## The Economic Outlook as of May 2011: Yes, This Is Called the Dismal Science. Why Do You Ask?

Urban Land Institute Spring 2011 Conference, Phoenix, AZ:

When I was a child my grandmother lived here in Phoenix: we would always visit in July or August. We children would think that everybody living in Phoenix was completely insane. Now that I am an adult I visit in November, January, March, and May--and the place makes so much more sense.

Thus I was very happy for the invitation to come and speak. I was very happy to come because it is still May, and so the Arizona desert is still beautiful rather than Gehennaish. I am, however, less happy at having to speak. This is a bad time to be an economist. If you were fresh from the womb and had no past opinions to defend, if you had never said anything notable before, it might be a fine time to be an economist. If you are one of those soap-opera characters who has complete amnesia and no memory of anything that they ever said or did or any intellectual position they took before January 1, 2010, it might be a fine time to be an economist. But for the rest of us--we who are now looking back at our opinions and analytic judgments and statements and pronouncements of the past 15 years and thinking: "how could I ever have been so stupid; how could I have missed so much?"--it is a bad time to be economist?

Four years ago we economists were writing learned papers about the "Great Moderation": about how it looked as though the governing institutions of the world economy had finally learned how to control and moderate if not completely eliminate the business cycle--the epileptic seizures of the economy that leave us with pointlessly high unemployment, pointlessly idle capacity, and pointlessly rusting away machines in spite of there being no fundamental cause for machines to be idle, factories closed, and workers unemployed. In such an epileptic seizure of the economy, workers are unemployed and machines are idle because there isn’t the demand to employ them, and there isn’t the demand to employ because the workers are unemployed and have no incomes.

We have been seeing these epileptic seizures called business cycles fairly regularly since at least 1825.

And we have been claiming that we have it licked fairly regularly since 1825 as well.

British Prime Minister Robert Peel thought we had it licked with his Bank of England reforms in the 1840s.

Yale professor Irving Fisher thought we had it licked in the 1920s--that the founding of the Federal Reserve and the successful winning of the war of drugs in America with the passage of Prohibition had raised living standards, eliminated the business cycle, and carried stock prices to a permanently high plateau.

In the 1960s the Commerce Department's Bureau of Economic Analysis was so convinced that the business cycle was licked they changed the title of their trademark publication from Business Cycle Digest to Business Conditions Digest. That way they could keep the BCD acronym--but they would no longer be tied to this outmoded idea that there was an inevitable business cycle.

They were all wrong.

But did we learn? No. We did it again.

In the 2000s, given the remarkable stability of the US and the world economy since the end of the Volcier Deflation in 1983, we were happy to take credit for superior macroeconomic management that had caused the "Great Moderation" and finally tamed the business cycle And we were once again wrong.

And now we are sitting here in the middle of the greatest macroeconomic catastrophe since the Great Depression itself, and we economists are all scratching our heads and saying: "what happened?"

The outline of the story is familiar. We had a global savings glut. We had the rich of the emerging global periphery looking for insurance--in the form of places to park their money where, if something went badly wrong at home, and they had to flee in the Lear Jet or the rubber boat, they could find a bolthole. So they were anxious to park their money in the United States. To an even greater degree, the governments of the periphery were anxious to keep the values of their currencies low so they could keep their exports high to provide employment for the masses moving to Shanghai. They bought up dollar-denominated assets at a furious pace, and then they had to park those dollars somewhere.

The result was a large increase in the demand for safe dollar-denominated assets.

Investment bankers saw this. Investment bankers calculated that if they could produce safe dollar-denominated assets--or even dollar-denominated assets that they could claim were safe without the rating agencies blowing them up--they could make fortunes. And so they turned their financial alchemists at work on the problem of turning risky-mortgage lead into derivative gold. And the financial alchemists took a look at the problem and got out the can of gold spray paint and let loose.

Then the salesmen got to work, saying that this time it was different--that this time the risk was really contained and diversified, and never mind the riskiness of the underlyings, the securities that we are selling you are as good as U.S. Treasury bonds.

