owners to renters... Among couples...,... any decision to sell and switch to a rental requires the assent of both partners. Even growing children, who may resent being shifted to another school district and placed in a rental apartment, are likely to have some veto power.

In fact, most decisions to exit the market in favor of renting are not market-timing moves. Instead, they reflect the growing pressures of economic necessity. This may involve foreclosure or just difficulty paying bills, or gradual changes in opinion about how to live in an economic downturn. This dynamic helps to explain why, at a time of high unemployment, declines in home prices may be long-lasting...

Even if there is a quick end to the recession, the housing market’s poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.

Captured regulator premise gets more backers

Forecast

Mark Thoma is coming close to the captured regulator position with regard to the Fed's handling of the financial crisis.

http://economistsview.typepad.com/economistsview/2009/04/using-antitrust-law-to-break-up-banks-that-are-too-big-to-fail.html

http://economistsview.typepad.com/economistsview/2009/04/the-professionals-are-not-being-held-accountable.html

In a couple of posts linked on the web site, including his post entitled "The Professionals are not being Held Accountable" on Economist's View, Thoma addresses this point. In one he cites Michael Pomerleano

http://blogs.ft.com/economistsforum/2009/04/the-crisis-holding-the-professionals-to-account/

Viral V. Acharya and Rangarajan Sundaram. The latter two point out: “The US recapitalization scheme ... is ... generous to the banks in that it imposes little direct discipline in the form of replacement of top management or curbs on executive pay, and secures no voting rights for the government“.

We seem to forget one of the successful lessons from the late 1980s savings and loan crisis in structuring positive and negative incentives: holding accountable the directors and officers, lawyers, accountants of the banks, investment banks and the rating agencies. ... The Office of Thrift Supervision, which regulates the US’s thrifts, and its sister agency, the Resolution Trust Corp which was in charge of disposing of the assets of failed S&Ls, embarked on a deliberate deterrence strategy targeting lawyers, accountants, directors and officers of failed thrifts that aided and abetted the excesses leading to the S&L crisis. The intent was to discourage future abuses and recover some of the lost taxpayer funds. ...

In the US, we are told that there are no culprits in the crisis. The attitude of the policy makers, regulators, bankers and traders involved in the crisis is virtually fatalistic, treating the crisis as an inevitable “force majeure”.

(Demand Side point: According to Wikipedia, force majeure, literally superior force, refers often to a common clause in contracts which essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as a war, strike, riot, crime, or an event described by the legal term "act of God" (e.g., flooding, earthquake, volcano), prevents one or both parties from fulfilling their obligations under the contract. However, force majeure is not intended to excuse negligence or other malfeasance of a party, as where non-performance is caused by the usual and natural consequences of external forces (e.g., predicted rain stops an outdoor event), or where the intervening circumstances are specifically contemplated.

Returning to Thoma, Pomerleano, Acharya and Sundaram.

All of them were observers and “no one saw it coming”. In short, the crisis is a Lemony Snicket’s “Series of Unfortunate Events”.

In reality the regulators that should have kept a close eye on the rapid growth of the shadow banking system were complacent, and the boards did not have the background in the industry and didn’t understand the risks. It is clear that the policy makers and regulators lack the moral authority to lead us out of the crisis. ...

The US Treasury plans to rely on the same firms and people that were involved in leading to the crisis to get us out of it. ... Clearly, nothing learned, nothing gained from the S&L crisis or the Swedish experience. Maybe this will change.

Saying it's not your fault you crashed the ship into the rock because the rock was underwater and hidden - nobody could have seen it coming - loses its force when you are navigating in waters that are known to be rocky. Even if you have the latest sonar based upon fancy, innovative math that is supposed to detect the rock before you hit it, and even if regulators were supposed to clearly map and mark all danger, if you hit it anyway, there's a reason why captains are expected to go down with - or at best be the last ones off - the ship. It ensures they'll do all they can to avoid hitting it in the first place.

Unquote

This is getting very close to the Demand Side position that the Fed and other financial regulators are no different than examples throughout government where oversight bodies have become captives to the industries they are supposed to regulate. The Fed's continued insistence on rescuing the financial institutions rather than stabilizing the banking functions in new, smaller, credible institutions is the ultimate proof.

Forecast: Recovery contingent on policy actions, Fed improvement

This Week

Listen to this episode

Another context for the forecast is those economists who are predicting the ultimate depression. This is actually a hopeful sign. Why hopeful? These same economists predicted until the middle of last year that the U.S. and the world would avoid recession entirely, or that one or another decoupling scenario would prevent the decline from becoming worldwide. That is, the current crop of financial prognosticators, with a few exceptions, is always wrong.

Discouraging signs: Some of them, including the Fed's open market committee, are seeing recovery in 2010. The FOMC is even more wrong than the mainstream economists.

The Demand Side observation. The worse the better. Bad news in the short run will do wonders to stimulate the dramatic and bold action needed for recovery. Also, we are lucky to have the president we have.

Paul Kasriel, Northern Trust

Now let's stick our toe in the forecast water with Paul Kasriel at Northern Trust, one of the few very good forecasters. His assessment released last week, quote

The current economic environment is indeed bleak and there are precious few signs of a recovery. But we believe that if the massive fiscal stimulus package being worked up in Congress is financed largely by the banking system and the Federal Reserve, there is a good chance the economy will begin to grow by the fourth quarter of this year and continue to do so throughout 2010. And if we are correct on this, we also believe there is a good chance that the consumer price index will be advancing at a fast enough pace by the second half of 2010 to induce the Federal Reserve to become more aggressive in draining credit from the financial system. This could set the stage for another recession commencing in 2012, or perhaps some time in 2011. So, the shape of the path of economic activity we see over the next few years is not a “V”, a “U”, or an “L”, but a “W” – down, up, down, up, all within four or five years.

