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Notes Toward Revealing a Housing Bubble in a Standard Economic Model

Let us first stipulate that houses themselves are unique entities, but similar enough that we can consider them comparable if not fungible. (In this, they are like any financial asset.) Let us further restrict them in acknowledging that there are significant transaction costs: one’s liquidity preference should not prefer housing to, say, cash-equivalents or marketable commodities, but they are arguably more liquid than a piece of sports memorabilia or antiquarian books or the like. (Given leisure and choice, one sells a copy of Action Comics #1 before one sells a residence; given a need for liquidity and reduced price uncertainty, this preference may change.  The implications of this are left as an exercise.)

Assume a standard lifecycle model with intergenerational wealth transfer; we should perhaps stipulate credit constraints in the first (accrual) period, but that assumption can be relaxed during the second (consumption/transfer) period.

As a complicating factor—or rather, to reflect reality—stipulate that in areas that lack significant emigration, transfer of housing assets commonly is done as a continuous flow (that is, the final stages of transfer are from “empty nest’ to Gen2 living with and supporting Gen1 to Gen2 possessing the domicile as the overlap ceases to be), while areas with notable emigration patterns tend to monetize the housing asset and transfer the cash-and-marketable-securities equivalent to the next Generation.

As a further complicating factor to the above, lands that tend to lack emigration may become areas from which people immigrate. Similarly, some areas may become loci of emigration as employment patterns shift and true Structural Change promulgates through a system.

In such a model, the housing component serves the dual purpose of providing housing and being a vehicle for savings.  Not a good vehicle for savings, under normal circumstances, but a piece of equity that can be passed to the next generation—either as a lump sum cash equivalent or as a domicile, depending on the externalities discussed in the Action Comics #1 parenthetic.)

This effectively transforms all housing purchases into rentals—rent for the generation, passing equity accrued to the next in whichever form is optimal.

From that point, it seems intuitive that if the incentive structure changes significantly—if, for instance, one can realize a substantially greater return from owning and selling than from renting—that a bubble might develop.  And as more people are incented to do what they ordinarily would not—to sell a house, to “trade up,” or to otherwise find ways to realize the gains that come from a relative mispricing in the market—that what might become a bubble either (1) will return toward its original trajectory, (2) will revert toward its original trajectory (though it may find a different [higher or lower] equilibrium point, or (3) grow until it is a clear bubble, that will burst.

Note that we can see graphically the difference between the non-bubble states ([1] and [2]) and the bubble state—the first two would show a sign of mean reversion (a decline), while the Bubble State continues to rise.  I wonder if there might be any evidence for one or the other of those hypotheses?


(via CR)

Maybe someone at the Federal Reserve Board of Boston should throw the above into some standard life-cycle equations and re-evaluate the presentations at this conference, including Glaeser, Gottleib, and Gyourko (PDF)?

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Inequality as a critical cause of the financial crisis?

by Linda Beale
crossposted with Ataxingmatter

Inequality as a critical cause of the financial crisis?

As readers know, Ataxingmatter is premised on a concept that I have called “democratic egalitarianism.” that This is the idea that sustainable democracy requires forces that push economic and other resources towards a more equal distribution rather than permitting resources to accrue more and more to the already powerful and well-resourced amongst us. Redistribution, that is, occurs all the time in every economy. Much of redistribution is redistribution upwards–power accrues power; wealth accrues wealth; and accordingly opportunity accrues opportunity. Taxation is one of the mechanisms that society can use to counter the natural tendency towards redistribution upwards. In a democracy, that mechanism is necessarily and appropriately limited, but it can be servicable on a small scale. Thus, mechanisms such as income rather than consumption taxation, progressive tax rates, taxation of large estates passed to beneficiaires, exemptions and refundable credits sufficient to ensure a sustainable livelihood for those who have (and earn) least, and similar provisions can serve to switch the default direction of redistribution from ‘redistribution to the have-mores’ to ‘redistribution to the have-nots’ at least to some degree.

So how does that view of democracy and the need for “democratic egalitarianism” impact upon one’s understanding of the causes and appropriate cures for the financial crisis that expanded into a deep recession bordering on depression?

In my own analysis of the financial crisis (to be published by the IMF, and currently available through SSRN here), I focused primarily on the deregulation/privatization/and tax cutting at the core of the reaganomics trickle-down ideology and the way that led to a predatory casino banking mentality that in turn was fed by the ease of speculation made possible by financial product innovations like naked credit default swaps. Similarly, the risk inherent in this type of banking was increased as institutions consolidated, increasing in resources and in interconnections with other financial institutions (including through the use of new-fangled derivatives).

