Housing Values

Data this week confirm the fact that a long awaited, inevitable and totally healthy event is taking place. Housing prices are stabilizing. On Wednesday we saw sales of Existing Homes fall 4.1%. AP described this as a "plunge." Without getting into semantic quibbling that strikes me as a drop but not a plunge. I like the NYT description better "Sales of existing homes fell in July to an unexpectedly low rate." That is good because it is accurate. A smaller drop in sales was expected.

What we are seeing is the effect of long-term serious inflation in values. Many people are going to put their homes on the market hoping to get top dollar but many of those homes will not sell. While this creates the appearance of a market headed lower it is simply not the case with housing. Folks are not distressed to sell their homes they are simply willing to cash out if the price is right. The vast majority of those who cash out will be buying another house with the proceeds.

As we have been cautioning for a year the risks are in those places where there has been speculative buying of non-owner occupied homes. Those will be hard hit. Especially hard hit will be condo projects with speculative buying. As always, values will be impacted in those areas where one industry dominates and that industry is having cutbacks. The savaging of values in certain cities in the Midwest will continue. If there are no jobs for would- be buyers values have to fall enough to make homes attractive to someone. The Midwest also suffers from not being a retirement destination.

Builders are going to slow down in the construction of new homes and that will most certainly affect GDP and certain industries and businesses: building materials, Home Depot etc. With rates having gone up on mortgages and purchases slowing our humble mortgage industry will have one of its secular shake outs - fewer loan agents and processors.

With values having gone up so far so fast it is probably inevitable that values will actually fall in some places but I have long held the belief that a prolonged period (say, 5 years) of flat housing values would be a healthy thing. The simple fact is that the cost of owning a home has gotten to darn high. This 1) makes them unaffordable for some and 2) means that folks have less to spend on other things. So my point is this: do not complain about flat housing prices for the next 5 years. This is overall beneficial to the economy and to people's lives in general.

Values are not going to collapse for a couple of reasons: 1) these is not technological change which is suddenly going to lower the construction cost of housing . That won't happen unto we have nanobot carpenters and plumbers and 2) folks are not going to dump their houses and start living in tents, motor homes or cardboard boxes. House are not like Internet stocks - people actually need them and they have tremendous utility value. It would take a major shift in the relative cost of renting vs. buying to cause many folks to give up being owners for an economic advantage of renting.

Chicago Fed President Moscow said "We currently are seeing a good deal of softening in housing markets, and home prices are increasing at a slower rate. Even if prices did decline nationally, history suggests that the impact on consumer spending would be modest and gradual."

Taking another point of view the chief economist at Merrill Lynch said that the slump in housing has raised the chances the economy will fall into recession next year to at least 40 percent. Of course if Merrill Lynch says so then one can count on the opposite being true.

Speaking of misinformation I have been troubled by a radio commercial I have been hearing in San Francisco for the past several weeks. It (I think) is a pitch for a seminar based on the idea that one can make money in the coming "real estate shakeout." If you attend you will be informed by (and I swear I am not making this up) George Foreman, Mark Burnett (the "Survivor" dude) and Bill Walsh. Now I will admit that all three of these gentlemen probably own a bigger house than I do but I don't think that they are really wells of information as to what is happening in the real estate market.

The humor aside higher home values have spurred economic growth by creating activity in the home building and related sectors and the higher values have afforded folks the ability to borrow more and spend more. That party is ending and it remains to see what the aftereffects are.

 

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Dick Lepre

Is Inflation Contained?

We can talk about what the Fed is doing and what yields are doing or going to do but when all the shouting is done it is all about inflation. The underlying reason is quite simple. The folks who buy fixed income securities: Treasury debt, corporate bonds and mortgage backed securities (or parts thereof) are people who already have a lot of money. If you are wealthy you are really not concerned about acquiring more money than you will ever be able to do anything with you are concerned about preserving the purchasing power of your present wealth.

For such a fortunate person the investment of choice is some sort of bond and the sole enemy is inflation. Thus, yield on bonds move with inflation or, more correctly, the perception of inflation.

The Measures of Inflation

Inflation is well-contained. By "inflation" we are almost always talking about CPI. But, there are other measures of inflation. Some of these are more forward looking than the backward looking, "this is what happened last month" nature of CPI.

Consumer Price Index (CPI)

CPI is a measure of the average level of  prices of a fixed "market basket" of goods and services purchased by consumers (food, clothing, utilities etc.). CPI is an indicator of inflation on the retail level.