[W]hat is our rationale for a late-2009 economic recovery and a subsequent 2011 or 2012 slowdown/downturn? Massive federal spending funded by the Federal Reserve and the banking system. The Obama administration and Congress are in the process of developing a two-year fiscal stimulus package that at last, but likely not the final, count totals $825 billion. This fiscal stimulus program will include all things to all people – traditional and non-traditional infrastructure spending, aid to state and local governments, expansion of food stamp and unemployment insurance programs, and tax cuts for households and businesses. This massive federal spending and tax cut program will be financed by issuing additional federal debt. Who is likely to purchase this debt? The Federal Reserve and the banking system.

The implication of the banking system and the Federal Reserve monetizing large proportions of nonfinancial sector borrowing – government or private sector – is that the borrowers are able to increase their spending without any other entity cutting back on its spending. Thus, in terms of the GDP accounts, total spending in the economy increases. This is why we expect a recovery in real GDP by the fourth quarter of this year.

If monetizing nonfinancial debt were costless, economically speaking, the Zimbabwean economy would be the envy of the world. But, of course, there are economic costs. Monetizing debt means printing money. And printing money ultimately leads to accelerating prices – prices of goods, services and assets. ... If we are correct that a real GDP recovery commences by the fourth quarter of this year, then we believe the Federal Reserve will cautiously begin slowing its credit creation in the first half of 2010 – that is, the Fed will begin to slowly increase the federal funds rate. We then see inflationary pressures intensifying in the second half of 2010 and the Fed reacting to this with more aggressive hikes in the federal funds rate. This is what we believe will trigger the next official recession, or at least, growth recession.

In conclusion, over much of 2009, the year-over-year change in the CPI is likely to be negative. We advise investors not to extrapolate this “deflation” into 2010 and 2011. With the massive monetization of debt that is likely to occur, increases in the CPI are expected to resume.

Demand Side Forecast

The Demand Side forecast is unchanged from November not entirely because we are too lazy to update the web site demandside dot net, but also because it is as accurate as anything contemporaneous. It sees a U-shaped recession that is severe enough in the short term to stimulate the needed policy measures. We anticipate the Fed's fever about inflation will be sufficiently chastened by its ineptness in the current crisis to prevent the aggressive intervention predicted by Kasriel.

History of Accuracy

We would like to buttress our credentials by pointing out that Demand Side has a record of accuracy. Irrespective of orthodox approval, in earlier forms we correctly predicted the fall of the quote New Economy unquote of the Clinton years. The Three Amigos of the time (perhaps even of Time Magazine) were Alan Greenspan, Robert Rubin and Larry Summers. Fed Chair, Treasury and Assistant Treasury Secretary. Neglected in the congratulatory analysis of Rubinomics was acknowledgment of fifteen dollar oil.

Demand Side was one of a very small number, maybe two, who saw the New Economy falling under the old economy weight of higher interest rates and higher energy prices. Most have put the cause of the downturn in 2001 as the delayed effects of the dot.com crash. Others, primarily Bush's group have put it down as some sort of reaction to 9-11, which happened five months after the start of the recession.

This first Bush Recession did allow Republicans to move their tax cuts through Congress, neatly changing the message of surplus -- "After all, it's your money," to one adapted to the need for economic stimulus. At the time it was assumed all tax cuts have stimulative value. Meanwhile Alan Greenspan changed high interest rates to rates of one percent, to stave off a newly feared deflation. Never mind he had stalled the economy with his fears of inflation only twelve months earlier.

No matter how hard we jumped up and down, our miniscule soapbox did not allow us the elevation to get onto the radar.

Demand Side correctly anticipated that tax cuts for the wealthy would be ineffectual. What ensued was the jobless recovery. We also made an early call that Greenspan's one percent rates were not restarting the New Economy, as he may have hoped, but shoveling debt into residential construction, a remarkably passive and unproductive form of capital investment. We were slackjawed in amazement that Congress came back for a second helping of the Bush tax cut poison. Clearly jobs and incomes were lagging and a speculative fever was inflating a bubble.

This was made most clear in Dean Baker's historical trend analysis of rents versus ownership. A rapidly growing divergence demonstrated, as he had with similar analysis of the dot.com experience, that the housing boom was a bubble. We repeatedly highlighted the fact that housing had become not just a place to live, but a financial asset. It was the asset price explosion that was sucking debt into housing, housing which was clearly unaffordable absent the imagined jump in equity.

We called the collapse of the housing bubble eighteen months before its time. We missed that call, but learned. The bubble was extended from a basic herd event by the corruption of the housing market in its late stages with fraud and abuse, widely cloaked by the perceived inevitability of prices rising forever. That is, the fever of the buyers slash borrowers to participate was enabled by machinations of sellers slash lenders to provide ever more capital. Extra leverage, financially engineered triple A securities, liars loans, and even criminal conspiracies exploited the boom.

The corruption of the markets had occurred also in the S&L crisis and in the stock market bubble. We had actully done some work with Baker at the end of the dot.com bubble where he preferred the primacy of the insider trading dynamic and we preferred the rudimentary herd theory. Of course, both exist. The bubble creates conditions for fraud and corruption -- and delays the natural boom and bust.

