I caught up with my email just after my last post, which questioned the role of the real economy in the current financial crisis. I found this in my inbox, by Thomas Friedman, currently the most-emailed article in the NYT:
Letâ€™s today step out of the normal boundaries of analysis of our economic crisis and ask a radical question: What if the crisis of 2008 represents something much more fundamental than a deep recession? What if itâ€™s telling us that the whole growth model we created over the last 50 years is simply unsustainable economically and ecologically and that 2008 was when we hit the wall â€” when Mother Nature and the market both said: â€œNo more.â€
Certainly there are some parallels between the housing bubble and environment/growth issues. You have your eternal growth enthusiasts with plausible-sounding theories, cheered on by people in industry who stand to profit.
Sound familiar so far?
However, I think it’s a bit of a leap to attribute our current mess to unsustainability in the real economy. For one thing, in hindsight, it’s clear that we weren’t overshooting natural carrying capacity in 1929, so it’s clearly possible to have a depression without an underlying resource problem. For another, we had ridiculously high commodity prices, but not many other direct impacts of environmental catastrophe (other than all the ones that have been slowly worsening for decades). My guess is that environmental overshoot has a lot longer time constant than housing or tech stock markets, both on the way up and the way down, so overshoot will evolve in more gradual and diverse ways at first. I think at best you can say that detecting the role of unsustainable resource management is like the tropical storm attribution problem. There are good theoretical reasons to think that higher sea surface temperatures contribute to tropical storm intensity, but there’s little hope of pinning Katrina on global warming specifically.
Personally, I think it’s possible that EIA is right, and peak oil is a little further down the road. With a little luck, asset prices might stabilize, and we could get another run of growth, at least from the perspective of those who benefit most from globalization. If so, will we learn from this bubble, and take corrective action before the next? I hope so.
I think the most important lesson could be the ending of the housing bubble, as we know it so far. It’s not a soft landing; positive feedbacks have taken over, as with a spark in a dry forest. That seems like a really good reason to step back and think, not just how to save big banks, but how to turn our current situation into a storm of creative destruction that mitigates the bigger one coming.
Two relevant conversations from the SD email list archive:
Bill Harris asks, in 2003,
… should a reasonable person think we are now in the down side of a long wave? That the tough economic times we’ve seen for the past few years will need years to work through, as levels adjust? That simple, short-term economic fixes wont work as they may have in the past? That the concerns we’ve heard about deflation should be seen in a longer context of an entire cycle, not as an isolated event to be overcome? Is there a commonly accepted date for the start of this decline?
Was Bill 5 years ahead of schedule?
Kim Warren asks, in 2001,
This is a puzzle – we take a large fraction of the very brightest and best educated people in the world, put them through 2 years of further intensive education in how business, finance and economics are supposed to work, set them to work in big consulting firms, VCs, and investment banks, pay them highly and supervise them with very experienced and equally bright managers. Yet still we manage to invent quite implausible business ideas, project unsustainable earnings and market performance, and divert huge sums of money and talented people from useful activity into a collective fantasy. Some important questions remain unanswered, like who they are, what they did, how they got away with it, and why the rest of us meekly went along with them? So the challenge to SDers in business is … where is the next bubble coming from, what will it look like, and how can we stop it?
Clearly this is one nut we haven’t cracked.
“As early as last summer we still thought Montana would escape this recession,” he said. “We knew the national economic climate was uncertain, but Montana had been doing pretty well in the previous two recessions. We now know this is a global recession, and it is a more severe recession, and it’s a recession that’s not going to leave Montana unscathed.”
Indeed, things aren’t as bad here as they are in a lot of other places – yet. Compare our housing prices to Florida’s:
On the other hand, our overall economic situation shows a bigger hit than some places with hard-hit housing markets. Here’s the Fed’s coincident index vs. California:
As one would expect, the construction and resource sectors are particularly hard hit by the double-whammy of housing bubble and commodity price collapse. In spite of home prices that seem to have held steady so far, new home construction has fallen dramatically:
Interestingly, that hasn’t hit construction employment as hard as one would expect. Mining and resources employment has taken a similar hit, though you can hardly see it here because the industry is comparatively small (so why is its influence on MT politics comparatively large?).
