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Friday, December 4, 2009

Transcript: 328 Forecast Bouncing along the bottom is not a recovery 1204

Listen to this episode
The stimulus is inadequate to restart investment
the Home Owners Loan Corporation
the BOTE model
and the magnitude of the debt problem

And remember, forecasts and explanations are symmetrical and reversible, as per Karl Popper. So when somebody says,
over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming. Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect.

you should say, "Bull. Your explanation is as bogus as your forecasts."

The quote is from Baffled Ben Bernanke.

And the proof is that Demand Side has approximately one one-hundredth of one percent of the statistical and data tools that the Fed has and consistently, regularly and inevitably outperforms their forecasts.

Why? Because the explanation is wrong. As my new favorite economist, Steve Keen, says,
Neoclassical economics—and especially that derived from Milton Friedman’s pen—is mad, bad, and dangerous to know.

But back to the topic at hand.

Tuesday we talked about infrastructure and energy retrofitting programs that would lever private investment and weatherization and retrofitting schemes that finance themselves while generating jobs. Nothing new to most of our listeners.

We offered those investments in productive public goods as an economic plan. But you probably noticed we did not estimate the impact in terms of stimulus. Part of the reason is to avoid the Obama stimulus trap, which is getting a lot of criticism for not working because it has not stemmed the tide of the economic collapse.

Please realize that the private debt to GDP ratio is impossibly enormous. Much higher than the same number that led to the debt deflation of the Great Depression. Stimulus spending is an attempt to jump start the economy, but we're facing uphill.

Business investment spending has dried up. Household debt has frozen consumption spending. State and local governments are cutting to and into the bone. Absent policy to reverse all three of these, there will be no recovery. The scale and scope of the restructuring is enormous. We are under no illusion it will be done without another and deeper crisis.

That said, we are willing to offer some actual numbers. And for that we rely on our -- ta da -- BOTE model. In case you haven't figured it out yet, BOTE is the acronym for "back of the envelope." It was as much fun to put together as swimming in a river of mud, but we finally got it together, using the income multiplier concept and linking the consumption function of different factors and the profiles of different sectors in terms of those factors and feeding that back into the sectors' uses. Hey. It's proprietary. You're not supposed to know how it works.

If I didn't mention this on Tuesday, however, we were sobered on how quickly the multiplier effect decayed. We had imagined the different estimates that were empirically derived were far too low. And we were right in the case of ... ah, can't remember his name ... Nobelist. But we were wrong in the case of Christine Romer et al. To make a long story short, we did not find a multiplier over two. That for government, as would be gotten with direct support to the states, was the largest, very close to two. The most significant thing about this model is it demonstrates just how important the consumption function is, and hence, how credit payments can dry up any stimulus. Reducing the function for labor by five percent reduces the multipliers by 30 percent, depending.

This means that without action on the debt levels of households and businesses, we are not going to recover, in the sense of get out of this mess.

So. Quickly. The $250 billion dollars per year in surface transportation infrastructure identified last week and detailed in the recently released report by the Surface Transportation Policy and Revenue Study Commission. BOTE says: $400 billion in additional action in the economy in the near term, plus beginning in the fifth year an additional $150 to $250 billion in benefits that will make the program self-financing in the broadest sense. The gas tax pays for the public goods that consumers enjoy and then saves an amount from 1.5 to 4 times that payment. Recognize that the improvement is a comparison to the infrastructure absent the construction. Failing infrastructure will cost. Hello Katrina. Hello Minneapolis bridge.

Oh, and before I get too much further. I apologize for the failure of our host in delivering the podcast this past week. You can go to the Demand Side capital letter feed and get it. I'll revise the link on the blog. I don't know what is going on there. May put up the feed on both sites. Although the capital letter site runs out of bandwidth.

Enough of that.

Weatherization plans on a broad scale could be self-financing, as we said on Tuesday. They could deliver as much as one percent of GDP in stimulus value, as resource use is traded for jobs. This is with heating and cooling retrofitting, weatherization and commercial buildings included. And remember, these come with a stream of benefits that pays for the investment. This means there is an actual return on investment you can't get at the Treasury, yet there is the certainty of a government-regulated utility. I am of the opinion that there is plenty of financing capital waiting for a program like that.

Plus, the energy distribution infrastructure along the lines of the smart grid. We said this would make possible profitable investments across the country in alternative energy projects of all kinds. As soon as these reach a critical mass, we have a new oil boom type impact, as IdeaLab's Bill Gross said on Tuesday.

And there are opportunities for ...

But we need to get to the HOLC. Let's review. As house prices rose in the 1990s and 2000s, people began to speculate in housing. By speculate, we mean, they invested in their homes not only for the housing services they would provide, but for the appreciation of prices. Then along came the ridiculously low interest rate. The home buyer made a calculation of how much she could afford per month in payments, and as interest rates fell, saw that the value of the home she could afford went up. Let's say the price. Because it turns out it was the price, not the value. Hey, I can afford a $400,000 home, when a couple of years ago, I could afford only $250,000. Well.... In any event, by reaching a little further, she could afford a $450,000 home. This created, and we'll leave out all the predatory permutations, a debt service payment

It is this debt service payment from homes and easy credit cards that is now the millstone around a floundering economy. To a great extent it doesn't matter that the interest part of the loan is not as big as it might be, because the home has gone down in value and the "principle" portion does not refer to equity any more. Thus, the federal loan modification programs miss the boat when they focus on reducing the interest payment. It is the principle that needs to be reduced.

A better plan came out of Treasury last week, to facilitate short sales. The Home Affordable Foreclosure Alternatives Program (I guess the acronym is HAFAP). In any event, the financial incentives for completing short sales or a deed-in-lieu transaction:

Borrowers would receive $1,500 from the government in relocation expenses.

Servicers receive $1,000 from the government.

Second liens holders can receive up to $3,000 of the sales proceeds for releasing their liens.

First lien investors can receive $1,000 from the government for signing off on payments to subordinate lien holders.

Borrowers must be fully released from any further liability.

Because residential investment is not the kind of investment that creates its own stream of debt servicing payments, it needs some kind of action. We can hope for inflation to float us off the rocks. Or we can go directly at the principle. These payments cannot be made, so inevitably they won't be. It is a matter of an organized recognition of this fact. The best way by far, though not painless to those who made these crazy loans, is to write down the amount between borrower and lender.

It has to be done.

That is what the Home Owners Loan Corporation of the 1930s did. Well, it also invented the 30-year fixed mortgage. But writing down the principle and getting the creditors to share the poverty is the only way out. Our -- ta da -- BOTE model indicates that any reduction in debt levels and consequent increase in the consumption function will mean other stimulus and recovery plans can get traction. Without this, not so much.

The Conference Board’s consumer confidence index may have improved (48.7 in October to 49.5 in November) and beaten consensus expectations, but it remains firmly in recession terrain. As David Rosenberg says, "It is so obvious that consumers are tired of the over-borrowing and over-spending days of yesteryear. Despite all the temptations provided by the government, auto buying plans dropped to an eight-month low (from 4.7 in October to 4.4 in November); home buying plans slipped to a new 27-year low of 2.3 (from 2.5 in October and 3.0 in September); and intentions to buy a major appliance stayed at a 14-year low (23.2)."

We mention that here, because the consumer confidence index has been much better than economists consensus, the Fed, or the stock market in predicting what is to come.

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