Sunday, March 19, 2006

Unemployment & Inflation figures, Housing Outlook and Deep Recession

During the last week or so I archived a few articles that I thought I should share with all of you. The 1st article discusses unemployment and Inflation, the 2nd and 3rd discuss the dismal outlook for housing and the last one, by a former Chief Economist of a US-China Commission, discusses the potential for a deep recession. Hope you enjoy...

1st article: Bill Fleckenstein’s The Numbers Behind the Lies

Economist John Williams says ‘real’ unemployment and inflation numbers -- figured the old-fashioned way -- may be two or three times what the government admits. Here’s why, and what it means for Social Security.

Corporate America likes to play that game, the better to boost stock prices. Folks might be surprised to learn that "Governmental" America also plays the game in its compilation of macroeconomic data. Beneath the surface are undesirable, sobering consequences for us all.

The always-terrific Kate Welling published an interview with an economist named John Williams. This article is the first one that I have seen in which all the flaws in the government data, pertaining to the Consumer Price Index, unemployment, Gross Domestic Product, etc., are disclosed in one piece by someone who's been following the data for a long time.

I have been aware of nearly all the statistical tricks used by the government since they were implemented. Nonetheless, seeing them collectively described in one article is incredibly sobering. Having said that, there is a bit more "black helicopter" insinuation and fewer data points than I would like to see in an article such as this. However, the main points are the math that most folks need to know, but likely do not.

Once you read it, think about it and understand it, you will see why so many thoughtful people -- like Jim Grant, Warren Buffett, Marc Faber, Bill Gross, Fred Hickey and Paul Volcker -- have grave concerns about the future of the dollar (due to the macro imbalances that exist today).

In fact, reading this article, you will conclude that there's no way out, short of running the printing presses. The problem with that end game: At some point, foreigners will revolt. One can only hope that, somehow, there will be a way out. But without an understanding of the issues, folks will have no way to react as events unfold, and adjust their assets as we get more clues as to how all this will play out.

Thus, I would encourage everyone to print out the article and read it as many times as necessary, in order to gain a full understanding of the issues. Since we don't know at what rate some of these problems will start to impact the markets, all we can do is be prepared -- by having our insurance policies (in the form of the metals and foreign currencies), and then being alert to signs that the beginning of a chain reaction may be under way.

Meanwhile, to pique folks' interest in the article, I'm going to take the time to provide some "Cliffs Notes" here.

Jobs data don't count the down-and-out.
Williams starts by discussing the headline economic data: "Real unemployment right now -- figured the way that the average person thinks of unemployment, meaning figured the way it was estimated back during the Great Depression -- is running about 12%. Real CPI right now is running at about 8%. And the real GDP probably is in contraction." (By "real," he means calculating the data the way they used to be calculated, not as inflation-adjusted.)

He then explains how the employment data are compiled, noting that 5 million chronically unemployed people are not included in the statistics. In fact, there are seven or eight different employment statistics. One called U-3 is the official one. The broadest one, U-6, currently shows unemployment as running around 8.4%. As he explains, the one that's the most historically consistent is running around 12%.

On the Potomac: Reverence for reverse-engineering
Williams differentiates between two data-manipulation practices. One is "systemic manipulations, where methodologies are changed." That's done in order to align the government's view of the world with the world, i.e., make things look better than they are. The second practice is out-and-out fudging of the data to produce whatever result is desired. Williams describes instances where various administrations have literally reverse-engineered the data to achieve that result (though politics is not the main purpose of the article).

For those not familiar with "substitution," he explains the practice's evolution in the CPI calculations. The concept of substitution was a concoction of Alan Greenspan and Michael Boskin, who basically argued that if one item were too expensive, consumers would substitute that with a cheaper one. Williams' response: "The problem is that if you allow substitutions, you aren't measuring a constant standard of living. You're measuring the cost of survival. You can keep substituting down and have people buy dog food instead of hamburger. It happens. But that's not the original concept behind the CPI."

That ticking sound? Social Security
Williams says that the government's motive in all of this, if there is a motive (of the government collectively; don't picture a group of men cooking up something in a back room), is its desire to put a favorable spin on all the data.

Another motive? Transfer payments like Social Security are indexed to the CPI, and they would be far higher if the CPI were accurate. In fact, says Williams, if the "same CPI were used today as was used when Jimmy Carter was president, Social Security checks would be 70% higher." That's seven-zero.

Though Williams doesn't get much into hedonics, he does talk about the inflation-understating impact of geometric weighting versus arithmetic weighting in the CPI statistics: "Geometric weighting ... has the 'benefit' that if something goes up in price, it automatically gets a lower weight, and if it goes down in price, it automatically gets a higher weight."