This is calculated every month by the Bureau of Labor Statistics and available online at http://www.bls.gov/cpi/

The are 2 major CPI's:
CPI-U (U is for Urban) which represents about 80 percent of the total U.S. population. It is based on the expenditures reported by almost all urban residents, including professional employees, the self-employed, the poor, the unemployed, and retired persons as well as urban wage earners and clerical workers.

CPI-W is based on the expenditures of urban households that meet additional requirements:
More than one-half of the household's income must come from clerical or wage occupations and at least one of the household's earners must have been employed for at least 37 weeks during the previous 12 months. CPI-W represents about 37% of the population.

It is the CPI-U which everyone (including me) calls "CPI".

CPI includes:

Food and beverages (cookies, cereals, cheese, coffee, chicken, beer and ale, restaurant meals)

Housing (residential rent, homeowners' costs, fuel oil, soaps and detergents)

Apparel and its upkeep (men's shirts, women's dresses, jewelry)

Transportation (airline fares, new and used cars, gasoline, car insurance)

Medical care (prescription drugs, eye care, physicians' services, hospital rooms)

Recreation (newspapers, toys, musical instruments, admissions);

Education and communication (tuition, postage, telephone services, computers);and

Other goods and services (haircuts, cosmetics, bank fees)

CPI is seasonally adjusted to cull apart the changes that are seasonal from the underlying economic changes. Seasonal changes are fluctuations in prices that occur at the same time very year. They might be due to: automobile model changeovers, weather and holidays. For example, gasoline costs more in the summer, tomatoes cost more in the winter. An interesting issue at present -when inflation is tame - is that the question may well be: are we actually measuring inflation or are we measuring the accuracy of this months seasonal adjustments?

The unadjusted data is what people actually pay. The adjusted data is what is reported in the media. CPI is a number that reflects prices with 1982-1984 averages as 100.0. The percentage changes announced month-to-month are adjusted so as to be a percent of the value of the last month's index.

CPI is based on a very large sample of goods in a very large sample of places. The one criticism that can be made is that it takes no account for what people actually buy. If, because of El Nino, tomatoes which cost $1.39 a pound in March now cost $4.59 a pound, people will diminish their purchases. Because of this, CPI is, in terms of what people actually buy, slightly overstated.

PPI

PPI is the Producer Price Index - this measures the average change over time in the selling prices received by domestic producers of goods and services. PPI's measure price change from the perspective of the seller. This varies from CPI this is a measure of price change from the buyer’s perspective. Sellers' and buyers' prices may differ due to subsidies, taxes, and the dynamics
of distribution costs. They also are affected by the "depth" of competition of the marketplace.

Implicit Price Deflator

While CPI might be the "Dow" of Inflation it is, in essence, a measure of the price that people pay for things and services. The economy, however consists of a bit more than individuals.

A broad measure of economic activity is GDP (Gross Domestic Product). The GDP Implicit Price Deflator or IPD is based on the Gross Domestic Product and therefore reflects price changes in all goods and services transactions in the United States, including the consumer, producer, investment, government and international sectors. The IPD for GDP takes into account
the price changes of the goods and services that actually happened. The IPD for the GDP is, thus, a more meaningful measure of inflation than either CPI or PPI.

IPD might, for example, be used to adjust the cost of a long term projects such as Civil Engineering projects. The EPA, for example, writes it into the bids for toxic cleanup projects. If one wanted to compare the economic impact of natural disasters from different periods, it would be appropriate to normalize the dollar losses at the time that the occurred using IPDs rather than CPIs.

ECI

ECI is the Employment Cost Index. When we were hearing about a tight labor market this might be where inflation would first show. ECI is the cost of labor on a fixed basket of occupations. This eliminates the effect of the influence of employment shifts among occupations. While the average hourly earnings data would be affected by a shift in the occupational composition of the workforce and would appear as a wage gains, ECI would not be affected. Wages & salaries account for about 72% of the ECI. The rest is benefit costs.

Data is available from BLS at:
http://stats.bls.gov/news.release/eci.t01.htm

FIG

FIG is a product of Economic Cycle Research Institute, Inc. This is a construct that is forward looking. It is a way to predict future inflation. The previously discussed indices take note of inflation that has already occurred. ECRI has a WWW site at http://www.businesscycle.com

This site is a, sort of, Bible on inflation. FIG is reputed to be able to predict inflation up to a year ahead.

 

 

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Dick Lepre

Politicians & the Economy - Some History

Over the years I have encouraged folks to understand and to think clearly about the economy. One important issue to me is separating the economy from politics - a truly difficult task.

