While there is a lot commentary on the failures of the government’s plan to address the housing crisis, few offer alternative solutions. This article outlines a better way to deal with this problem, and not surprisingly, it is by letting the market work.
The government has thus far employed the Neville Chamberlain approach to economics: “we have jobs in our time”. An $8,000 tax credit will stimulate demand this year, but mostly by pulling demand forward from 2010 and 2011. Low interest rates do not help housing unless you lower the risk inherent in the loan. Lowering the cost of risk or giving people $8,000 tax credits is welfare. It simply shifts demand from the future to the present, and from non-housing goods to housing.
The downside to the government's effort is, of course, that we will get to the future at which point slack demand will prolong the recession. We have not only pulled demand from the future into housing, but we have pushed it away from productive sectors. So government’s solution is in short: fix housing by breaking everything else. The net effect is to encourage people to build houses that no one wants, nor can afford.
Unlike the government’s approach, this solution actually changes the dynamics of housing. It lowers the likelihood of future foreclosures even if asset values continue to fall. It is a series of incentives which get people to refinance their loans with additional capital. This is materially different than what the government is doing because the refi’s under the current program require neither additional financial or human capital. (Human capital is the upkeep you do on your house).
Here is the consequence. There is a home in Michigan the mortgage on which is about 25% underwater. The owner likes the place enough to keep the mortgage current. But in the back of his mind, he knows that it is likely that this house is going into foreclosure, so he invests zero into the house beyond the monthly mortgage. In his mind, he no longer owns the home, but is simply renting it from the bank. He treats the house like rental property.
Incentives can take many forms, but I will illustrate one as an example. Currently people are not allowed to take a tax loss on a primary residence. The government could enable people who refinance an upside-down mortgage with additional capital to take a tax loss based on the amount of the capital that they add to the loan. No one would dispute that paying say $10,000 into a loan that is $25,000 underwater is a tax loss. No sensible lender on a non-recourse loan would refuse to accept said money to refinance the loan.
Here is why this approach is better than what the government is doing. The market knows more about loan quality than the government does. The government’s approach is unfocused, wasting billions of dollars on loans that no one intends to repay as demonstrated by the default rate on loan modifications (more than 50%). People will only put more money into a loan that they plan to pay-off. So the market will direct the incentives to loans which the borrower at least thinks are good.
This transaction isn’t for everyone, and really is meant to show the consequences of the incentive. The guy in MI would take this deal because he doesn’t want to be a renter. More important than increasing the loan quality, this approach gives him an incentive to invest human capital in the house, if nothing more than raking up leaves. He happens to be rather handy with tools, and is more than willing to work on the house provided that the he shares in the benefit of the work. At this point, however, all of his work goes to the bank because that house is heading for foreclosure when he gets tired of paying so much in rent.
Again, this is just an example, here are the factors that you want to see in any incentive :
1) Verifiable : In the case above, the mortgage lender will get a check for additional principal.
2) Tied To Existing Housing : We do not want to encourage people to build more houses
3) Focused: The government may create the incentive, but the market must allocate it for it to work.
Monday, September 28, 2009
Monday, September 14, 2009
The current discussion of inflation and deflation is focused narrowly on money supply, which is important but only a small part of the equation. Gold bugs worry that printing money will lead to massive inflation. Deflation proponents argue that the government is not adding to the money supply because the new money simply replacing demand that has been lost to the deleveraging process. These oversimplied views of inflation miss the point: inflation is as much a function of the supply of goods and services as it is a function of money supply.
Once you factor in the supply of goods, and services you will see a struggle between inflationary and deflationary forces that will play out in this country on an uneven basis across the economy. Inflation will affect industries differently based on capacity, profit margins, productivity and exposure to a falling dollar. Secondly, you have to consider on what the government spends money rather than how much money is printed. Some industries will experience inflationary pressures sooner than others, while some industries are going to be stuck in a deflationary cycle for a long time.
For the near term, inflation in aggregate is unlikely. Today, the economy has massive over capacity, resulting from a decade long build-out to support consumer demand that was fueled by debt. That debt pulled consumption forward from the current recession into the boom years. So our industrial capacity exceeds consumption demand, and will for a long time. That demand is gone, but the capacity is here, and it will be here fighting inflation until it is worked off over a longer period of time. Basically it is very difficult to pass along higher prices when you have 10 competitors who are willing to hold the line on prices.