And then came the collapse of lending standards. For, after all, if the riskiness of the derivative is not dependent on the riskiness of the underlying because of the financial alchemy, who cares about the riskiness of the underlying? The key is to make the loans and then to spray paint the lead bars with gold--not to make only those loans that pass some quality test.

We economists watched this process. And we economists had worries about Wall Street. But our worries were not about systemic risk arising from subprime.

Some of our worries were about Glass-Steagall repeal. Others were about Fannie Mae. The old Glass-Steagall Act of the Great Depression built this wall between commercial and investments banks. The government was going to guarantee commercial bank deposits and did not want investment bankers then using those deposits toplay the investment banking game of heads we win and tails the government pays. We feared that. But that wasn't the disaster that hit us. It simply was not the case in the 2000s that those post-Glass-Steagall investment banks with large commercial banking deposits were in any sense engaged in riskier behavior than those that had only hot money liabilities. The JP Morgan Chases which had large inertial commercial bank deposits came through in much stronger shape precisely because their funding sources were government guaranteed and so were not hot. The connections of commercial and investment banking were, this time--and I want to stress the "this time" because the theoretical basis for our worries is strong--not the problem.

And Fannie Mae was not the big problem. The worry was that Fannie May would be trading on its implicit government guarantee. It would take on lots and lots of risk because it could do so and yet still attract funds because it had a government guarantee, and then something would go wrong. If we had actually had a Fannie Mae-centered crisis we would be a lot happier right now. It would have worked out like the savings and loan crisis of the 1980s: costly, embarrassing, painful, lots of bills to be paid by taxpayers, but not a macroeconomic disaster because the failure of Fannie Mae would not have induced any other bank failures or any general panicked flight to safety. The unemployment rate in the U.S. rose by only 1.5% as a result of the S&L crisis--not by the more than three times as much it has risen this time.

As the foundations of this crisis were laid, there were always arguments against massive regulatory intervention to deal with it. Those arguments always sounded convincing. The stayed convincing even as the situation transformed itself from a justified boom in long duration assets driven by advances in diversification and by capital inflows pushing down interest rates, to froth, to irrational exuberance, to a full-fledged bubble.

The first argument was: "well it is their money." Countrywide probably knows what it is doing. There are major benefits from diversification and better access to credit. Even if it does not know what it is doing, it isn't the government's job to rescue the investors in Countrywide from the fact their risk controls are not what they ought to be.

Second, Alan Greenspan really is a Randite, really is a follower of Ayn Rand. He really does believe that it is a bad thing to infringe your freedom and protect you from yourself. He really is the kind of person who thinks that it is bad for you if the government keeps you from making stupid investments that cost you all your money. You can ask him--"do you think there should guardrails on the ledge of the Grand Canyon?"--and he might well say no--that there should be warnings, but if grown-ups wish to venture too close to the crumbling edge... they are grown ups, and should not be treated like children.

The third argument was: "who is going to get hurt?" Investors in Countrywide, but they are rich and risk-loving and if they want to build the rest of us houses we should probably say "thank you." And somebody buying a house east of Riverside California with a zero-down, a teaser rate, a pick-what-you-pay mortgage--what they are really doing from an asset-price perspective is renting a house at a below-market rent for three years and being given a free call option on the house. They will be sad if the house price doesn't go up and the call option is not worth exercising. But that is regret. That is not harm: they did still get to live in the house at a low rent for three years. So why should the government step in and keep people from getting these deals if Countrywide wants to provide them?

Fourth, and most important, it is a big political looser for regulators to go before Congress. The Democratic members would whack them: why aren’t you letting my constituents buy the houses they want to buy? The Republican members would whack them: why aren’t you letting my contributors make the loans they want to make?" That’s a very unpleasant position for a regulator to be in--when both Republicans and Democrats agree that you are an ass.

Fifth, there was the fact that the old framework for lending locked lots of people out of the real estate asset class, and a belief that we should be experimenting with new ways to get money to people who want it to make investments--that we should be trying to broaden the access of the poorer half of Americans to high-return investment vehicles.