By missing the corruption of the housing markets we also missed the devastating impacts on the financial sector of that corruption. The allocation of capital, the management of risk and the mobilization of savings -- the core functions of a working financial system -- were completely broken by the practices of the big banks, the mortgage companies, the investment houses, and the other members of the shadow banking system. We quickly picked up on the work of Nouriel Roubini and Joseph Stiglitz in 2007 to come in far ahead of the curve on the crash.

And you may remember our first editions of the podcast calling the beginning of the recession in the last week of October 2007, statistically for November. We witnessed months of denial by others, lasting well into May, 2008. Subsequently the National Bureau of Economic Research identified the recession as beginning in December, 2007. Their call came after the November elections, our call came contemporaneously, fully a year earlier.

Parenthetically, while the NBER garners plenty of respect for its probity in making this calculation, at Demand Side we do not see the value for policy of a determination made so long after the fact. It only adds to the confusion. Decisions that need to be made in real time cannot wait until the committee gets consensus, particularly when the committee is stacked with boneheads.

One event we did not miss at Demand Side that others have -- even the most notable -- was the commodities bubble. Following the work of analyst Charles Peabody we called the oil and commodities bubble as it emerged in November 2007. Our correct stagflation forecast for the first half of 2008 was based on the premise that liquidity was chasing the rising asset price -- commodities -- and rising asset prices were creating cost-push inflation and subtracting another fraction of effective demand. We tracked the commodities bubble upward and called its peak virtually the week it happened. We made lots of virtual money in our fantasy portfolio as oil, metals, grains and energy dropped like a stone. Oil from $147 to $40.

On the way up we cautioned about the euphoria in alternative energy. On the way down we warned about the devastating impacts on commodity producers and made mention of the collateral damage on the auto industry. Both the income shock of $4.50 per gallon gas and the micro shock to the companies, as they lacked the hybrid technology so much in demand. Hybrids and alternative energy have floated to the back of the collective consciousness today, as the collapse of the banks have replaced every other economic news.

We should make mention before we leave the commodity bubble story that the brevity of the bubble and the fact that oil did not reach $200 per barrel as called for by Goldman Sachs was in part due to prompt and aggressive oversight in Congress. Fraud and market manipulation in commodities no doubt occurred, but on a scale far below that of the other bubbles.

Forecast

Let's be clear. Demand Side's forecasting success arose not because of statistical models or any real econometric expertise. Were were clear about our method at the time. We correctly observed the conditions of stagnating wages and incomes that underlay the housing bubble and that would be revealed when the tide went out. The huge increase in debt under Bush was papering over a very weak underlying economy. The current decrepit economy is the economy of 2001 minus ten trillion dollars of debt.

This recovery depends on policy choices and bold action. Any future recovery depends on their being instituted, and so our forecast depends not on the imagined quote natural economic forces unquote, but on the political will of the nation and its leaders. As soon as policies are changed, the economy will improve. Until they are made, the economy will be frustrated.

Here are six key actions:

1. Reduce the principle in mortgage debt.
2. Reconstruct the financial sector by dealing directly with insolvent zombie banks
3. Stop the contraction of state and local governments with grants to replace collapsing revenues.
4. Step up infrastructure, green energy and jobs spending.
5. Institute improvements to the social insurance system by instituting national health care and improving social security retirement.
6. Coordinate similar policies with other nations. Use the power of the dollar to create physical and human capital around the world. Inevitably this will create wealth and markets for the U.S. to sell its products into. More importantly it will mobilize cooperation that we need to meet the incredible challenges ahead, economic, environmental and social.

There are primary obstacles to recovery. Five on top are:

1. The consumer economy.
2. Reaganomics
3. The obtuseness of orthodox economics
4. The institutional power of the Fed
5. The burden of debt

Next Week

Next week we'll look at the debt. Much has been made of the federal deficit, but a great deal more borrowing has been done by the private sector. Reducing this debt burden is essential to recovery. Part one of reducing this debt, rather than simply transferring it to the taxpayer, needs the Fed to act radically different than it now is.

Housing Bust Shatters State Migration Patterns

William H. Frey has put up a stark reminder that economic dislocation is not all about your statement of net worth.

Frey is a senior fellow at Brookings in the Metropolitan Policy Program. The link is here.

Analysis of the new Census Bureau annual estimates of state population changes for 2006-7 shows that the sinking housing market has yanked back high-flying states like Nevada and Arizona. An even bigger tug in growth occurred in Florida, another housing-boom driven state. With credit harder to get and the disappearance of housing deals, the allure of these states appears to have dimmed.

Meanwhile, the up-scale states—California, New York, New Jersey, and Massachusetts—are seeing fewer residents leave for a lower cost of living elsewhere. And those states benefiting from the previous flight to affordability—Nevada and Arizona in the west; Florida in the south; and Pennsylvania and New Hampshire in the east—have shown slower migration gains or greater declines.

Even the states surrounding Washington, D.C., another hot market, have attracted fewer migrants. Potential home buyers in the outer suburbs of Virginia and Maryland face trouble getting credit and recent buyers in the District and inner suburbs are stuck because they cannot sell.

The D.C. region has, in short, become a microcosm of the nation’s reaction to the housing bust. Like in Nevada and Arizona, the market for the region’s suburban buyers is drying up due to the credit crunch, and construction and in-migration is stalling. But the District and inner suburbs are more like coastal California, where housing-rich residents are waiting to sell in order to move to opportunities elsewhere.