Most voters seem to subscribe to the thesis that the president has a significant impact on the economy. To a large extent this belief has persisted for many years. I believe that it was heightened by the Clinton years in the White House. He made the economy the primary focus of his 1992 campaign and the economy did well during his two terms so it seems natural to believe that he had something significant to do with it. In my opinion, the last time that a President had a significant and long-lasting effect on the economy was when Carter nominated Volker to be Fed Chairman.

Let's try to go back over administrations of the 20th century to quantify what actually happened.

In 1913, during the Wilson administration, the Federal Reserve was created. Financial panic and depressions had been regular occurrences before this. Too much power was in the hands of a handful of powerful businessmen. Theodore Roosevelt understood that and "stood up" to powerful businessmen when their interest and the interest of the public were out of synch.

Unfortunately, during its first decades the Federal Reserve did not know what it was doing. In 1923 Coolidge became president and was dedicated to the concept of laissez-faire which is French for "butting out." In 1924 the stock market became popular and started a spectacular rise. It was like the dot-com thing but on a larger scale. People traded up equities with little basis but greed. From May 1928 to September 1929, the average prices of stocks rose 40 percent. This was despite the fact that many of what we would regard as economic indicators were flashing "red". Folks were making ill-informed investment decision or maybe they were merely being greedy. Greed plus bad information is not a formula for success. It is a great formula for disaster.

In August 1929 a recession began. For the next two months GDP fell at an annualized rate of 20% and personal income fell at an annualized rate of 5%.

The stock market crash started on October 24. The Fed lowered the Fed funds rate from 6% to 4% and added to the money supply during the first few months but then did nothing more until 1932. It essentially stood on the sidelines trusting that the markets were undergoing a normal correction process. The Fed failed to abate the Great Depression in its early stages by not increasing money supply and not drastically lowering interest rates. The Great Depression could have ended much sooner if the Fed understood then what it does now. The Great Depression got worse until 1933. GNP fell 31%, unemployment was almost 24%, equities lost 80% of their value, the money supply was reduced by 31%, there were over 10,000 bank failures.

FDR was elected in 1932. Roosevelt took some drastic actions: he declared a "banking holiday" to stop the run on banks, he increased taxes dramatically. Roosevelt understood that government spending would spur on the economy but refused the Keynesian notion that deficit spending was needed and another recession occurred in 1937-1938.

Starting in 1939 the U.S. economy boomed as the world went to war. The U.S. came out of World War II as the world's only intact economic superpower.

Interestingly, the next big event that stimulated the economy was the Vietnam War. But a Johnson tax cut coupled with war spending led to inflation . That was inherited by Nixon. The Ford and Carter years are regarded as an economic disaster area but the strange fact is that 10,000,000 new jobs came into being during Carter's term. The Ford and Carter administrations had very high inflation. One of the strongly contributory things was the Arab Oil Embargo of 1973.

(It has to be noted here that the Johnson tax cut and war spending are certainly similar to what is happening now. The question is this: is it the case that the Federal Reserve is more adept and can survive this potentially inflationary situation with monetary policy alone? We shall see.)

The tide may have shifted when Carter appointed Volker to be Fed Chairman but few realized it at the time. Reagan ran on a "misery index" platform and unseated Carter. It was not until Reagan's second term that economic recover, under Volker's leadership, started to have a dramatic effect.

In 1991 Bush I suffered a mild recession and got blamed for it. Clinton, reprising what worked for the Reagan campaign, expertly emphasized that the issue was the economy (It's the economy, stupid) and looked great. Like Reagan, Clinton certainly knew how to work the audience. The present Bush's inarticulate manner of speaking is comical as compared to Clinton's very articulate speaking ability or Reagan's down-home, actor inspired connect to the average guy manner.

During the Clinton administration GDP growth averaged 3.5% per year, inflation was tame and unemployment low. Equities had some nasty boom/bust cycles but that was about greed and stupidity on the part of casual players. The president was responsible for neither the booms nor the busts.

Bush II inherited lowering GDP growth and that coupled with the economic shock of 9/11 created a min-recession and impetus for the Bush tax cuts. While those tax cuts were expansionary and achieved strong GDP growth they certainly have increased the deficits and national debt. It is concern about this last issue that were the basis for my suggestions for a new fiscal authority.

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Dick Lepre

Global Warming

I wrote this last fall and really should improve it but I want to make the point that the question of global warming has advanced to the point where it is a political issue. This piece has one point: global warming is a scientific issue and it needs a considerably amount of science to construct a model to describe the interactions of the sun, land, oceans and human activity before we can figure out what to do. The science is complex.

This is a lengthy piece which requires some attention and time. Since many will get lost reading it I want to bring my conclusion to the fore.