I didn’t focus, though, on a singular fact about our society that relates to our deepest economic woes during the Great Depression as well as our current Great Recession–the rapid growth of inequality, and the attitudinal changes that likely accompany that (e.g., rampant expansion of greed as a primary motivating factor for human behavior, acceptance of incredible differences in access to resources and influence over governmental decisions without an acknowledgement of corresponding obligations, predatory behavior by lenders and other businesses). But surely it is noteworthy that of all the remedies that could have been taken to address the economic crisis that developed out of the financial institution crisis, the only one that would have kept more people in their homes and protected entire neighborhoods and cities from the blight of foreclosed properties–permitting bankruptcy adjustments of home mortgage loan principal amounts–was never a real option. Banks ended up being more important than millions of homeowners (and the communities that were impacted by their homelessness and joblessness).

Raymond H. Brescia, at Albany Law School, has filled that gap, with an article titled The Cost of Inequality: Social Distance, Predatory Conduct, and the Financial Crisis (draft Aug. 17, 2010) (available on SSRN). He starts with a pair of quotes that are noteworthy in themselves.

An imbalance between rich and poor is the oldest and most fatal ailments [sic] of all republics. Plutarch

The injunction of Jesus to love others as ourselves is a recognition of self-interest . . . We have to tolerate the inequality as a way to achieving greater prosperity and opportunity for all. Lord Brian Griffiths, Vice Chairman, Goldman Sachs International

In the abstract, Brescia explains that the “stunning increase in income inequality…was reminiscent of … the years leading up to the Great Depression.” In the paper, this is illustrated with the following graph: Table Three: Share of Total Income Going to Top 10%, id. at 14.

Brescia notes “several possible explanations for the potential connection between rising income inequality and the great strains on the economy it causes. Did rising income for certain sectors lead to an ability to use that income to influence po,icymaking in such a way that favored those sectors? Did such income inequality pressure politicians to promote policies that favored easy access to credit as a way to mollify lower income constituents who might otherwise grow frustrated with their own stagnating wages in the face of such inequality?” He offers a third explanation–“that both income inequality and racial inequality created greater social distance and this social distance, in turn, led to greater predatory conduct… that turned a mortgage market into an economic killing field.” The abstract further notes critical insights from looking at the crisis from the perspective of inequality data.

1) the greater the income inequality in a state, on average, the greater the delinquency rate in that state.
2) the greater the generalized trust in a state, the lower that state’s delinquency rate
3) the higher the social capital in a state, and the higher the level of volunteerism in a state, the lower its delinquency rate
4) the higher the median income in a state, the higher the delinquencyrate in that state
5) an index of indicators–income inequality within a state, the size of the African-American population in a state and the median income of the African-American population in that state–reveals a strong correlation between these indicators and delinquency rates…[suggesting that] middle-class Afircan-Americans were targeted for, and steered towards, loans on unfair terms, precipitating the foreclosures that are now concentrated disproportionately in communities of color.

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Creating American Jobs and Ending Offshoring Act (S. 3816)

by Dan Crawford

I haven’t the time to check it out, but here is a note and link to a Senate bill on offshoring:

The Senate is scheduled to vote TODAY on the Creating American Jobs and Ending Offshoring Act (S. 3816) to set a time limit for debate and cut off a filibuster.

The bill has three main components:

To encourage businesses to create jobs in the United States, it provides businesses with relief from the employer share of the Social Security payroll tax on wages paid to new U.S. employees performing services in the United States. To be eligible, businesses must certify that the U.S. employee is replacing an employee who had been performing similar duties overseas.

The bill eliminates subsidies U.S. taxpayers provide to firms that move facilities offshore by prohibiting a firm from taking any deduction, loss or credit for amounts paid in connection with reducing or ending the operation of a trade or business in the United States and starting or expanding a similar trade or business overseas.

It also ends the federal tax subsidy that rewards U.S. firms that move their production overseas. Under current law, U.S. companies can defer paying U.S. tax on income earned by their foreign subsidiaries until that income is brought back to the United States. This is known as “deferral.” Deferral has the effect of putting these firms at a competitive advantage over U.S. firms that hire U.S. workers to make products in the United States.