In sum, there appears to be a migration correction going on. We’re at the beginning of a leveling off of migration between unaffordable and affordable America. As with the broader economy, we don’t know how much longer it will last.

Forecast and Commentary from April 2006

I've been bad about bragging without documenting the correct calls of the past. This is from my stint at the Northwest Progressive Institute. I'm dragging those posts to this site and came across it today.

One of the dreadful experiences of understanding a little economics is to watch those approaching retirement vote against schools. They have dollars in the bank, their kids are grown, Why should they worry?

Another is looking at the enormous investment in housing. Homeownership is a beautiful thing, look at the employment and tax revenue coming in, How can we lose?

The May 2006 issue of Harper's has on its cover a man carrying a house on his back. The article is entitled "The New Road to Serfdom." In it there is a graphic I pray is not correct. It identifies 90% of debt since 2000 as being mortgage debt. That would mean only 10% of debt has gone to credit cards, college loans, and oh yeah, plant and equipment.

The current debt-driven economic activity is founded on housing investment. Investment creates jobs up front. Every kind of investment. But investment in essentially passive assets, like housing, does not generate economic well being down the road like productive assets do – education and equipment and so on. It generates interest payments.

The Harper's article is instructive, if a bit pat. It's great if you like charts, because that's what it is - a dozen charts with explanatory captions. It advises of a possibility that low interest rates lure people into enormous debt loads, possibly shackling the owner to his house for decades, making payments as equity shrinks, giving lie to his hope for a valuable asset at the end of his working years.

The situation is similar to the pension crisis. (See the Seattle Times 04.04.06 article.) For dozens of years people worked, in part, for the promise of an affluent retirement funded by the company's pension. Now, one after the other, the corporation's promise has been turned over to the government for fulfilment. The "self-made" men and women wait in line to see what can be salvaged of their expectations.

Bethlehem Steel, US Airways, Kaiser Aluminum, Pan Am, and locally Consolidated Freightways, Lamonts, and Longview Aluminum, have given up their pension obligations to the federal Pension Benefit Guaranty Corporation, which now has $56 billion in assets v. $79 billion in future liabilities.

The point I want to make is that today's sure bet is tomorrow's last place finisher. Do not look at dollars. Dollars are a great medium of exchange, but a lousy store of value. They're a good way to compare goods, as in eggs are expensive, cars are cheap, but it is wrong to assume that both are being measured by a standard unit which has value in itself. They are expensive and cheap relative to each other. The dollar is simply a medium to make the comparison.

If you want your house to be worth something, or your pension to be there, or your stocks to pay off, you need to build an economy that works, with workers who will be able and willing to pay the price you want. It is their demand, not some numbers on a bank statement, that ensures value. You can lock up your greenbacks and bury them in the ground, but without that growing economy, they'll turn to dust no matter how well you wrapped them. There is no "I've got mine, now you guys fend for yourselves." You can be robbed by inflation, crashing stocks, ballooning health care, etc., etc., etc., but at its root it will always be a weakening economy that could have been floated by sound investments and reasonable trade structures.

Taxes for schools will generate economically viable citizens and reduce unnecessary drains on public coffers in the future. These are the people who will buy your house, fund your pension (including Social Security) and make your stocks worth something.

Mortgage borrowing, federal debt, everyone a millionaire... It's a hoax that is often too disturbing to contemplate, so we don't. But someday we'll have to. Our hind ends will get blasted if we keep our heads buried in the sand.

P.S. - In my last post I forgot to mention that Paul O'Neill, the former Treasury Secretary under Bush, also termed "not acceptable" W's 1990 scam with Harken Energy that we covered earlier this year. "Did I ever do an untimely filing of Form F?" O'Neill said. "No. Any other questions?"

It's timely now because W's fellow travelers at Enron are in the dock this week.

Forecast Friday arrives on Sunday

The most comprehensive presentation of our deviant forecast is now up on DemandSide.Net. It will surprise nobody that we predict bad news for a long time. The short form of the prediction has been up for a month:

We are already in recession.

The various prognosticators trying to see over the horizon by jumping up and down on their statistical trampolines will not get the official word for another three months. But without housing employment, the US would have been in at best a stagcession over the past three years. Now there is no housing, no housing employment, and the consumer spending derived from home equity is gone.

Inflation is guaranteed by the bidding up of commodity prices and the flip side, the falling dollar. Very likely the Fed will panic again, this time to the upside. The same matrons screaming at their husbands during the credit crunch will be screaming just as loud for rate hikes when they see their dollars eroded by the very cut they demanded in the first place.

While some, notably Larry Summers call for additional rate cuts, the likelihood these will produce demand are low in the present environment. The risk is that the Fed will see the inevitable inflation rounding the corner and panic to the upside.

Demand should be generated by government spending on infrastructure and energy projects. The market has proven it is blind to the upcoming global catastrophe. It is time for the government to "make the market" and get us off the dime.

Conference Board Indicators Point to Weakening Economy

Our call that the economy was in recession as of the last week of October has still not found takers among the statistical model crowd, but here's a look at the Conference Board's latest thinking, Notice that all the indicators are negative except the stock markets and the supply of money. Both are explained by the financial sector crisis and bailout. The Fed's easing created the money. The flight from all sorts of alternative investment vehicles back into the mainline assets explains the stock market.

