The End of the Federal Housing Credit

On April 30 the eight thousand dollar federal home buyer credit will expire. This has prompted a brief spike in home sales as people lower the prices of their homes in order to try and sell before the credit expires. Despite a recent increase in the number of pending sales and contracts the housing market has continuously underperformed during the current recessionary period. After the housing market collapsed in 2008 home prices have refused to rebound in any significant way. Housing prices hit all time lows even after the introduction of state and federal subsidies for new homebuyers which were enacted to stimulate demand. Speculators worry that repealing the federal home buyer credit will result in a further decrease of the value of homes since any demand created by the credit will be removed. Some lawmakers advocate extending the credit although there are no figures on whether the plan had any significant effect on demand for new homes. Even if the credit is not extended there are plenty of states that also offer home buyer credits. Despite an impending debt crisis California voted to extend a 10,000 dollar home buyer credit last week, New Jersey and South Carolina have similar plans.

What the government can’t seem to understand is that artificially creating demand will do very little to stimulate the economy in the long run. And unless you keep the programs in place forever, which they very well might try and do, the demand will evaporate as soon as the artificial stimulation is repealed. Housing prices need to be allowed to fall to their real market value, the whole reason we got in this mess in the first place is because prices have been artificially inflated creating rampant consumer spending not backed by any real production. Price deflation in the housing market is a result of market forces at work trying to bring housing prices back to reality so that more people will be able to afford homes and capital can be allocated in a more efficient manner. The recent spike in housing sales highlights this, more homes are being bought and sold because sellers have lowered prices in anticipation of the end of the credit, if the credit stays in place there will be no incentive to lower prices instead the opposite will happen as artificial demand will produce artificially high prices. Sure this will benefit the few sellers who are able to close on their homes but it will also allow people to take out loans based on artificially high prices and spend and speculate their way into the next recession while also denying people access to affordable housing.

Japan

After the financial crisis in 2008 many countries throughout the world have engaged in stimulus spending in order to prop up sagging demand and reinvigorate many of the world’s largest economies including, of course, the United States. Therefore I think it will be prudent to examine other countries that have utilized stimulus spending in the past and see how the measures have affected their economy and whether they were an appropriate tool in bringing an economy back to vitality. Japan in the 1990’s is an interesting case because it provides us with a financial situation not very different from what many countries face today. Japan can also give us keen insight on the effects government stimulus, regulation, and access to easy money have on an economy and whether these are effective measures to combat a recession.

After World War 2 ended Japan was brought back onto the world stage with the help of the United States. With special trade privileges and access to American technology and consumer markets Japan was able to claw its way towards being the world’s second largest economy. Japans economy was controlled by the central government, large parts of the banking and corporate sectors were controlled by relatively few powerful families or organizations called keiretsu. The Ministry of Finance used tax revenues and access to the large savings of many Japanese as a direct outlet to fund industrialization and infrastructure projects. Also the closely intertwined banking and corporate sectors enabled access to virtually unlimited sources of credit. The economy was assumed to continue growing as housing and stock prices skyrocketed, this had the effect of fueling the economic fire as a viscous cycle of investment and inflating asset prices continued. What is interesting is that this economic collapse occurred under a very centrally controlled system, even with the power to lend and spend consolidated in the hands of a few, low interest rates and access to easy sources of credit led to a collapse in the Japanese economy. Japan’s problem was not a lack of regulation or oversight, as the government was intricately connected with industry, access to easy credit and the proliferation of rampant speculation fed the economic bubble in Japan much as it did in the United States during the 2000’s. We see the use of these same methods throughout the world today as countries attempt to solve a problem by continuing with the very policies that caused the problem in the first place.

After the bubble popped in 1990 real estate and stock prices began to collapse. Deflation began to take hold as credit dried up and the Japanese began to spend less. This deflation is seemed by many to be a horrible economic phenomenon that occurs when an economy enters a recession and resources are not being utilized to their fullest. To many economists deflation is to be avoided at all costs. What many, including the Japanese, do not understand is that deflation is a necessary part of the economic cycle that occurs after an economy that has been spending and speculating too much and must come to terms with its loose monetary policy and large number of malinvestments. In effect the economy is trying to right itself; consumers are saving more so that eventually their savings can be loaned out again into projects that are hopefully more efficient and useful. This period is necessary and is a result of market forces trying to balance out the distortions caused by loose money. The Japanese and apparently the United States did not and do not understand this concept as both economies sought to re-inflate their economies by keeping access to credit artificially easy. This of course causes bad and inefficient investments to be made all over again as consumer savings now and in the future are squandered on centrally directed projects. For Japan this has meant over a decade of stagnation as the economy keeps on falling back into recession after repeated attempts at stimulation, for the United States whose debt dwarfs that of Japan the consequences could be dire.

Fannie and Freddie

Fannie and Freddie:

According to the New York Times, on Friday March 5, 2010 Rep. Barney Frank of Massachusetts noted in a speech to the press that debt issued by Fannie Mae and Freddie Mac is different from bonds issued by the Treasury Department. This worried investors who believe debt issued by Fannie and Freddie is backed by the United States government since the government has taken over the two companies. Since the statement has been made the U.S. treasury department has been forced to reiterate its support in Fannie and Freddie. Fannie Mae and Freddie Mac are two mortgage finance companies that together own or guarantee around half of the mortgages in the United States.