Most important, however, was the overall belief on the part of the regulators that they could handle it. Subprime was a small asset class in the global economy. The Federal Reserve was powerful. Whatever stupid things financial markets did, the Federal Reserve could clean up the mess afterwards and build firewalls between finance and the real economy so that we would not suffer from high unemployment and a deep recession. The Federal Reserve had handled it in 1987 with the stock market's Black Monday, had handled it in 1991 with the Savings and Loan crisis, had handled it 1995 with the Mexican crisis, in 1997 with Malaysian crisis, in 1998 with the triple crisis--the Korean crisis, the state bankruptcy of Russia as it became clear that just because you were a nuclear armed ex superpower that did not mean the IMF thought you were too big to fail. the bankruptcy of the largest hedge fund in the world, LTCM. We had the 2001 collapse of the dot-com bubble. And in every single case we managed to handle it: contain systemic risk, stabilize the financial system, and avoid a deep recession.

We did worry back in the mid-2000s. But what we worried about was the dollar crisis. What happens when the Chinese government suddenly decides it wants to sell some of its dollar-denominated asset holdings and the dollar falls by 40% in a month--or when European investors decide that the Chinese government is about to sell some of its dollar-denominated asset holdings and the dollar falls by 40% in a month? I remember back in 2005 a bunch of us quizzing then-New York Fed President Tim Geithner in the wilds of Grand Teton National Park about how he was guarding against the next financial crisis. We asked a lot of questions about the dollar and global imbalances. We asked no questions about subprime--it was, we thought, too small to pose any systemic risk.

Even in the spring of 2008, when I was a worrywort, the general line was that all the losses in subprime mortgages had a maximum value of $500 billion in a global economy with an$80 trillion asset base. A loss of $500 billion out of a total of$80 trillion is not, should not be the kind of thing that could set the whole financial system on fire. It is one eighth the size of the dot-com crash. It is one fifth of the size of Black Monday in 1987 on the stock market. And there were all these fancy derivative securities associated with subprime mortgages to spread the risks associated with holding them all over the world and to keep them from being concentrated in the large and highly leveraged money center banks.

But they were concentrated: the derivative securities didn’t spread risk, they concentrated it.

There was regulatory arbitrage: banks decided that now that we’ve gotten Moody’s to rate this security as AAA we might as well hold them as if they were AAA. And it turned out that the banks themselves did not have any idea what their risks were. CEOs would ask if they were hedged against subprime right. Subordinates would say: "Right, chief, we are." And the subordinates would lie.

So we had the crisis, and the collapse. We had the subprime losses. We had the general panic as everybody feared that the large highly-leveraged money-center banks' debt was no good because they held a lot of subprime and their subprime losses had eaten through their capital. And we had a bigger panic as people feared other things that might go wrong--the same financial establishment that had no clue what risks they were running in subprime probably had other points of vulnerability as well. All confidence that the highly-trained and highly-compensated risk management professionals on Wall Street knew what they were doing evaporated.

It was the standard story.

It was the story that we have seen over and over again since 1825.

As my old teacher Charlie Kindleberger liked to describe it: panic, revulsion, and discredit. Nobody trusts anybody else’s paper. Everybody stops spending on currently-produced goods and services to build up their holdings of safe assets. But because one person's spending is another person's income, stopping spending stops income too--so there is no buildup of safe assets but rather a fall in demand, production, employment, and incomes that further increases risk and further increases people's desire to cut back on spending in order to build up their safe asset stocks. The result is the deepest downturn in the post World War II era, and a painfully slow recovery since.

Now, this downturn is not nearly as bad as it could have been. Kevin O'Rourke and Barry Eichengreen point out that the 2008 shock to the world economy was bigger than the 1929 shock. In 1933 our unemployment rate kissed 23%, and our nonfarm unemployment rate kissed 28%. This time the unemployment rate only kissed 10%. The nonfarm unemployment rate didn’t get anywhere near the 28% of the great depression, it didn’t get anywhere near the 16 or 17% that Allan Blinder and Mark Zandi calculate would have been the peak unemployment rate had the government followed ineffective and counterproductive Herbert Hoover policies.

I think that if you could go to Tim Geithner get him to tell you what he thinks, he would say that a 10% unemployment peak is not a good thing but it is not 17%, and it is definitely not 28%. He would say that he and his peers have done a lot better job at handling this than their predecessors 80 years ago did handling their problem.