My points are the following:
1) global warming is happening.
2) significant changes in the earth's average surface temperature have been occurring for several million years and were obviously unrelated to human activity. Ice ages and global warming are natural occurrences.
3) presently the polar ice caps on earth are melting but so is the southern polar ice cap on Mars.
4) little of the greenhouse gas including carbon dioxide (which gets a lot of attention as a cause of global warming) comes from human activity.

Is Global Warming Really Happening?

There is substantial melting of the polar ice caps so something is going on. The second question is: what causes global warming or, more accurately, what causes long-term (multi-decadenal) changes in temperature? The answer, unfortunately, is quite complex.

The Sun as the Source of Energy

To make things simple the sun shines down on the earth and the earth reflects back some of that energy and traps some of that energy. For the sake of simplicity the primary thing which determines how much of the sun's energy gets trapped in the atmosphere is what is called greenhouse gas. The expression "greenhouse gas" is a reference to the fact that a greenhouse is designed to trap part of the incident solar energy as a form of natural heating because plants like a certain amount of heat.

Greenhouse Gas

So what controls temperature on the earth and consequently global warming? The answer is - two things. The energy from the sun and the amount of greenhouse gas in the atmosphere. Unfortunately, discussion on this topic often equates greenhouse gas with CO2 apparently an attempt to convince folks that the problem is made made or at least "man controllable."

The largest percentage of the effect of greenhouse gas comes from water vapor which is naturally occurring. Less than 20% of the greenhouse effect comes from carbon dioxide.

There are only two things which can be responsible for global warming: the energy incident on the earth from the sun is increasing and/or the amount of greenhouse gases in the air is increasing.

Not Quite a Circle

First let's deal with the sun since that is apolitical. There are two things which could make the incident energy from the sun change with time: one is the sun outputting more or less energy and the other is a lot more subtle. Let's take the subtle part first. Everyone knows that it is hotter during the day that it is at night. The reason is obvious the earth rotates on its axis and the sun rises and sets. It is warm in the day because of solar energy. It is also warmer during the summer than during the winter. The reason is that the earth is tilted on its axis (the line from the north pole to the south pole) relative to its ecliptic (the orbital plane). You can observe this because the sun is more directly overhead in the summer than it is in the winter. There are two effects here: 1) the days are longer in the summer and 2) the sunlight has, on the average, to pass through less atmosphere (which attenuates the effect) in the summer.

That got a little windy but the point is that everyone knows that summer and winter happen even if they don't exactly understand why. Also, no one thinks that global warming is indicated by the fact that it is hotter in the summer and no one thinks that global warming is going away when fall is here and winter is approaching. The longer-term effects we call
global warming/ice ages may be, largely, more subtle versions of day/night and summer/winter.

Sunspots?

Apart from day/night and summer/winter variations there are two factors which affect the energy incident on the earth from the sun. The energy output of the sun is not constant. Spacecraft observations show the Sun's output varied by 0.1%
during the past 11-year solar activity cycle. While sunspots have an 11 year cycle the magnetic polarity of the sun inverts every cycle giving it a 22 year "grand cycle." Sunspot activity has been increasing since 1700. See:
http://earthobservatory.nasa.gov/Library/SORCE/sorce_03.html
Sunspots indicate greater total energy being output by the sun and, consequently, reaching earth.

A Guy with a Lot of Time on His Hands

So much for the obvious. There are three other factors which affect the energy of the sun incident on the earth and this is where we need to credit a Serbian mathematician named Milutin Milankovitch who in 1911 started working on a mathematical model to explain the fact that the earth has had ice ages and successive periods of global warming. He had 600,000 years of geological data to work with. What is amazing is that this guy worked for 30 years without the aid of computers and developed a near-complete model. His calculations were based on the fact that there are 3 cycles in the relationship between the sun and the earth:

1) the shape of the earth’s orbit around the sun changes with a periodicity of 96,000 years.

2) The earth is tilted on its axis (currently 23.5 degrees) but that changes from 21.5 to 24.5 degrees with a periodicity of 41,000 years and

3) the earth's axis of spin (the north pole is currently pointed at the north star) wobbles with a period of 23,000
years.

When he published his work in 1941 there was some excitement but that was a bad time for science because the world was preoccupied at the time. In the late 1960's geologists were able to study deep-sea sediment cores going back several million years and the results validated Milankovitch's work. In fact these are referred to as Milankovitch cycles. Milankovitch's theory while not perfect (there are cycles predicted but not observed) is the basis for long-term (tens of thousands of year) cycles of global warming and ice/ages.

