Notes on the Economy – 12/29/08

1. A decade ago in these commentaries I predicted the demise of General Motors and the big three.  In the tradition of good forecasting, I did not provide a date.  But it has come to pass.  GM has been liquidating itself for years now.  It sold 51 percent of its best assets, General Motors Acceptance Corp and gave the proceeds to its unions, failing to use the funds to improve its car designs or its factories.  Ford and Chrysler have done much the same.

On the ropes in the weak economy, the former big three are following on the heels of Fannie and Freddie, looking for taxpayers to bail them out.  While we were distracted with housing, Congress passed a $25 billion loan package for companies with plants more than 20 years old.  Gee, what a surprise that this leaves out the companies that are doing the best job producing cars, Toyota, Nissan and Hyundai.

This is throwing good money after bad, supporting inefficiently operated firms and delaying the inevitable failure of these companies in some form or another.  But it’s an election year, so of course Congress will seriously consider undertaking such folly.  Why not, they can use your money and the problems won’t materialize for years.  Maybe they can be re-elected one more time before disaster strikes as it has in our congressionally run mortgage industry.

2.  September housing starts fell to about 700,000 at an annual rate.  Two years ago, that number was 2 million and it was that unrealistic level of activity that left us with several million houses with no families to live in them.  We need about 1.3 million homes each year to meet the demands of new household formation and to replace housing units removed due to obsolescence, natural disasters and economic conditions.  We built way more than we needed.

So, the 700,000 figure is bad news for today’s economy since it means fewer construction jobs and lower economic growth.  But it’s good news for the future since we are producing fewer houses than fundamental demand requires, so we can get rid of some of those excess house that are currently depressing home prices.  The faster we get rid of the over-supply, the sooner we can get back to building.

Houses and condos have become a real bargain, especially in states like Florida, California, Nevada and Arizona.  For the baby boomers, there will never be a better time to get that retirement home.

3.  A famous secretary of state once observed that the Soviet Union had attained their goal of equality, the citizens were all equally poor.  Indeed, until very recently, per capital GDP in Russia was lower than in Mexico.  This is no longer the case.  What happened?

The answer is an injection of capitalism.  Income inequality is on the rise in Russia, China, India, everywhere that there is solid economic growth.  The poor are not losing ground, they are gaining.  The U.N. reports dramatic reductions in poverty in countries applying a dose of capitalism to their ailing economies.  A middle class is appearing in these countries, they are eating much better, one of the causes of recent food price increases, and living better.  And many citizens in these countries are getting very rich.  New multi-millionaires are showing up in India, China, Russia, Mexico and elsewhere.

Economic growth is good for everyone, especially the poor.  But growth only occurs where economic freedom is growing as well.  We’ll watch with interest the economic fortunes in Russia and places like Zimbabwe where economic freedom has been severely impaired.

4.  At the core of the credit market problems is one simple fact:  we built a million more homes, condos and rental units than we have people to live in them.  Trying to get these sold to someone is depressing house prices.  This in turn undermines the value of the mortgages that were used to finance building all of these houses and destroys the value of all of the complex assets created on the back of these mortgages with huge leverage.  The government can buy these toxic assets from banks, but that will have no impact on the decline in house prices.  We just don’t have enough people to buy them.  And so defaults on existing mortgages for homes worth less than their mortgages will continue as well.

No less than the New York Times warned about the distortions in the mortgage market that Fannie and Freddie would create, and that was in 1999!  But Fannie and Freddie lavished hundreds of millions of dollars on selected members of Congress and headed off all attempts to regulate them.  They bought a trillion dollars of subprime mortgages in support of Congress’ affordable housing push.  Now they are bankrupt and you have to pay the cost.  That’s a bummer.

5.  On average, profits have declined about 15 percent in past recessions.  Today’s market has priced in a decline of twice that magnitude.  If you think we are going to experience an average recession, then stocks are clearly a great buy.  If you think a depression is coming, then stocks are still too high.  Clearly investors are very uncertain about the future, particularly because of the global interdependencies that now exist that were much less important in past recessions.