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The money quandary

The Federal Reserve, the Bank of England, and the Bank of Japan are considering further quantitative easing. It’s an explicit statement, as with the Federal Reserve and the Bank of England, or implied by the fact that the foreign exchange intervention will eventually be sterilized if the policy rule is not changed, as with the Bank of Japan. Why more easing?

In response to this question, BCA Research (article not available) presented a version of the quantity theory of money. They looked at the simple linear relationship between the average rate of money supply growth (M2) and nominal GDP growth (P*Y).

The chart is a reproduction of that in the BCA paper, but with a sample back to 1959 (they went back to the 1920’s when M2 was not measured). The relationship illustrates the 5-yr compounded annual growth rate of money (M2) against that of nominal GDP, and has an R2 equal to 50% – okay, but not perfect.

Nevertheless, the implication is pretty simple: the current annual growth rate of M2, 2.8% in August 2010, corresponds to an average annual income growth just shy of 4%. Sitting beneath a behemoth pile of debt relative to income, 4% nominal GDP growth is unlikely provide sufficient nominal gains for households to deleverage quickly or “safely“.

However, notice the 2000-2005 and 2005-2009 points, where the relationship between M2 and nominal GDP growth deviated away from the average “quantity theory” relationship. Would a broader measure of money account for the weak(ish) relationship in the chart above? Yes, partially. (Note: the relationship almost fully breaks down at an annual frequency.)

These days it’s all about credit. I’m sitting in Cosi right now – bought a sandwich and charged the bill on my credit card. Actually, I prefer to use cards. But M2 doesn’t account for this transaction as money if the balance is never paid in full. M2 is essentially currency, checking deposits, saving and small-denomination time deposits, and readily available retail money-market funds (see Federal Reserve release).

One can argue about the merits of including credit cards balances as “money”, per se. However, the sharp reversal of revolving consumer credit, and likely through default (see the still growing chargeoff rates for credit card loans), would never be captured in M2. The hangover from the last decade of households using their homes as ATM’s (i.e., home equity withdrawal) and running up credit card balances to serve as a medium of exchange is dragging nominal income growth via a sharp drop in aggregate demand.

The Federal Reserve discontinued its release of M3 in 2006, which among other things included bank repurchase agreements (repos). Including M3, rather than M2, in the estimation improves the the R2 over 30 percentage points (to 81%).

This is a very small sample, and removing the latest data point from the original estimation improves the R2 slightly to 64%; but clearly there’s something going on here. I think that it’s fair to say that we may be disappointed by the M2 implied average nominal GDP growth rate over the next 5 years (4%).

According to John Williams’ Shadow Statistics website, M3 is still contracting at (roughly because I don’t subscribe to the data) 4% over the year. The relationship in the second chart implies that nominal GDP will fall, on average, about 4.5% per year. Japan’s nominal GDP never contracted more than 2.08% annually during its lost decade, but the implication is that “things” may not be as rosy as the M2 measure of money suggests.

Rebecca Wilder

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Beale/ NYT room for debate…Extending the tax cuts for the wealthy

by Linda Beale
crossposted with Ataxingmatter

Extending the tax cuts for the wealthy–the discussion continues

The New York Times asked me for my views of Robert Samuelson’s recent argument in the Washington Post that extending the tax cuts for the wealthy made sense because they would otherwise cut back their spending, tax cuts for them will create jobs (770,000, he claims) and not extending the tax cuts would raise taxes on “small” businesses and thus “discourage hiring and expansion.”

The discussion appears in theNew York Times “Room for Debate” forum on the trickle down argument, at Hey Big Spenders: The Trickle-Down Argument, Sept. 27, 2010.

Here at ataxingmatter I’ll add some introductory context, which is somewhat harsher on Samuelson and his claim to question “the ritual of sound-bite economics” than the short form posted at the New York Times.

Robert Samuelson claims to sound a voice of reason, but he is merely part of an increasing cacophony of ideological extremism.

He starts with a distorted sound-bite—that “the left sees salvation only in ever-larger government … [that] threatens long-term economic growth through higher taxes, regulations or budget deficits.” I’d say rather that the left questions the right’s theories behind expanding government intrusions on individual rights and bloating government warmongering rather than relying on the likely more successful and certainly less costly art of diplomacy. On the other hand, the right pushes for deregulation no matter the record of negligence and active harm caused by reliance on so-called industry self-regulation or the harm that ensues from inadequate prudential behavior, which we so amply witnessed in the financial meltdown and broader economic crisis of the Great Recession. Similarly, the right is schizophrenic on budget deficits—favoring them to provide tax cuts for mega-corporations and wealthy Americans who can amply manage without them, but bemoaning even uncertain future deficits from programs benefitting ordinary Americans, such as Social Security.