As we've said, and will repeat this weekend, Look for a strong stock market and rapidly weakening economy.

Prediction holds: Strong Stock Market, Weak Economy

Here is our Sept. 29 forecast, with updated text in CAPS.

The economy slips toward recession and stocks ignore it. Why? Courage from the average investor perhaps? Confidence in the underlying strength of the economy? Hardly.

Investors are in full flight, trampling each other to get out from under the collapse of the housing industry, just as they rushed out of stocks and into housing after the so-called dot.com bust. Now they are fleeing housing after creating a similar fiasco in that market. But the money has nowhere to go.

The Fed’s solution to every crisis since 1987 has been to pump low-cost money into the financial markets. That’s one reason Wall Street thinks IT SEES strength over the past four decades while Main Street has turned into a row of double-wides.

The money pump rattled into action again on September 18, when Bernanke and the Fed cut rates by half a point. There was only one excuse: To give the financial markets "confidence" so they can “run smoothly.” Bailing out financial institutions is a central bank theme. IT KEPT CHUGGING ALONG ON OCTOBER 31, WITH ANOTHER QUARTER POINT. AGAIN,THE AVOWED PURPOSE WAS TO:

"forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time." (Fed statement, 10/31)

"GROWTH OVER TIME" MEANS THEY KNOW INTEREST RATES DON'T SIFT INTO THE REAL ECONOMY FOR 18 MONTHS. THIS IS NOT ABOUT ECONOMIC HEALTH, IT'S ABOUT BAILING OUT THE BANKS.

IN THE OLD DAYS, "LIQUIDITY" USED TO MEAN CASH AND LIQUID ASSETS, NOW IT MEANS ACCESS TO CREDIT. THE RATE-CUTTING ACTION OF THE FED IS EQUIVALENT TO PRINTING MONEY FOR THE FINANCIAL SECTOR.

So we have plenty of money sloshing around at the top. But where to put it? Housing is deflating. (Pity the poor homeowner who was counting on that to finance his retirement.) Stocks? It IS rumored some companies have foreign presence. Bonds? Sure, but you’re going to lose real value if inflation kicks up. COMMODITIES, OF COURSE, ARE TOPS AS AN INFLATION HEDGE AND AS A FIRST BET ON THE NEXT BUBBLE.

BOTH PRINTING MONEY AND BIDDING UP COMMODITIES MEAN WE ARE IN FOR INFLATION. INFLATION AND RECESSION IS THE RULE NOWADAYS, AND UNFORTUNATELY THE MILLIONS OF INFLATION FIGHTERS IN THE FORM OF THE UNEMPLOYED CAN'T TOUCH A COST-PUSH INFLATION THEY DIDN'T START.

The smart money is buying foreign securities. Even if they don’t appreciate in value, you can ride up with the underlying currency. Or at least avoid sliding down with the dollar.

WEAKNESS IN THE STOCK PRICE OF THE FINANCIALS IS NOT WARRANTED. THE FED IS PROVING "TOO BIG TO FAIL" IS STILL IN OPERATION. WHAT COULD BE BETTER FOR A BANK THAN ACCESS TO THE MINT? A MASSIVE TRANSFER OF WEALTH FROM THE REAL TO THE FINANCIAL ECONOMY IS UNDER WAY. GET THOSE FINANCIALS WHILE THEY'RE DOWN.

Forecast: Inflation and Recession

We are already in recession.

The various prognosticators trying to see over the horizon by jumping up and down on their statistical trampolines will not get the official word for another three months. But without housing employment, the US would have been in at best a stagcession over the past three years. Now there is no housing employment, and the consumer spending derived from home equity is gone.

Inflation is guaranteed by the bidding up of commodity prices and the flip side, the falling dollar. Very likely the Fed will panic again, this time to the upside. The same matrons screaming at their husbands during the credit crunch will be screaming just as loud for rate hikes when they see their dollars eroded by the very cut they demanded in the first place.

(Beware, I have learned my lesson, and I'm not calling for a precipitous drop in the dollar that would be indicated by the fundamentals, just the current slide. There are plenty of players with powerful positions who will do all they can to stem the tide. They may be successful for as long as eighteen months.)

Be that as it may. Tomorrow's Forecast Index on the web site will be a review of the past, in a probably futile effort to gain credibility by showing we've been right before. But I did want to get in ahead of the pack, or most of the pack, on this one.

Recession and Inflation

Crisis will be deepened by Fed action.

How do you make sense of the markets, post housing crash?

ANOTHER Financial Sector binge covered up by the chief enabler -- the Fed.

Investors bidding up commodities, equities and currencies is the same thing -- dumping the dollar.

Look for a serious run on the dollar soon. By election time '08.

Why?

Think of the recent Fed bail-out as giving away money to the Financial Sector. Jim Cramer and the other hysterical old ladies of the high rolling investor class dropped their macho risk tolerance facade and started crying just long enough to get Papa Ben Bernanke to give them more money. Now they are busy converting that money into real wealth -- stocks and commodities, oil, gold, wheat -- and into secured financial wealth -- bonds.

The Fed's bailout follows the pattern of 1987 and 1998. Unregulated markets made fools of geniuses, upon which the Fed lent them the financial stability of the country so they could be geniuses again.