Latest News from Mars

The thesis that the global warming may have more to do with the sun than the earth's atmosphere and human activity got a boost last year from the Mars Global Surveyor Project which stated, "for three Mars summers in a row, deposits of frozen carbon dioxide near Mars' south pole have shrunk from the previous year's size, suggesting a climate change in progress." The density of the Martian atmosphere is 1% that of the earth and is comprised mostly (95%) of CO2. I would offer the strong opinion that global warming on Mars is not caused by anything we are doing on earth. We may be piggy but are not that piggy.

Global Warming Becomes Political

Despite the fact that we know that there are long-term periods of Ice Age/global warming cycles we have at hand the sociopolitical interest in ecology and recognition that people have an effect on the health of the planet.

Anthropogenic CO2

Any contemporary discussion about global warming deals almost exclusively with anthropogenic (man made) CO2 and the thesis is that an abundance of anthropogenic CO2 is responsible from global warming.

A Concrete Problem

There are 155 billion tons of CO2 pushed into the atmosphere each year. How much of this is man-made? Answer: 4%. 90 billion tons comes from the oceans (a gigantic sink/source of CO2). 60 billion tons come from plants. Less than 6 billion tons come from human activity. There is one gigantic source of anthropogenic CO2 which is hardly ever discussed. That is the manufacturing of cement. Cement manufacturing is responsible for about 25% of all man-made CO2. In short, the percent of non-cement human generated CO2 is about 2.5% of the annual amount of CO2 pushed into the atmosphere.

In addition CO2 is not the only greenhouse gas. Water vapor is also responsible for heat trapping. Man-made CO2 is responsible for about 0.8% of the increase in greenhouse gas.

Deforestation

There is another side and that is sequestration of CO2 by trees and other plants. CO2 is reduced from the atmosphere by photosynthesis and it is also dissolved into the oceans. Here the issue is that deforestation reduces the amount of CO2 removed from the atmosphere by about 1%. Mankind thus affects the amount of CO2 by 5%. 1.5% from cement, 1% from deforestation and the other 2.5% from energy and transportation. Forest capture CO2 while they are growing but release it back into the atmosphere when the trees die.

The questions then are 1) is the 0.8% (20% of the 4%) that we contribute "the straw that broke the camel's back?" and 2) what can we do about it.

I believe that what has happened with global warming is an example of science by consensus. It is fashionable to advocate global warming with the implication that it is man-made and that we can make changes in our behavior which affect it. The problem is that this conclusion is drawn without taking into account the science involved.

Good Intentions Are not Good Science

This is a generation which looks at what is wrong with the planet and concludes that we have screwed things up and we want to do things to correct that. This is fine. It is an expression of good intentions. The air in L.A. is cleaner than it was in the '60's. Endangered species have protection. CFCs were recognized to lead to ozone depletion and the "Montreal Protocol on Substances that Deplete the Ozone Layer" was negotiated and signed by 24 countries in 1987. The ozone hole over Antarctica is now shrinking. There is a big difference here - CFC's were almost totally man-made. CO2 is 4% man made and is only 20% of greenhouse gas.

Conclusions

Global cooling and warming have been happening for few million years. The primary cause have likely been the variation in the energy output of the sun and the Milankovitch cycles. Absent a much better understanding of the interactions among the atmosphere, the oceans, the clouds, and plant and animal life we should recognize that our contribution to global warming is minimal. 96% of the CO2 pushed into the atmosphere comes from flora and the oceans. Has man's small increase unbalanced a natural process or is the increase in non-anthropogenic CO2 the result of higher temperatures generated by increased solar radiation associated with increasing sunspot activity? Maybe. This is not far-fetched but must be done correctly. It is necessary to understand the science in order to be able to correctly deploy solutions.

We should spend money on basic research with the purpose of better understanding the interactions between the oceans and the atmosphere, plants (and animals) and the atmosphere, cloud physics, and the effect of volcanoes before we spend any significant amount of money on the abatement of anthropogenic CO2. It may be that case that lessening the amount of man-made CO2 is not a sufficient solution.

Political correctness must take a back seat to science. Science needs to explain global warming and it needs to do so without predisposition as to the causes. Scientists need to proceed without predisposition to a "politically correct" answer. That is plain stupid.

There are practical issues here. One, for example, is coal gasification - making automobile fuel from coal. The problem is that this process, much like cement manufacturing, generates a lot of CO2. Plans for present coal gasification programs call for sequestration of the generated CO2. It would be really a fine thing if we could know if that is necessary.

 

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Dick Lepre