DATE: October 12, 2008
FROM: Stephen Levy
SUBJECT: The Current
Two major economic events are happening
at the same time---1) the beginning of a recession (a downturn in spending
and jobs) and 2) a loss of wealth that is occurring because our major
assets (homes and stock portfolios) are being reevaluated downward--sometimes
These two events are related but it is also helpful to think of them separately in terms of solutions.
There is ample time to assess blame and
responsibility and address how to prevent the housing bubble from recurring
but now is the time for action. The federal government can and should
approve a large economic stimulus package to minimize and end the coming
recession. And our policies should push borrowers and lenders to voluntarily
renegotiate as many home loans as within reach of saving by prudent
Even with these policies we will experience a loss of wealth from inflated values for homes and stocks that will only slowly recover and then only if we invest for a prosperous 21st century American economy.
The Housing Bubble and the "Prices can only go up" Fantasy
Everyone is now familiar with the housing
bubble that took place in many parts of the country and throughout most
of California. For reasons ranging from a blind faith that home prices
could only go up to a series of lending (and borrowing) practices that
were based on the "only go up" fantasy and then compounded by a
lack of oversight, housing prices got way out of line with incomes
and are now coming back to more reasonable levels.
The first round effect of this bursting
of the housing price bubble was a drop in new home construction, housing
prices and lending activity. The second round effect was the loss of
capital by institutions that made the loans or bought the loans as part
of mortgage backed securities that held the promise (turned false) of
better income yields with low risk. Thus the housing bubble became a
financial bubble with as yet undetermined losses in wealth for banks,
investors and homeowners.
We are seeing the impact of the financial
sector losses and freezing up of lending in the bank failures, bailouts,
stock market declines and general loss of confidence and resulting paralysis.
We are entering a third round of effects
where the initial drop in spending and employment from the housing decline
is spreading to a drop in consumer spending as substantial wealth losses
and modest job losses are restraining consumer spending. The result
will be a recession of as yet undetermined depth and length.
The wealth losses may persist for
some number of years as housing related assets were overpriced, but
the recession will be bounded because the federal government has the
tools and bipartisan intention to use these tools to support spending
and eventually end the recession.
The federal government and governments
around the world also have the tools to release the paralysis in world
So over the next days and weeks governments will use these tools and "throw money"--in this case a good and responsible policy--at both the real economy and credit markets.
The Real Economy--Jobs and Income
For the real economy, there will be a
second stimulus package and, if needed, a third stimulus package. It
will be a combination of direct spending on infrastructure, grants to
state and local governments to prevent cuts in critical services and
direct payments to families (a tax rebate and more unemployment insurance,
food stamps and the like).
We will see more job losses and rising
unemployment for a few more months as the restraint on consumer spending
will not be turned around quickly. But in the longer-term view it is
very unlikely that the California recession will be as deep or long
as the 1990-94 downturn or even as drastic as the dot.com bust.
There is an unusual consensus on the
need for action and we have the tools to dampen and end the recession
through direct federal anti-recession spending.
California legislators should come together immediately and, in combination with legislators in other states, urge an immediate and large federal anti-recession program to maintain state and local government services and infrastructure spending.
We have seen an enormous infusion of
money into credit markets and that will continue including steps toward
buying shares in banks and guaranteeing more and more banking arrangements
(deposits and loans) until people are comfortable to lend again.
There will be a public cost in terms of increased national debt and that will have implications for future federal spending and tax policy, but we have learned the lesson of the Great Depression and will not let the economy slide downward through inaction or belief that government has no proper role.
Housing Markets and the Financial Sector
Housing construction is down 60% in the
nation and throughout California. Yet our population continues to grow.
We are likely at the bottom in terms of new housing construction although
the turnaround will depend on how quickly housing markets can clear
an inventory overhang made large by foreclosures.
The good news is that we are seeing evidence
of underlying demand in markets in California like Sacramento where
prices have dropped nearly 50% from the peak. It is likely that prices
will drop a bit more in many markets before they get back into equilibrium
with incomes and prices may overshoot on the downside temporarily as
people are forced to sell into a market with few buyers.
But the price drop will soon end and
the slow recovery will begin.
I think the "obvious" solution to
part of the housing market is voluntary renegotiation (or voluntary
under threat of legal action) by lenders and borrowers. Last week in
California Bank of America announced a plan to renegotiate loans made
by Countrywide Financial, which is now owned by B of A.
The renegotiation path is a recognition
by both sides that the losses from renegotiation will usually be much
less than the losses from foreclosure, at least for owners who can make
payments on a renegotiated loan. There will be losses in the renegotiation
process and loans that are "beyond renegotiation" but eventually
the lack of new building and the removal of homes from the market by
renegotiation and some foreclosures will clear the market.
I think one of the barriers to renegotiation
and one of the great questions surrounding the "bailout/rescue"
package is a game of chicken between lenders and the government in an
attempt to bluff the government into overpaying for the bad loans. If
the government holds firm or chooses another path to put money into
the banking system, more of these loans will be voluntarily renegotiated.
I am not saying any of this is simple but it is really important for
a number of reasons for the government not to overpay for toxic loans.
There will be a loss of wealth that families
and the nation must deal with. I don't know how long or deep this
loss will be. We were living "beyond our means" as families and
a nation in terms of spending more than we earned (although not by that
much) and in doing so pushed home and stock values to a very high level.