Samuelson then attacks Obama as “subvert[ing] confidence” because he “fights Wall Street bankers, oil companies, multinational firms, health insurers and others.” These titans of commerce began the fight when they retained all productivity growth for their owners and managers at the expense of ordinary Americans. Health insurers benefited by denying coverage, or delaying payment. Multinationals drained the federal fisc through transfer pricing games, tax credit manipulation and other tax shelters. Oil companies polluted waters and fisheries to save a few bucks on safer deep sea drilling and companies continue in their efforts to stymy legislative action to regulate questionable fracturing procedures to extract natural gas from shale. Wall Street bankers profited immensely from speculation in a casino financial system with interconnected and layered risks at the expense of the non-financial heart of the economy.

Then Samuelson spouts the worn arguments from Reaganomics for letting the rich avoid a fair share of the tax burden, even while they garner an ever increasing share of the nation’s wealth. (Continue to the New York piece, Better Ways to Use $700 Billion.)

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Ratings agencies nailed.

Robert Waldmann

D. Keith Johnson, a former president of Clayton Holdings, a company that analyzed mortgage pools for the Wall Street firms that sold them, told the [financial crisis inquiry] commission on Thursday that almost half the mortgages Clayton sampled from the beginning of 2006 through June 2007 failed to meet crucial quality benchmarks that banks had promised to investors.


“We went to the ratings agencies and said, ‘Wouldn’t this information be great for you to have as you assign tranche levels of risk?’ ” Mr. Johnson testified last week. But none of the agencies took him up on his offer, he said, indicating that it was against their business interests to be too critical of Wall Street.

“If any one of them would have adopted it,” he testified, “they would have lost market share.”

The investment banks who paid Clayton Holdings for the analysis used it to get the mortgages for a low price but didn’t share the data with investors. Both the investment banks and the ratings agencies defend themselves noting vague statements about declining underwriting standards in prospectuses and “research and commentary” respectively.

Clearly the vagueness was deliberate “some loans in the pool don’t meet the declared standards” is no briefer and less informative than “most loans in the pool don’t meet the declared standards.” It is almost as clear that no one will pay penalties proportional to the direct harm to investors (let alone the indirect costs of the crisis). Morgan Stanley executives settled out of court with the State of Massachusetts for $102 million — and laughed all the way back to their bank.

I’m going long pitchforks.

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Unemployment Rates, an International Apples to Apples Comparison

by Mike Kimel

Unemployment Rates, an International Apples to Apples Comparison

Cross posted at the the Presimetrics blog.

One of the things we all know about America is that labor laws are more flexible here than in other developed countries, so we have lower unemployment rates than in other countries with relatively more rigid labor laws. Its one of those facts we are told over and over again, like cutting taxes spurs economic growth or that the folks benefiting the most from our largess in Iraq and Afghanistan, not to say an assortment of tin pot dictators throughout Central Asia, are pro-democracy and pro-America.

A lesser known fact is that unemployment rates are computed differently from country to country. (So is GDP, but that’s a topic for another post.) The Bureau of Labor Statistics, the folks who compute the unemployment rates here in the land of the (relatively) free market went through the effort of adjusting the unemployment rates of the US and nine other countries (Canada, Australia, Japan, France, Germany, Italy, Netherlands, Sweden, and the UK) between to allow for an apples to apples comparison. I think the most interesting data – the comparison of overall unemployment rates from 1970 to 2009 – is in table 1-2, which I’ve imported into Excel and graphed below.

Figure 1.

The chart is a bit busy, but hopefully you could tell what’s going on if you look closely. And what I see is this…

For most of the sample, one or two countries produced, hands down, the best outcomes in the sample. For the entire sample, Japan is always one of those countries, but the other front-runner changes mid-sample. Sweden (yes, “socialist” Sweden) was the other in the period from 1970 to 1990, and the Netherlands (yes, “socialist” Holland) becomes the usual leader of the pack starting in the late 90s. Japan, of course, like Sweden and the Netherlands, is not exactly well-known for its flexible labor laws.

I don’t know enough to say what happened in Holland and/or Sweden but I have a hard time concluding that in their respective heydays they were a libertarian paradise.