So, where’s the bottom? For metro home prices nationwide, futures markets think it’s 10 to 20% below today, some time around the end of 2010. If the recession turns into a depression, that’s probably too rosy, and it’s hard to see how Montana could escape the contagion. But the impact will certainly vary regionally. The answer for Montana likely depends a lot on two factors: how bubbly was our housing market, and how recession-resistant is our mix of economic activity?
On the first point, here’s the Montana housing market (black diamonds), compared to the other 49 states and DC:
Prices above are normalized to 2000 levels, using the OFHEO index of conforming loan sales (which is not entirely representative – read on). At the end of 2003, Montana ranked 20th in appreciation from 2000. At the end of 2008, MT was 8th. Does the rise mean that we’re holding strong on fundamentals while others collapse? Or just that we’re a bunch of hicks, last to hear that the party’s over? Hard to say.
It’s perhaps a little easier to separate fundamentals from enthusiasm by looking at prices in absolute terms. Here, I’ve used the Census Bureau’s 2000 median home prices to translate the OFHEO index into $ terms:
Among its western region peers, a few other large states, and random states I like, Montana starts to look like a relative bargain still. The real question then is whether demographic trends (latte cowboys like me moving in) can buoy the market against an outgoing tide. I suspect that we’ll fare reasonably well in the long run, but suffer a significant undershoot in the near term.
The OFHEO indices above are a little puzzling, in that so many states seem to be just now, or not yet, peaking. For comparison, here are the 20 metro areas in the CSI index (lines), together with Gallatin County’s median prices (bars):
These more representative indices still show Montana holding up comparatively well, but with Gallatin County peaking in 2006. I suspect that the OFHEO index is a biased picture of the wider market, due to its exclusion of nonconforming loans, and that this is a truer picture.
Ira Artman takes a look at residential real estate price indices – S&P/Case-Shiller (CSI), OFHEO, and RPX. The RPX comes out on top, for (marginally) better correlation with foreclosures and, more importantly, a much shorter reporting lag than CSI. This is a cause for minor rejoicing, as we at Ventana helped create the RPX and are affiliated with Radar Logic. Perhaps more importantly, rumor has it that there’s more trading volume on RPX.
In spite of the lag it introduces, the CSI repeat sales regression is apparently sexy to economists. Calculated Risk has been using it to follow developments in prices and price/rent ratios. Econbrowser today looks at the market bottom, as predicted by CSI forward contracts on CME. You can find similar forward curves in Radar’s monthly analysis. As of today, both RPX and CSI futures put the bottom of the market in Nov/Dec 2010, another 15% below current prices. Interestingly, the RPX forward curve looks a little more pessimistic than CSI – an arbitrage opportunity, if you can find the liquidity.
Artman notes that somehow the Fed, in its flow of funds reporting, missed most of the housing decline until after the election.
The Fed has just doled out over $300 billion in loans to bail out Bear Stearns and other bad actors in the subprime mortgage mess. It’s hard to say what fraction of that capital is really at risk, but let’s say 10%. That’s a pretty big transfer to shareholders, especially considering that there’s nothing in it for the general public other than avoidance of financial contagion effects. If this were an environmental or public health issue, skeptics would be lined up to question whether contagion in fact exists, whether fixing it does more harm than good (e.g., by creating future moral hazard), and whether there’s a better way to spend the money. Contagion would have to be proven with models, subject to infinite scrutiny and delay. Yet here, billions are doled out with no visible analysis or public process, based on policies invented ad hoc. Perhaps a little feedback control is needed here: let’s create a bailout fund, supported by taxes on firms that are deemed too big to fail by some objective criteria. Then two negative feedbacks will operate: firms that get too large will be encouraged to split themselves into manageable chunks, and the potential beneficiaries of bailouts will have to ask themselves how badly they really want insurance. Let’s try it, and see how long the precautionary principle lasts in the financial sector.
Update: Paul Krugman has a nice editorial on the problem.
And if financial players like Bear are going to receive the kind of rescue previously limited to deposit-taking banks, the implication seems obvious: they should be regulated like banks, too.