Then for the ticking time bomb: Social Security. The proceeds from withholding do not go into a lockbox or trust fund. They are spent, thereby reducing the size of the stated deficit. More importantly, he notes that the government's accounting for the deficit doesn't include any accruals for Social Security or Medicare liability.

In fact, if that were done and the government used GAAP accounting, the deficits for 2003, 2004, and 2005 would each have been around $3.5 trillion. That's a trillion, not billion. In 2004 alone, the deficit on an accrual basis would have been $11.1 trillion, due to a huge one-time spike for setting up the Medicare drug benefits. In essence, as he points out, we're piling up additional liabilities in an amount roughly equivalent to our total GDP every three years.

Lots of these imbalances have existed for some time, and they haven't mattered. Such macro problems only matter when they matter. Once that point in time is reached, events have a way of swiftly getting completely out of control -- which is why one has to understand the nuances and be alert for potential signs of chain reaction, as I mentioned earlier.

Charge that Maybach to my imputed income
Returning to the subject of GDP, Williams illuminates a wrinkle that I had not known about, called "imputations": They are "an outgrowth of the theoretical structure of the national income accounts. Any benefit a person receives has an imputed income component. If you're a homeowner, the government assumes that you pay yourself rent on your house, so that's rental income. ... Imputed interest income, for instance, accounted for 21% of all personal interest income in 2002, and was growing at an annual rate of over 8%. Meanwhile, fully 62% of total rental income that year was the imputed variety."

He goes on to point out that folks really aren't doing that well, which is why their incomes aren't growing, which is why they've borrowed money. And that's why understanding the housing ATM is so important -- because as that sputters to a halt, folks will be stuck in the same place they were before (which precipitated the borrowing, i.e., not enough income growth). Only now, they're going to be stuck with incremental debt of their own creation.

What festers underneath the data
Next, he strings together the stock-market and housing bubble, for a summation of where we are: "When that (stock) bubble burst (in 2000), without a foundation of strong income growth, or a financially sound consumer, it triggered a recession that was a lot longer and deeper than the government would have you believe.

"In fact, I contend that what we are in now is a protracted structural change that goes back to the beginning of that 2000 recession, which eventually may be recognized as a double-dip downturn. We did have some recovery in 2003, but in 2005, you started to see signs of a downturn in a variety of leading indicators that I use."

That's not so far off from what I believe. In other words, if you really looked at the data and understood them, you'd see that what appears in the headline numbers is nowhere near what the real supporting data show. Our financial condition is a ticking time bomb. What none of us knows is when it implodes.

2nd Article: John Talbott, a former Goldman Sachs investment banker and visiting scholar at UCLA's Anderson School has much to say about Housing

When John R. Talbott gazes into his crystal ball to discern the future of America's housing market, it isn't a pretty picture he sees.

"I don't want to be a Chicken Little," he says, "but it's gonna be bad for housing. It's a real threat to everything."

The gory details of that threat can be found within the pages of Talbott's latest book, "Sell Now! The End of the Housing Bubble," published in January by St. Martin's Press.

A financial consultant and former visiting scholar at UCLA's prestigious Anderson School, Talbott views the housing market as a house of cards on the verge of collapse. He predicts rising interest rates and plummeting property values, followed by widespread foreclosures that will not only affect the real estate industry, but almost every aspect of the economy.

"It's already started," says Talbott. "We've had 20 years of up, up, up with real estate. This spring will be brutal."

Talbott regards the latest data on the Bay Area housing market as mounting evidence for his prediction: rising interest rates, decreasing appreciation, 10 straight months of declining sales and, in January, the lowest number of sales in five years.

The problem, he says, is that home prices are way overvalued -- just as Internet stocks were during the 1990s before that sky collapsed. As evidence, he points to the growing discrepancy between Bay Area home prices and rents, an indicator commonly used by economists to determine a property's true value.

Novato's RealFacts puts the average Bay Area apartment rent in the fourth quarter at $1,324; DataQuick calculates that the typical homebuyer in December committed to a $2,867 mortgage payment.

"It paints a very scary picture," Talbott says. "Something has economic value because it has cash flow. If you discount for general inflation and go back 120 years in history, you'll discover that, in real terms, housing prices were relatively flat until 1997 -- then (they) shot up about 70 percent."

To buy these overvalued homes, he says, many consumers overextend themselves financially by borrowing more from banks. They end up paying an inordinately high percentage of their monthly income on mortgages. In Los Angeles, he points out, the average new homeowners, usually a young couple, are spending 55 percent of their monthly income on a mortgage payment.

"They have to make decisions about whether they're going to pay the mortgage or go to the movies," Talbott says.

Banks are lending more, he says, because they are sticking to their old qualifying formula of computing the ratio of the loan applicant's salary to the mortgage payment. They're doing this, he said, without adjusting for inflation.

"So the banks are using the same stupid formula. They convince these young couples to borrow a million-dollar note that they're never gonna get out from under."