The discussion also misses the question: how is the money going to be spent? Not all government spending is equal. It is possible that, and has on rare occasions, government deficit spending leads to disinflation. For example, the money that the government spent on building out the Internet, has had significant deflationary affects by promoting productivity and competition. The inflationary impact of government spending is really a question of ROI. Wisely spent money isn’t inflationary, where as poorly spent money is.
As you consider what the government is spending the money on, you should worry more about inflation. The bulk of the money has gone into the financial system where it creates no supply of goods or services. The vast majority of the new money enables the Fed to hold troubled assets. This new money serves only to protect the foolish from the consequences of their action. Only the silliest of bureaucrats talk about making money on these investments. We are making pennies on the Goldman Sachs and State Streets while losing dollars in AIG, Citibank, and the rest of the portfolio.
Worse, the government is altering consumer demand in order to fight deflation where it is needed, at the expense of creating it where it is not needed. Housing in this country is overpriced. Cars in this country are overpriced. Yet, the government encourages us to buy houses, cars, and energy efficient products. When a buyer takes these incentives, it is at the expense of other parts of the economy. In my specific case, I am replacing a perfectly good air conditioner which is an energy efficient one solely because the government will pay me to do something stupid. Given the size of that expense, I am not painting my house which actually needs to be done. While this is my individual decision, it is clear from the statistics on car sales and retail sales that there is a transfer of consumption from retail to autos that is in part caused by cash for clunkers program.
The net effect of this is going to be terrible for the long-term economy, which leads me to believe that inflation wins out in this struggle over time. The government thinks that it is smarter than the market. In my case, the air conditioner company wins, while the painters and my neighbors lose. Whatever economic activity that is created by the winners will be more than offset by the economic loss created by the losers. People who need to be farmers, or painters, or waiters will continue to live on the government’s dime working in banking, and auto production, and whatever other business the government decides is good for the economy. At which point, money supply is somewhat beside the point.
Once you factor in the supply of goods, and services you will see a struggle between inflationary and deflationary forces that will play out in this country on an uneven basis across the economy. Inflation will affect industries differently based on capacity, profit margins, productivity and exposure to a falling dollar. Secondly, you have to consider on what the government spends money rather than how much money is printed. Some industries will experience inflationary pressures sooner than others, while some industries are going to be stuck in a deflationary cycle for a long time.
For the near term, inflation in aggregate is unlikely. Today, the economy has massive over capacity, resulting from a decade long build-out to support consumer demand that was fueled by debt. That debt pulled consumption forward from the current recession into the boom years. So our industrial capacity exceeds consumption demand, and will for a long time. That demand is gone, but the capacity is here, and it will be here fighting inflation until it is worked off over a longer period of time. Basically it is very difficult to pass along higher prices when you have 10 competitors who are willing to hold the line on prices.
The discussion also misses the question: how is the money going to be spent? Not all government spending is equal. It is possible that, and has on rare occasions, government deficit spending leads to disinflation. For example, the money that the government spent on building out the Internet, has had significant deflationary affects by promoting productivity and competition. The inflationary impact of government spending is really a question of ROI. Wisely spent money isn’t inflationary, where as poorly spent money is.
As you consider what the government is spending the money on, you should worry more about inflation. The bulk of the money has gone into the financial system where it creates no supply of goods or services. The vast majority of the new money enables the Fed to hold troubled assets. This new money serves only to protect the foolish from the consequences of their action. Only the silliest of bureaucrats talk about making money on these investments. We are making pennies on the Goldman Sachs and State Streets while losing dollars in AIG, Citibank, and the rest of the portfolio.
Worse, the government is altering consumer demand in order to fight deflation where it is needed, at the expense of creating it where it is not needed. Housing in this country is overpriced. Cars in this country are overpriced. Yet, the government encourages us to buy houses, cars, and energy efficient products. When a buyer takes these incentives, it is at the expense of other parts of the economy. In my specific case, I am replacing a perfectly good air conditioner which is an energy efficient one solely because the government will pay me to do something stupid. Given the size of that expense, I am not painting my house which actually needs to be done. While this is my individual decision, it is clear from the statistics on car sales and retail sales that there is a transfer of consumption from retail to autos that is in part caused by cash for clunkers program.
The net effect of this is going to be terrible for the long-term economy, which leads me to believe that inflation wins out in this struggle over time. The government thinks that it is smarter than the market. In my case, the air conditioner company wins, while the painters and my neighbors lose. Whatever economic activity that is created by the winners will be more than offset by the economic loss created by the losers. People who need to be farmers, or painters, or waiters will continue to live on the government’s dime working in banking, and auto production, and whatever other business the government decides is good for the economy. At which point, money supply is somewhat beside the point.
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