Relevant and even prescient commentary on news, politics and the economy.

Katrina and Psychology

Several people have asked me in recent days whether I think Katrina will have any measurable economic impacts on the national US economy. In general, I think it’s hard for localized events such as a hurricane (or even a large terrorist attack) to have effects on the US economy as a whole, simply because the US economy is so vast and so diversified. Sure, massive rebuilding after a big storm (e.g. after Hurricane Andrew) could add a couple of tenths of a percent to GDP for a quarter or two due to increased construction and replacement of damaged assets, but I would still discount that as a relatively minor impact on the US economy.

However, there’s one way in which I think that a purely local event can have a significant and lasting effect on a national economy: by changing the psychology of individuals across the country. And as far as that goes, I wonder if Katrina may have been just the wrong storm at just the wrong place and wrong time.

A lot of economic behavior is driven by psychology. After all, many economic decisions that people and firms must make every day depend crucially on their expectations for the future. And those expectations are often not measurable or knowable in any concrete way, but rather depend in large part on speculation, estimates, presumptions, guesses, conjectures, and gut feelings. That’s why many economists believe that simple optimism and pessimism can play huge roles in the course of the business cycle. That’s what Keynes’ famous notion of “animal spirits” was all about, after all.

And lately I’ve been a bit worried about which way animal spirits were heading in the US.

  • The economic expansion has almost certainly peaked (in terms of growth rates) and growth seems to be slowing, if anything.
  • There is much debate about the health of the labor market right now (see our very own PGL for much more on this), but nearly all economists agree it is not nearly as strong as we would like it to be, particularly for the mature phase of an economic expansion.
  • The signs that the real estate market is at or very near its peak in many hot markets are slowly becoming more abundant (see Calculated Risk for much more on this), and the unwinding of regional housing market bubbles will almost certainly bring at least moderate discomfort (financial and psychological) to many individuals.
  • But the most important contributor to a growing sense of economic angst, I think, is simply this: people are really getting tired of paying $40 or $50 to fill their car with gas, and are tired of finding that gas prices continue to rise month after month, and are starting to think about how much their heating bills are going to be this winter.

Now add Katrina. If it turns out, as seems increasingly likely, that Katrina will cause some supply disruptions in the gasoline and oil markets in the US – whether due to lost refinery capacity, damaged port and transportation infrastructure, or damaged petroleum infrastructure – then the resulting spikes in oil and gas prices in the US could really put individuals and firms in a bad mood.

Even temporary problems can get magnified if they contribute to a broader change in psychology. And I think that the current situation contains the seeds for such a shift in sentiment. My personal odds for a recession in 2006 have just gone up, thanks to Katrina.


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I’m Back

Hi all – sorry for the extended hiatus, but I’m back now. Alas, the end of August brings with it the end of my summer travels, and the end of my otherwise slothful and dissolute summer schedule. (Well, at least I tried to keep August as slothful as one can with a two-year old and a two-month old at home.) I hope that the end of the summer was peaceful and pleasant for you. It seems that the world managed to get on without my interference for the last several weeks… but that’s enough of that.


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Robert Hall and Real Business Cycle Theory

Robert Hall discusses Separating the Business Cycle from Other Economic Fluctuations at the Federal Reserve Bank of Kansas City’s annual Jackson Hole conference. David Altig claims Hall explained it all. But what does Hall say about the most recent weakening of the labor market?

For example, all practical accounts of the recession of 2001 emphasize the huge decline in high-tech investment. In earlier recessions, declines in home-building were prominent features. On the other hand, more theoretically inclined macroeconomists tend to take a decline in productivity—or at least a pause in the normal growth of productivity—as the central driving force.

While this statement is part of what we tried to cover here, Max Sawicky is not convinced:

The notion that productivity explains fluctuations strikes me as an utter dodge. What is productivity?

Come to think about, we were not convinced either.

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Housing and Recession

My thoughts are with the residents of New Orleans and the Gulf Coast tonight.

This week two prominent economists predicted a housing bust and possible recession in ’06; three if you count Chairman Greenspan. Actually Greenspan’s comments, made at the Federal Reserve’s Jackson Hole Conference, were not predictions, but general observations. Quoting from Greenspan’s closing remarks (emphasis added):

“… the housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home price increases will slow and prices could even decrease. As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures. The estimates of how much differ widely.”

There is no question that equity extraction has been an important driver of consumer spending over the last few years. Even if housing prices remain elevated, a housing slowdown will lead to lower equity extraction, lower consumer spending and an economic slowdown. How much will the economy slow? Estimates “differ widely”. But clearly there is reason for concern; from Greenspan’s opening comments:

“… newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

Is Greenspan predicting a recession? Maybe. Princeton economist Dr. Krugman went much further predicting the housing bubble would “burst” soon:

“I’ll give you a forecast which might very well be wrong, but I think it will burst in the spring of next year,” he said at a derivatives conference in Brazil’s winter resort of Campos do Jordao.