Now the market knows. Don't worry about risk. Papa Fed will bail you out. It's no accident that instead of vigorous industry, plant and equipment, we have instead the equivalent of a mammoth video game parlor called Wall Street. Fine for entertainment, but these games have real guns, and those are real people losing homes, families and hope. One of the things those real people don't understand is they are paying the freight

Certain inflation will follow the dollars fall and this bidding up of commodities. Pensions and endowments will lose their real value to that inflation. The financial system is gimmicked and rigged to such an extent the Fed has lost control.

It's not inflation OR recession. It's inflation AND recession.

If the Fed tries to stem the inflation or support the dollar with higher interest rates, it becomes a deep recession.

Why a run? This country's trade deficit over the past thirty years has put trillions of dollars in foreign hands. The money is in the form of securities, because those securities were a good deal with rising values. No longer the case. With the value of the securities fading and the value of the dollar falling, the foreign holders are seeing their investments eroded from two sides. Better get out sooner than later, hence a run.

Tomorrow:

5 Lessons from the financial meltdown in housing
and
7 Remedies for the Financial Sector

The housing debacle

What are the lessons from the housing debacle that is now unwinding?

First and most important, we were right. We predicted the housing collapse. We'll dig up the links and enter them on the web site treatment on Friday.

We predicted that the low interest policy of the Fed would produce the bubble. Others have talked about how the leverage and corruption of the mortgage brokers was key, but the cycle begins at the beginning -- turning housing into an investment. Speculation fever follows as prices rise. Then the leverage and the corruption.

Too much congratulations and not enough corporal punishment are being dealt the Fed. Under Greenspan and Bernanke, there was low interest at the beginning and bailing out at the end, with absolutely no oversight in the middle (or anywhere, really).

Second, others predicted it as well. Dean Baker is foremost among these. Baker of CEPR and now the American Prospect used a simple historical trend analysis comparing housing rents to home prices over time. It worked. He should be on every talk show in the nation.

Third, the people who didn't see it coming are still the "experts." (Much like in another key blunder, when Thomas Friedman and even the Neocons blew the Iraq analysis, yet are still showing up as experts. Compare this to others -- George McGovern, Joseph Stiglitz -- who offered accurate analysis and peaceful, productive resolutions. They are still on the outside.)

So, fourth, the people who say, "Nobody saw it coming" were and still are listening only to each other.

This debacle continues the ballooning of the financial sector. Henry Kaufman, formerly of Salomon Brothers and now of Henry Kaufman & Co. and hardly a communist, reported that the Finance Sector is now bigger than Health Care and Energy combined. Why not? Too bad some homeowners can't get hold of that "liquidity" and out from under their ARMS. Now is the time to buy stocks in the financial sector, before everybody realizes that -- just like in 1987 and 1998 -- the Fed is bailing them out. They get a hundreds of billions of "too big to fail" insurance for free.

Upcoming we'll look closely at tool the world class analysis at the Fed is linked too. It looks a lot like a catapult. The Fed's single blunt instrument is its control over short-term interest rates. It doesn't matter how smart you are, the interest rate is (1) ineffective against inflation, (2) operates with a lag in producing growth and is wildly inferior to fiscal policy for jobs, but (3) is great at bailing out a financial sector.

Outlook for the economy as housing deflates? Which economy?

• The financial sector will likely bounce back with great new investment opportunities.


• The wealthiest 20 percent will no doubt wonder what everybody is complaining about.


• The middle class will watch their home values receding in front of them as they approach retirement.


• The multiplier will bring down wages.


• The collapse of housing could create more hysteria in the immigration discussion, as migrants move out of their niche in relatively low-skill residential construction and residential support and compete for other jobs.


• A huge burden of private debt has been created, for the purpose of building an immense stock of passive housing vs. productive assets. And very little of this building was green. Both the debt and the character of the housing stock will weigh us down.

What a mess.

Why listen to the Market when it is talking gibberish?

Steve Conover at the Skeptical Optimist displays the vagaries of jobs numbers today and wonders what the Market will make of it.

Any Market response to jobs numbers is unintelligible over the sound of investors trampling each other at the exit door of real estate and "alternative" investment vehicles.

As Michael Metz, chief investment strategist at Oppenheimer Holdings said yesterday, the Market has stopped sending rational or intelligible signals.

Rational investors and students ought to see current strength in the stock market as money with no other place to go.

Chaos reigns in currency markets as well.

Strength in stocks in the face of an impending downturn in the domestic economy is, at best, Pig Latin.

see previous Demand Side take: Strong Stock Market, Weak Economy

Prediction: Strong Stock Market, Weak Economy

The economy slips toward recession and stocks ignore it. Why? Courage from the average investor perhaps? Confidence in the underlying strength of the economy? Hardly.

Investors are in full flight, trampling each other to get out from under the collapse of the housing industry, just as they rushed out of stocks and into housing after the so-called dot.com bust. Now they are fleeing housing after creating a similar fiasco in that market. But the money has nowhere to go.

The Fed’s solution to every crisis since 1987 has been to pump low-cost money into the financial markets. That’s one reason Wall Street thinks strength over the past four decades while Main Street has turned into a row of double-wides.

The money pump rattled into action again on September 18, when Bernanke and the Fed cut rates by half a point. There was only one excuse: To give the financial markets "confidence" so they can “run smoothly.” Bailing out financial institutions is a central bank theme.

So we have plenty of money sloshing around at the top. But where to put it? Housing is deflating. (Pity the poor homeowner who was counting on that to finance his retirement.) Stocks? It IS rumored some companies have foreign presence. Bonds? Sure, but you’re going to lose real value if inflation kicks up.
The smart money is buying foreign securities. Even if they don’t appreciate in value, you can ride up with the underlying currency. Or at least avoid sliding down with the dollar.