And he would be right.

But now we have a stubbornly persistent slump in the economy. Now we have economic growth at about our normal long-run pace, with very little signs of closing the gap between the productive capacity of the American economy and its current level of production. We have a Washington DC that is dysfunctional--out of ammunition to take any effective additional steps to boost the economy. There is now substantial fear of inflation--even though there are no signs of inflation gathering anywhere rather than energy and food prices, and we understand that those reflect China’s growing demand and not any domestic price spiral. There is now substantial fear of crowding out--that boosting US government spending or cutting taxes to get more money into the hands of the consumers would discourage private investment even though there are no signs of crowding out even at our rapidly-growing level of the national debt. It is a fact that a bunch of us--including me--think that there really should be signs of crowding out right now--that financial markets should be scared of the fiscal future of America--but they are not. And there is the problem that Washington DC has degenerated into pure Dingbat Kabuki theater on lots of levels.

It is a fact that if congress simply goes home--doesn’t do anything for the next 10 years except keep the federal government on autopilot, or if it does do things if it pays for whatever increases in spending it enacts by raising taxes and pays for whatever tax cuts it enacts by cutting spending--that we do not have a long run deficit problem. If congress goes home for ten years our program spending is matched to our tax revenues, which means a declining debt burden because the growth rate of the economy is larger than the interest rate on our debt.

Our belief that we have a long-run deficit problem is based upon the belief that congress will pass laws that increase spending and that cut taxes--that it will repeal the Independent Payment Authorization Board's authority to try to make Medicare more efficient, that it will repeal the Affordable Care Act's tax on high-cost health plans. Given that the fear is based on a belief that some future congress will bust the budget, it is hard to see how we can address this fear through any possible piece of legislation today--for no congress can bind its successors.

This is a problem.

But the biggest problem generated by this right now is that Washington DC's focus on the Dingbat Kabuki theater of the long-run fiscal stability of America is keeping it from taking any effective steps to use government to boost employment and output now. And things aren't helped by the fact that the way the rescue of the banking system was carried out convinced a lot of people that stimulus policies exist to enrich the top 1% of Americans at the expense of everybody else.

This means that our hopes for economic recovery right now rest not on any government boost to aggregate demand--whether through fiscal, monetary, or banking policy--but rather on the natural equilibrium-restoring full-employment achieving market forces of the economy, especially in the labor market.

And so we are in trouble: right now there are no signs that the economy is crawling up back to anything like full employment on its own.

Back when I started in this business, back in the Spring of 1980, I had as teachers two of the smartest men I have ever known: Marty Feldstein and Olivier Blanchard. They taught that John Maynard Keynes had feared that if the economy got itself wedged into a situation of high unemployment that it would never recover by itself--that it would settle into an "underemployment equilibrium." It would need some large positive shock--either a wave of business exuberance, either rational or irrational, or activist stimulative monetary, banking, and/or fiscal policy on the part of government in order to knock unemployment down and employment back up to where it ought to be. Back in 1980 they said that we economists had learned that the market system worked better than that, and that there were substantial equilibrium-restoring forces in the world economy.

But look at the U.S. labor market over the past two years. Those forces are not there. There are no signs that the share of American adults with jobs has been growing, or is about to start growing. Ben Bernanke and Barack Obama both like to talk about how the unemployment rate is falling. But all of the decline in the unemployment rate has come from the fact that people have been dropping out of the labor force. None of it has come from any increase in the share of the adult population with jobs.

That suggests, to me, that we fact a very long slog. The economy will grow, but we won’t close the gap between actual and potential output. We will not for a long time to come get back to the 62 to 64% of the adult population having jobs that we thought was normal back in the decades of the 2000.

And that is the depressing overall macroeconomic picture.

I wish I could paint a better one.

But what is, is.

Now let me briefly turn to construction. We expected a construction slump after the mid-2000s boom. Take construction spending in the United States as it stood back in 2001--when nobody thought we were overbuilding or overbuilt--and project it forward at the 3% growth rate of the American economy. We should probably project the construction trend at a slightly higher rate than that, because as people grow richer they do want to spend a greater share of their larger incomes on housing in a way that they don't for, say, food.