As to the US… frankly, it did pretty lousy relative to the others from 1970 to about 1982, whereupon it began improving, eventually getting the point of contending for the top spot in the peloton. The US had a brief shining moment in the Sun – producing the second or third best performance from 1993 to 2000… but its been downhill from there. Put another way… things started going downhill, relatively, for US unemployment when the country began benefiting (ahem) from the most free market administration in the sample.

What I don’t see in the graph is any sign that the US approach to the labor markets can be described as the best, or even in the top three or four in this sample, assuming the goal is to keep unemployment down.

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Let’s be real folks..marginal tax cuts don’t motivate

From the LA Times op-ed page comes this piece by an entrepreneur:

I’m a venture capitalist and an entrepreneur. Over the past three decades, I’ve made both good and bad investments. I’ve created successful companies and ones that didn’t do so well. Overall, I’m proud that my investments have created jobs and led to some interesting innovations. And I’ve done well financially; I’m one of the fortunate few who are in the top echelon of American earners.

For nearly the last decade, I’ve paid income taxes at the lowest rates of my professional career. Before that, I paid at higher rates. And if you want the simple, honest truth, from my perspective as an entrepreneur, the fluctuation didn’t affect what I did with my money. None of my investments has ever been motivated by the rate at which I would have to pay personal income tax.

As history demonstrates, modest changes in the tax rate for wealthy taxpayers don’t make much of a difference if the goal is to build new companies, drive technological development and stimulate new industries. Almost a decade ago, President George W. Bush and his Republican colleagues in Congress pushed through a massive reduction in marginal tax rates, a reduction that benefitted the wealthy far more than other taxpayers.

We were told the cuts would accelerate business growth and create jobs. Instead, we got nearly a decade of anemic job growth, stagnating wages, declining incomes and high inequality.

The supply-side, trickle-down economic policies of the last decade benefitted people like me, but the wealth didn’t trickle down. So while we did quite well, people who live from paycheck to paycheck didn’t.

When inequality gets too far out of balance, as it did over the course of the last decade, the wealthy end up saving too much while members of the middle class can’t afford to spend much unless they borrow excessively. Eventually, the economy stalls for lack of demand, and we see the kind of deflationary spiral we find ourselves in now. I believe it is no coincidence that the two highest peaks in American income inequality came in 1929 and 2008, and that the following years were marked by low economic activity and significant unemployment.

What American businesspeople know, and have known since Henry Ford insisted that his employees be able to afford to buy the cars they made, is that a thriving economy doesn’t just need investors; it needs people who can buy the goods and services businesses create. For the overall economy to do well, everyday Americans have to do well.

(h/t Dan B.)

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Extend the Obama Tax Cuts

Robert Waldmann

Majority Whip James E Clyburn proposed extending the Obama tax cuts. Some assert that he means the Bush tax cuts on income under $250,000. I sure hope he means that Obama tax cuts.

I have been arguing for some time that the Democrats should propose permenent extension of the Bush cuts on income under $250,000 (which implies tax cuts of around $6,000 next year for each rich family) and additional temporary tax cuts which equal for everyone (I like $500 per family). But now I think that it would be better politics to propose making Bush tax cuts on family income under $250,000 permanent and extending the Obama tax cuts one year (that is 400 per individual taxpayer or $800 per family for all but the richest few percent of working families).

Like the Bush tax cuts, the Obama tax cuts are scheduled to expire (the cuts apply to 2009 and 2010 income and were enacted as part of the stimulus bill).

A key advantage of such a debate for the Democrats is that it would force Republicans to admit and journalists to report that there are Obama tax cuts that might be extended. In the last poll only 8% of US adults knew that Obama and the Democrats have cut taxes for most US families.

I think the assumption that Clyburn must have been talking about the Bush tax cuts has something to do with the fact that even political junkies overlook the Obama tax cuts.

Finally, of course, temporary tax cuts for the non rich are a better stimulus than temporary tax cuts for the rich.

Now I wonder does House Majority Whip James E. Clyburn agree with me ? Did he mean what he said. His web page is no help.

The answer is (no surprise) on Talking Points Memo

“As the whip, I have been counting votes for President Barack Obama’s tax cut,” Clyburn said. “And I like the votes that are there for an extension of President Obama’s tax cuts. You may recall that all the American people–95 percent of the American people got a tax cut–in our legislation, that we call the recovery package. And what we’re trying to do is extend that.”

He quite definitely means the Obama tax cuts when he says “the Obama tax cuts.”

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