Heavy debt puts the economy in trouble

The universal elements of financial crashes are:

• Substantial and steady increases in the value of an asset -- tulips, stocks, property.
• Leverage -- borrowing -- that is easy to get.
• Nearly universal belief that a new form of wealth creation has been found that is immune from the limitations of past economics.
• Disgust with and marginalization of any naysayers.
• A precipitous retreat of values and panic dumping of assets.
• Denial, after the fact, in the form of scapegoating individuals or a sector and minimizing personal culpability.
• Astonishment and anger that lenders, as John Kenneth Galbraith put it, "should now in hard times, ask for payment of debts so foolishly granted and incurred."
• Phenomenally short memories with regard to any lessons learned.
  

Background

In the year 2000, interest rates as arranged by the Fed and its then chairman Alan Greenspan were at an all-time high. This was not an effort to rein in the dot.com bubble, but a reaction to invisible threats of inflation discerned by Maestro Magoo. [Reining in the stock market bubble should have been done by adjusting margin requirements, tightening rules on brokers, and jawboning to discourage blatant speculation. Never done.]

Inflation never showed up for Greenspan, but the economic slowdown did. And down came the interest rates, until eighteen short months later they were at their lowest point in history. Highest to lowest. The fact that the reduction was meted out in monthly quarter point drops makes it only cosmetically less drastic.

A few of us predicted the economic slowdown based on the fact that energy prices were spiking at the same time Greenspan was spiking interest rates. Others -- notably Dean Baker of the Center for Economic and Policy Research predicted the dot.com bust, but not the slowdown. Most, you may recall, had discovered the "New Economy" and "Dow 36,000," a new age of information technology unrestricted by the fundamentals of the past.

The effort of the Fed to restart the economy with low interest rates succeeded after a fashion, but not in the way that was hoped -- by restarting business investment. Instead, millions of Americans took advantage of the low rates to buy homes. With interest rates down, principle can go up while the payment remained the same.

Home values increased, partly based on demand, and partly based on the seemingly inexorable rise in the values. Where was a stock market shy investor going to make his big bucks now? Speculation moved from the stock market into real estate.

What now?

Now things have changed. Residential investment is plummeting. See EPI's chart.

The Financial Times reported yesterday:

The US homebuilding sector slowed dramatically last month as new home construction tumbled to a six-year low, according to figures released on Friday which contained troubling signs for the economy.
....
There was a clear indication of further weakness ahead for the construction industry as building permits for residential homes fell to the lowest level in nearly a decade after a drop last month of 6.3 per cent to 1.5m, while the number of permits issued in September was also lower than previously thought.

The fall in permits for new homes suggests the housing market has reached a critical point as builders abandon speculative residential developments to curb oversupply.

What does a housing crash look like?

In housing, a crash may have a different dynamic. "Panic dumping" is less feasible. Speculators may dump their property at the first downturn, but homeowners who live in their assets will tend to hold on, perhaps thinking they are whole, since they have to spend on shelter anyway.

But there are inescapable consequences. When prices go down, the equity in homes will go down, with four depressing consequences: (1) There will be no more equity to tap for current spending, which has been a significant source of spending for the past decade, (2) Mortgage payments that are much higher than (lower) home values warrant, making people feel poor, and hence hold back on spending, (3) The retirement piggy bank that people were counting on in the value of their homes recedes before them, creating the need for other types of savings, and (4) A continuing depressing influence on the housing market, as potential buyers delay purchases because in a few months they may pay less.

So as it plays out, the crash could be a long, slow depletion of economic vigor.

The problem of the debt

As we've shown elsewhere, there is no "growth," only borrowing, a shift of action from the future into the present.

Debt is a burden on our future, but seemingly necessary for our present. Should our overseas partners, the less wealthy countries that are subsidizing our purchases of homes and other goods, decide to reduce their lending, the pressure will become more intense.

Interest on the debt is going to begin taking its bite. No jobs are created when interest is paid. It would be one thing if the massive debt had created productive assets, infrastructure, or human capital. That is not the case.

Federal debt has been spent on a destructive war and nonsensical rewards to the rich. Private debt is in the largely passive and nonproductive asset of housing. [Note: The "Federal" bar in this chart shows only the so-called "unified" budget deficit. A segment should be added to each red bar in this chart to reflect the hudreds of billions of dollars per year in borrowing from Social Security and Medicare funds.]

When will it start?

Considering the "political business cycle," the fact that the Republicans pushed every spending choice and every positive indicator they could into the pre-election period, a return to reality happens right after the election. Housing weakness has been around for some time, but is now becoming serious.

As long as we can borrow, the day of reckoning can be pushed out. With weakness starting to show, however, our lenders may begin to lose confidence.

With Democrats in control, the chances that the Middle Class will get some attention is good, and this is fundamentally positive for the economy as a whole. Likewise, the serious attention by adults now in Congress to the debt will be significant. But the fundamentals and embedded debt are so heavily negative that it will take concerted and disciplined action to avoid serious loss to our standards of living.

For most of the country, it is likely to begin soon, by next spring. For the Puget Sound, with its trade-based economy that runs counter to the rest of the country, it will be delayed.

Recovery? Who? Where?