As all economists do, Krugman then offered some caveats (see article). Dr. Leamer, of UCLA’s Anderson Forecast, also suggested that a recession was very likely:

In Leamer’s view, the housing market appears to have peaked “in California and elsewhere. It will take more than a year for this weakness to turn into job losses and to affect the economy in general.”

And, yes, he’s using the “R” word. As in “recession.”

If housing has peaked, why will it take a year for the economy to slide into recession? I believe Dr. Leamer is relying on historical evidence that shows recessions start about 8 to 12 months after the number of housing transactions peak. Here is a look at the last three consumer recessions (four counting the ’80s double dip). The gray area signifies that the economy was in recession based on the National Bureau of Economic Research’s cycle dates. Even both recessions in the early ’80s were preceded by significant declines in sales volume.

Click on Graph for larger image.

I believe this historical evidence is the reason Dr. Leamer is suggesting “it will take more than a year” for the housing slowdown to impact the economy.

It is possible that the economy will slow sooner this time since housing is a much larger percentage of the economy. Also, unlike the previous periods, housing is now the main engine of the economy. This is especially true when the substantial contribution of equity extraction to consumer spending is included. Even if housing prices stay stable, lower equity extraction could lead to significantlyly lower consumer spending, as has happened in the UK.

As an aside, the Bank of England rate cut hasn’t helped the UK housing market:

House prices in England and Wales fell for the 14th straight month in August for an annual rate of decline of 3.7 percent, a survey showed on Monday.

And I see Fleckenstein is declaring: It’s RIP for the housing boom. It is possible that housing has peaked (in transaction volumes), but we cannot be sure for several months.

Best Regards, CR Calculated Risk

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High Housing Prices are Here to Stay?

Could the most sensible NRO “economics” piece of the week be from Jerry Bowyer? Or have I lowered my standards to say that something that is only half right is worth reading?

Bowyer gets the data right – new housing sales are strong, which reflects the strong housing construction over the past several years. He also notes that the demand for housing increased as interest rates fell. As far as immigration increasing the demand for housing, doesn’t all population growth tend to shift the demand curve outwards? Also note that if the increase in housing supply outpaces the increase in housing demand, one would expect housing prices to fall.

Actually, there are two debates going on regarding the rapid increase in housing prices. The bubble types argue that housing prices exceed what the fundamentals would suggest. The fundamentalists, which seems to include Bowyer, are arguing that the high housing prices are due to the above changes in fundamentals. Bowyer’s premise seems to be that housing prices cannot fall, but if the fundamentals change – then why wouldn’t housing prices decline? Interest rates have been increasing of late – and population growth over the next generation is likely to be quite modest.

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Kudlow on Demand and Supply for Oil

Mark Thoma reads Lawrence Kudlow we don’t have to. Mark rightfully suggests that Kudlow does not understand monetary policy. Kudlow, however, was more focused on the demand and supply for oil – another topic where he displays confusion:

On the oil-price shock, I say at least two cheers for higher prices. Why? Because I believe in markets. When the price of energy goes up, demand falls off and supply increases … The spread of global capitalism to places like China, India, and Eastern Europe is the main cause of the spike in energy prices. It’s a market signal that the new and prospering world economy needs more power. Consequently, this is not a recessionary supply crunch like we had in the 1970s. It’s a growth-oriented demand increase.

OK, Kudlow does seem to understand that the supply curve has not shifted inward but what does “demand falls off” mean? Larry – try this: an outward shift of the demand schedule, which has led to the dramatic increase in the price of oil.
Kudlow also suggests a higher elastic supply schedule for energy:

As Dan Yergin, president of Cambridge Energy Research Associates, recently wrote in the Washington Post, rising energy prices today will cause energy supplies to explode tomorrow.

I’m not so sure we shall see a dramatic increase in energy prices by tomorrow or anytime soon. And if one looks at forward prices, the market does not seem to share Kudlow’s belief in highly elastic supply curves.

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The Silent Majority Turns Invisible

Thirty-five years ago, young patriots such as Lt. John Kerry vocally expressed the view that our brave soldiers should return home from Indochina immediately. President Nixon claimed that the majority of Americans disagreed but were “silent”. Today, the success of Camp Casey at attracting national attention to the Iraq War issue has driven certain right-wingers to desperate measures such as smearing Cindy Sheehan. The folks at the National Review want us to know that a lot of folks support President Bush and so they have provided pictures of Camp Qualls.

CrooksandLiars notes that there do not appear to be any people in these pictures. Apparently those who put up these signs have turned invisible. Or is it the Soylent Green theory from Duncan Black that someone ate all the Bush supporters?

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