We did have a large four year housing boom. We all thought when that boom came to an end the country would be somewhat overbuilt. We did expect a post-boom construction slump.

But we didn’t expect this construction slump.

We didn’t expect construction to go back below trend and then stay below trend not for the amount of time and the depth that it had been above trend before, but for a slump relative to trend that now is, cumulatively, four times as large as the boom was. And a slump relative to trend that shows no sign of ending.

It is certainly true that a bunch of our boom houses were in the wrong place. We built a lot of single family houses in the swamp of Florida and in the deserts between Los Angeles and Albuquerque when we probably would rather have had more multifamily units in--say--close in Atlanta or in Venice Beach, California where people could actually commute to jobs. We would rather not have so many houses in Las Vegas, where the major industries are entertainment, are distribution for Los Angeles, and are building more houses in Las Vegas.

But the fact that we build some of our boom houses in the wrong place should strengthen rather than weaken post-crash demand for housing.

The fact that we find it hard to envision a future in which gasoline prices go and stay as low as they had been from 1986 to 2005 also mens that a bunch of our houses are in the wrong place, that we rather have more infill and more ramping-of density, and that too should strengthen rather than weaken post-crash demand for housing.

And we also have the wild part of global warming. Over the next generation, we could have zero degrees of warming and we could have a two degree Fahrenheit warming. Bet on one degree Fahrenheit, but that bet has enormous variance--and every place in the world will be different as some places will get hotter, some will get colder, some will get rainier, some will get dryer, some will get floodier, some will get droughtier. I have no idea whether in 30 years the flow of water down the Colorado River will be greater and support more people in Phoenix than it supports now or less and support fewer instead. Maybe the winter storms that now feed the Colorado will drop their moisture on the Snake and the Columbia instead.

We just don’t know.

But things are going to change. Our current location distribution will turn out to be non-optimal. That too should boost demand for construction.

All these factors really should be pulling housing construction out of its depression right now. And I think they will pull us into a housing boom. But they will do so only when the employment-population ratio recovers, and only when people become confident that if they lose their jobs that they will be able to find a new one, and only when people get so profoundly sick of doubling up and living with their in-laws that they are willing to pay any price and take on any mortgage burden in order to escape.

I keep thinking that we are now so underbuilt relative to trend that the next housing boom should be coming any day now. But I thought that back in May of 2009. And I have thought that "any day now" every month since.

I wish I could say that we will have a rapid recovery to a normal employment-population ratio, and that there will be enormous pent-up demand for housing that will fuel a construction boom when that normal employment-population ratio is reattained. I can say that we built an extra $150 billion x four years times--because it is a triangle--1/2 =$300 billion extra of construction spending over 2003 to 2006 that left us overbuilt relative to trend. And I could say that there is now 1.2 trillion of construction spending below trend during the bust--of underbuilding--that’s going to be a $2 trillion gap of underbuilding before we get back to normal. When incomes and employment patterns return to normal and people get sick of living with their in-laws (and their in-laws get sick of living with them), Americans are going to want to buy those extra$2 trillion worth of houses.

Americans will want to buy them. Americans are an optimistic bunch. There will be this $2 trillion of pent-up demand. There will be population growth. There will be the effects of globalization. A word about this last: I can’t look forward and see any future in which immigration falls. Move any Indian engineer with an M.S. degree from Bangalore to the San Francisco Bay and you double their productivity. Move anybody gutsy enough to crawl through a storm sewer into San Diego from Chiapas to the United States and you quadruple their productivity. With such enormous economic incentives to move here, people will find a way. Globalization means more people will see how big the rewards to getting to America are. And when they get here and attain an American standard of living they will want to buy houses. That means that the long term picture for urban land prices and construction has to be bright. And I haven't even mentioned that China and India’s demand for energy is rising so fast that I am fearing any week now that my next Prius fillup will cost$60, and \$60 Prius fillups have powerful implications for boosting construction spending.

But that will not come until we get full recovery. And each month that passes with no further upward movement in the employment-population ratio makes me extend by two months, my forecast of when that full recovery will come.

And let me stop there. Questions?

4663 words: May 18, 2011