The economic recovery and the onset of good times reported on the financial pages have passed much of America by in the night. Median income for those under 65 fell, the poverty rate rose, and more people by number and percent are without health insurance today than at the beginning of this "recovery" in 2001. These are the findings of a white paper released Friday by the Center on Budget and Policy Priorities (CBPP).

• Median income for those under 65 fell again in 2005 and is now $2,000 lower in real (inflation-adjusted) dollars than in 2001. That's a 3.7 percent cut.


• The poverty rate is higher today (12.6 percent) than in 2001 (11.7 percent).


• Health Insurance coverage is lower. The number and percentage of people without health insurance was much higher at the start of 2006 than in 2001.
  

These findings corroborate the feelings of a good majority of Americans. The economy they see is not doing as well as the economy the Bush machine describes in its well-orchestrated media pushes. Even the official unemployment rate is suspect, as we posted (see unemployment with a stable participation rate post).

So who is recovering?

A second CBPP white paper released Thursday has a positive ID on that.

• In the first half of 2006 the piece of the pie going to corporate profits was bigger than at any time since 1950, having grown under Bush at twice the average rate of other recoveries.


• The share going to wages and salaries was at its lowest level on record (77 years).


• Hourly private nonsupervisory wage earners (four out of five of us) made less now than when the "recovery" began in 2001 in real (inflation-adjusted) terms. This came in spite of productivity numbers growing faster than in all but one of the previous recoveries. This blows up the official line that productivity gets translated directly into wage gains.
  

This is not really a recovery. It is an accounting gimmick, as we borrow growth from the future via massive federal deficits (see the "Net GDP" post ) and enormous and growing private debt (see borrowing chart post).

The economy is not stronger, but much weaker.

Prediction Tuesday says any more of this kind of "recovery" and we'll all be dead. For our scare story on what happens if we borrow too much see scare story post. And for our early warning about when a recovery is not a recovery, see "A Jobless Recovery is not a Recovery," Parts 1, 2, and 3.

Prediction Tuesday - Construction Employment

Last Prediction Tuesday we decided it was a Midas touch of the Governor that was keeping the fire lit under the economy, and continuing the string of plus-side corrections to revenue numbers. I didn't mention it at the time, but in looking through the June forecast for reasons weakness hasn't shown up yet, one thing really bugged me. It is illustrated in the following chart.

It is not so much that the lines of the future look improbably pacific compared to the radical agitation of the past. This is a function of using actual observations to inform the past and projections based on macroeconomic movement (i.e., ignorance) to inform the future. And it is not the seeming contradiction in the lines, where sometimes employment goes up as the other two go down, or vice versa. This has to do with the lag between permit and construction.

What troubled me was that the change in employment somehow stays above the changes in the projected permit activity. The difference may look tiny on the chart, but the green line stays higher. Construction firms don't have you on the payroll unless you're working. What gives? If anything, it should be lower.

I asked my friend (... I like him, he tolerates me ...) in construction trades. [Now this gets interesting, so follow along to the end.]

Commercial construction, says he.

I said, of course, "What commercial construction?"

The Olympics is drawing construction labor from north of Seattle. Snohomish County has broken ground on a $4.1 billion sewage treatment plant. Sound Transit is all over the light rail in Seattle, and that's going to go on for awhile. DOT projects, including the second Tacoma Narrows bridge, are going full steam, and Olympia and the Port of Tacoma have just signed off on a study of a rail coordination facility in the South Sound.

Public works! That's what commercial construction! The Keynesian in me loves it.

That is very interesting, but here is the really good part:

Skilled construction work is in demand and will be in demand over the next half dozen years. The kind of work that is done on these complex, long-term projects. If you need a career and don't mind union benefits, union wage scales, being reliable and being motivated, get hold of one of the union apprenticeship programs. This is not $8 per hour framing that is over at the end of the season. It is skilled work, and it is not particularly seasonal, and there are openings. The union programs are the best, says my friend, and biggest.

Unskilled or semi-skilled workers are going to be looking around for other jobs after residential building tapers off, and it likely mean significant dislocation and stress for some of us, both newcomers and others. But skilled workers are at a premium. Some projects go unstarted because there aren't enough skilled workers for the top layer to graduate into site supervision. That is, the tools are needed, so upward mobility is retarded.

So, clink! To public works! Good employment. Better infrastructure for everybody. And support under demand for local businesses. Your tax dollars at work. Clink!

NOTE: Anyone who wants to explore apprenticeship opportunities in Washington should start at the Labor & Industries website www.lni.wa.gov that shows a full listing of the programs and application procedures.

Housing bubble floating ever upward?

Global Insight rated housing for many NW cities. The results could be scary. I gave Global Insight a bad time for its predictions on oil prices and inflation, but here they rate housing in line with Dean Baker's analysis at the Center for Economic and Policy Research. (On the same scale, that is. I don't know what the methodology is.) See Baker's "The Menace of an Unchecked Housing Bubble."

Notice the closer you get to California, the more overpriced housing is. If you look at the full list, California is all above 60%. Also, notice the further east (or actually toward the Midwest), the less overpriced housing becomes. Many cities in the Great Plains and Midwest have housing that is actually underpriced.

When the assessor comes around, he is judging market value based on comparable sales. That is the price in the newspaper. That is the bubble price. But beware. If housing returns to a level predicted by long-term trends, this is the amount your equity could drop.

That is not only bad news for you, since you're on the hook for the difference between your loan value and the equity (and the bank can ask for that difference in cash), but it's bad news for the state's economy, since residential construction has been the engine of growth over the past five years.