To make matters worse, Talbott says, an increasing number of borrowers are taking out variable-rate and interest-only loans. According to San Francisco's, half of all Bay Area homebuyers used interest-only loans to make their purchases last year. With so much of their income already relegated to their mortgage payment, says Talbott, even a small rise in interest rates will push many to -- and beyond -- their limit. For others, a divorce or job loss will spell financial ruin.

Because of the above factors, Talbott predicts a wave of loan defaults and foreclosures. Bank presidents will be fired for making so many risky loans. The new presidents, wanting to clean up the mess, will unload the properties at a loss, perhaps for 40 to 60 cents on the dollar. This will flood the market and deflate home prices further.

And then, according to Talbott's prediction, the financial impact will, like an especially vicious virus, spread. First, the real estate industry will falter. Then, industries tied to real estate -- including banking, construction, home supply stores -- will be hurt.

"And then you've got a real recession," he says, "that will wash across the middle of the country."

People should protect themselves, Talbott says, by divesting themselves of any investments in real estate, including stock. They should sell their vacation homes. They should get out of any variable-rate or interest-only loans. They might even consider selling their primary residence, investing that money in something other than real estate, and renting for a while.
"And after this mess," he says, "cash will be king."

3rd Article: Executive Intelligence Review author Richard Freeman’s View on Housing:

In response to a U.S. housing bubble report in The Nation, Lyndon LaRouche stated today, "This indicates that the Senate and House have no time to waste on adopting the measures I've proposed. There are those who propose that we wait until after the election to deal with these problems. That is irresponsible."

In an article in the March 12 issue of The Nation, entitled, "Leaking Bubble," Doug Henwood writes: "The past several years have seen the most extraordinary boom in the U.S. housing market in history, rivaling the dot-com stock market madness of the late 1990s. In the third quarter of 2005, the average new house sold in the United States cost 4.9 times the average household's yearly income, up from 3.9 times in the late 1990s.... Turnover of new and existing houses in the third quarter of last year was more than 16% of GDP, way above its long-term average of 9 to 10%, and easily beating the levels reached in the housing frenzies of the 1970s and '80s."

Families are buying homes on outrageously risky terms: In 2005, 43% of first-time home buyers "made no down payment at all." The housing bubble has metastasized into the entire U.S. economy, especially as homeowners borrow against the bubble-ized increase in the value of their homes. Henwood writes, "Americans have been using their houses as MasterCards, turning about $726 billion of their home equity into (borrowed) cash between 2001 and 2005. That's a big number, even by the standards of the U.S. economy; it's equal to almost 40% of the growth in personal spending." Moreover, he declared, "Wall Street economists estimate that 40 to 50% of the growth in GDP and employment over the last several years has been driven by the housing boom" (emphasis added).

In 2000, when the financial system was threatened with the bursting of the stock market boom, Alan Greenspan intentionally fed the housing bubble, by lowering U.S. interest rates to 1%, Henwood said. However, mortgage rates are rising; home sales are sagging: "So many households have taken on so much mortgage debt that if prices merely stop rising, they're going to find themselves under water.... The broad economy has become so dependent on home-equity credit that its withdrawal could come as a terrible shock."

Last Article: Thomas Palley, formerly Chief Economist of the U.S.–China Economic and Security Review Commission says we’re headed for a Deep Recession:

To quote Yogi Berra, “It’s tough to make predictions, especially about the future.” Many (including myself) expected that the bursting of the stock market and Internet bubbles in 2001 would cause a deep recession owing to large excesses of borrowing and spending by both the household and corporate sectors. Now we know that the recession of 2001 was fairly mild and of short duration, though the economic recovery has also been the weakest since World War II.

After having been wrong once, it’s either brave or foolish to make a second prediction that the next recession will be deep and difficult to escape. But the facts point to it being just that—despite the optimism of the Federal Reserve. This is because the economic factors that helped escape the last recession have been largely exhausted, and will not be available to fight the next recession.

The main reasons why the last recession was so relatively mild are the federal budget and interest rates. In fiscal year 2000 the federal government ran a budget surplus of $236 billion dollars, but within three years this had reversed to a deficit of $378 billion. The overall budgetary U-turn was therefore $614 billion dollars, equal to about six percent of economic output (gross domestic product). This turn provided an enormous injection of spending that helped prevent a deeper recession and jump start recovery.

The role of government spending in damping the recession and driving the recovery is evident in the employment statistics. From March 2001 (the beginning of the recession) to January 2006 government employment rose by 4.5 percent (one million jobs) to 21.9 million jobs. Over the same period, private-sector employment rose by just one percent. Government, which accounts for just 16 percent of total employment, created half of all new jobs in the four years after the recession ended. The private sector, which accounts for 84 percent of total employment, created the other half. Moreover, part of the increase in private-sector jobs involves government contract and defense-related work, so that the government’s overall job contribution was even larger. In effect, increased government employment has masked persistent private-sector weakness.