The dot com crash came because we all paid a lot for stocks that never had any earnings to begin with and didn’t deliver the earnings we had hoped for.  This time around, companies like Citicorp and GE which have historically delivered profits based on the operation of a real business, not a web site, are remarkably low in price.  Investing now of course takes some nerve, but more importantly a long view.  When markets swing a thousand points in a day, it can be disconcerting.  However, those with nerve and the long view are likely to be handsomely rewarded in the future.

6.  The latest data on the housing market was a good news bad news story.  The bad news of course was that construction on only 600,000 new homes were started.  Two years ago, that figure was 2 million.  The result of building so many homes was the construction of over a million homes and apartments that there was no one to live in.  The resulting fall in home prices is the result of that bubble.

The good news is that we need over a million new homes each year.  If we are only building 600,000, we will use up the excess stock of homes we have accumulated.  The fewer the starts today, the weaker the economy today, but the faster we get rid of the overbuilding problem and the sooner we can get back to building a million new homes each year and enjoying the jobs and GDP growth that will provide.

We enjoyed the housing boom and the run up in home values, but it wasn’t real and the sooner we clean up the mess, the sooner we can get back to business as usual.

7.  Nobody likes inflation.  It is a tax on your earning power, chipping away at the value of the dollars in our paychecks.  It is like a negative interest rate, reducing the real interest rate paid on our savings.  It deflates the purchasing power of the value of the stocks and bonds we own.  And we were recently reminded, it increases the burden of government programs on us taxpayers.

Social security, the largest government transfer payment program, was indexed to inflation decades ago after the benefits received by the elderly were ravaged by the inflation of the 1970s.  As is typical of government regulatory changes, payments were “over indexed” and it took years for Congress to fix that mistake.

So, payments to retirees are indexed every year to inflation as measured by the consumer price index.  Next year, payments will increase for 51 million social security recipients by 5.8 percent, adding $13 billion to government outlays in 2009 and an average of $23 billion to outlays every year after.  That will require an extra $150 in taxes each year for every worker to pay for the raise.  So, you and I will pay for today’s inflation for years to come.  That’s why the Fed has to fight inflation.  WSJ 10/20/08

8.  Unless you travel overseas fairly frequently you probably haven’t noticed the impact of the exchange value of the dollar.  But in 2001, a euro cost 80 cents.  Last year, it took $1,40 to get a euro.  As a simple example, a 100 euro hotel room cost you  $80 in 2001 and $140 last year, almost double.  Many attribute the rise in the price of oil in part to the fall of the dollar.  Makes sense.  Gas prices didn’t rise as much in Europe because the euro strengthened and oil is priced in dollars.

Here’s another interesting impact of the weaker dollar – outsourcing has become much more expensive.  As a result, jobs are coming back to the U.S.  IKEA has opened a plant in the U.S., for example, and Wall Mart is buying more U.S. made goods.

The rising cost of transportation is also favoring business development back in the U.S. It is all about economics.  Business is always trying to lower cost so goods can be sold at a lower competitive price.  Just as manufacturing moved from the north to the south to take advantage of lower costs, so too does business move around the world in order to keep costs low for consumers.

9.  Barney Frank, head of the House Financial Services Committee, has insisted for decades that there was no implicit guarantee behind the debt of Fannie Mae and Freddie Mac.  Of course he was wrong and now our publicly held federal debt has officially doubled from 5 to 10 trillion dollars, now 80 percent of our GDP (WSJ, 9/9/08).  The cat is out of the bag.

Fannie and Freddie have been protected from attempts to reform their operations, in exchange, of course, for hundreds of millions of dollars in lobbying money and campaign donations (aka bribes) that a quasi-government agency should never have been allowed to pay.  Congress diverted as much as a billion of Fannie profits to create a special “affordable housing” fund.  Congress has also tolerated a succession of crooks running these agencies, lining their pockets at the expense of shareholders, whose stock is now worth zero.

So now our mortgage markets are nationalized, taxpayers are on the hook for the losses, isn’t Congress doing great things for us?  Now the auto and airline industries can get in line.  Gee, why don’t we let Congress manage our health care too?