This fiscal stimulus was accompanied by an extraordinary extended period of monetary ease that kept interest rates at historical lows. In 2000, the year before the recession, the Federal Reserve’s target interest rate (the Federal funds rate) averaged 6.24 percent. When the recession began, the Fed cut this interest rate aggressively, lowering it to 1.67 percent in 2002 and 1.13 percent in 2003. Moreover, the Fed then held interest rates at historical lows three years after economic recovery had officially begun, so that the Federal funds rate was only 1.35 percent in 2004. Only since late 2004 has the Fed reversed itself and started systematically raising short-term interest rates.

There are three significant features about this monetary easing. First, it contributed importantly to warding off the recession and generating recovery. Second, the weakness of the private-sector recovery, despite the extraordinary scale of the fiscal and monetary stimulus, points to the underlying fragility of the private-sector economy. Third, the monetary easing has promoted massive consumer indebtedness and a housing price bubble, a combination that poses grave future threats.

The Fed’s lowering of interest rates to forty-year record lows served to spur the recovery. It inspired a mortgage re-financing boom, providing immediate relief to households who were able to spend their mortgage interest savings. Lower interest rates also made houses more affordable, triggering a house price bubble that contributed significantly to escaping the recession. Higher house prices increased homeowner equity, and many owners used this increased equity as collateral to borrow against.

Their borrowing then financed consumption, which significantly explains the consumer-spending boom. Higher house prices have also allowed some existing homeowners to cash out, and some have spent part of their windfall. Meanwhile, homebuyers have financed house purchases with loans, which has increased the money supply. Lastly, rising house home prices have also created enormous profit margins for builders, providing an incentive to build new homes and spurring a construction industry boom.

The problem now is that these special conditions are largely spent. The projected federal budget deficit for fiscal year 2006 is $423 billion, approximately 3.3 percent of national output. With the budget already in deficit, this leaves less room for the type of U-turn that occurred in the last recession.

With regard to interest rates, the federal funds rate now stands at 4.5 percent—so there is room to lower it. However, lowering it is likely to have far smaller effects than last time. Why?

Homeowners have already significantly refinanced so that the stock of high interest rate mortgages available for refinancing has been depleted. Consumers are borrowed to the hilt, leaving less access for further borrowing. House prices are already at all-time highs by every measure—so lower interest rates are unlikely to spur another price boom, with all its expansionary effects. Instead, house prices could actually start falling as new supply continues to come on to the market, and this effect could be amplified by recession-induced job losses that trigger mortgage defaults by workers losing their jobs. Taken together, these factors point to future interest rate reductions likely being akin to pushing on a string.

Adverse domestic economic conditions will also be echoed globally. The 2001 recession was business investment-led, with little consequence for China and East Asia. This is because those economies export consumer goods and the American consumer kept spending. However, a consumption spending-led recession will quickly spill over into East Asia, triggering job losses and a decline in investment spending in those economies. Consequently, a U.S. recession will quickly ricochet around the globe.

This is not about predicting when the next recession will happen, but rather about its character. The when game is impossible. As Nobel Prize-winning economist Paul Samuelson once quipped, “Economists have correctly predicted nine of the last five recessions.” However, it is possible to anticipate future difficulties and proscribe possible remedies.

First, the Federal Reserve should be very careful about over-shooting with its rate hikes, and at this time it should take an inflation chill pill. Second, the current recovery has been extraordinarily weak, which should finally discredit the notion that tax cuts for the rich drive growth and job creation. Third, the speculative financial market paradigm—which has ruled the policy roost for twenty-five years—is out of gas. It is time for a new paradigm that links growth to rising wages rather than to asset price boom-bust cycles


I Believe said...

When is the Rapture?

Anonymous said...

As somebody who did very well under the "save and buy as you go" economy, I have been praying for an end to this stupid, unproductive and damaging cycle of the past few decades.

If rising interest rates are the cure for this then send 'em through the roof! I'll be SO happy and relieved when saving your money in a CD account is the way to riches again and home "equity" is seen as the imaginary fraud it truly is.

Anonymous said...

Great articles,

Some of this stuff can be hard for most to follow so it’s often overlooked or just ignored and nobody like bad news. One day we will be dealing with this mess and only then will we wise up, painfully adjust, just to forget and do it all over again.

Out at the peak said...

My company recently bought another company based in the Mid-East (US). One employee was visiting and I met his wife. Somehow we quickly got on the subject of real estate since it sounded like they were thinking of relocating out here (California Coast).

My manager and I told her how we both sold our homes and are saving by renting. She was very confused because we would no longer have equity. Instead of debating, I just declared myself as a [downward] speculator.