Since September 2008 the two mortgage finance companies were taken over by the U.S. government. The two mortgage giants control a considerable portion of the U.S. mortgage market, mortgages and the homes that they are backed by are considered the principal sources of wealth for many Americans. Since the takeover of Fannie and Freddie investors have been able to purchase these mortgages assuming that if the homeowners default they will be compensated by the federal government. This raises the value of these mortgages and lowers the risk associated with them. When a representative from the government states that these loans are not the same as treasuries investors become less willing to take on the risk of the mortgages and therefore ask for a higher return on their investments. This could cause mortgage interest rates to rise and ultimately depress the housing market.

Through this reaction we can trace how the United States government is in effect propping up housing prices. The government has taken over Fannie and Freddie and has guaranteed the mortgages owned by the two companies. Since half of the market is controlled by Fannie and Freddie half of the mortgages in the U.S. are very safe investments and have low interest rates. This drives up the demand and thus the price of homes. The federal government has sunk 127$ billion into the two companies and has acknowledged its backing of the 6-7$ Trillion of assets and debt held by Fannie and Freddie.

China

There is currently a debate raging inside the China National People’s Conference about the future direction of the enormous Chinese economy. The recent economic crisis has highlighted a weakness of the Chinese economy, its reliance on exports. With decreasing demand in most parts of the western world Chinese exports took a significant hit, this forced Beijing to enact a massive investment and loan program. This position is unsustainable for the Chinese because it encourages risky lending and inflation due to access to easy money. Chinese president Hu Jintao is currently pushing for a fundamental shift in the structure of the Chinese economy to secure it against future downturns in the global economy, and to prevent massive inflation and un-productive allocation of capital. The president plans to reign in the growth in most coastal areas by increasing wages and making these areas less competitive. This, combined with other initiatives, will increase the competitiveness of the manufacturing industry inland and will focus the economy more towards selling goods domestically. This can be achieved because of heightening levels of Asian consumption; by 2006 Asian consumer spending had surpassed that of the United States for the first time. In China car sales have jumped 59% since 2009 and imports have increased by a staggering 56%. Some claim that this growth in consumption can be attributed to the massive stimulus plan in China and the housing bubble that it has been believed to have created. However, unlike the United States most homebuyers in China actually own most of the value of their homes. One quarter of Chinese homebuyers pay upfront and the average mortgage only covers 50% of the property’s value. Also, unlike other Asian countries like Japan, which essentially built roads to nowhere in order to keep the population working, China is in need of infrastructure development. Hu is currently being challenged by an opposition which wishes to keep the Chinese economy focused on exports. This side of the argument is supported by powerful interests in the exporting sector, who do not want to see their profits go inland. However, if Hu is able to push his new economic policy through there could many implications for the United States and the rest of the world.

During the economic crisis the Chinese have kept the value of their currency pegged to the dollar so that Chinese industry would be given a favorable position when exporting to the United States. If China decides to focus more on domestic consumption there will be less incentive for the Chinese to keep their currency pegged to the dollar thus leading to the appreciation of the RNP against the dollar. This will have two effects, firstly it will make U.S. firms more competitive in the Chinese and domestic market as Chinese goods will become more expensive. But because of this Americans will experience an increase in the cost of many goods, think anything you purchase at Wal Mart. Perhaps because of the possibility of decoupling China has been slowly taking steps towards establishing the RNP as an international reserve currency. In September 2009 the Chinese government issued 6 billion Yuan of bonds in Hong Kong. This is an important move because it is the first time China is selling bonds in the international market place. This is seen more as a move towards establishing the Yuan as an international currency than to raise funds because the Chinese are not in need of any additional funding. RNP denominated bonds would encourage corporations to issue debt in the Chinese currency and encourage new markets for financial products based on the RNP.

Another important implication of this potential decoupling is the effect on the amount of treasuries and dollars the Chinese will buy. Currently China owns about 1 Trillion dollars of United States debt which amounts to nearly half the stock of treasuries thought to be in the hands of foreign official owners. China holds so much U.S. debt in order to keep its currency pegged to the U.S. dollar, if this is no longer necessary China may curb its purchasing of U.S. debt. Additionally this will further hedge the Chinese against potential fluctuations in the U.S. market. The potential effects of this can already be seen; in 2008 China purchased bonds equal to about half the size of our budget deficit while in 2009 China only purchased bonds worth 2% of the deficit. This is very significant for the United States. Reduced demand for U.S. treasuries could drive up interest rates, push down home prices, and possibly start a run on the dollar as investors lose confidence in the currency. The U.S. economy is currently dependent on artificially high housing prices and other government stimulus efforts. These efforts were highlighted last week in my examination of Fannie and Freddie. The stimulus is dependent on debt issued to foreign economies, mainly China. If foreign nations do not purchase our debt and we are forced to sell it to the Federal Reserve massive inflation could follow. If there is a decreased for demand for U.S. debt we will see interest rates rise and investors will become less willing to take on this debt. If the U.S. is not able to finance its spending it will quickly be left with a huge deficit that it will be unable to repay which would have many disastrous effects not only for the United States but most of the world.

Update March/17/2010: China has concluded its National People’s Congress and has announced its plan for the direction of the Chinese Economy. China will continue its government stimulus efforts to encourage economic growth. Interestingly this money will be spent on reducing citizen’s biggest expenses, mainly by encouraging the construction of affordable housing and reducing the costs of healthcare and education. These changes confirm that China is moving towards a self sustaining economy by increasing the purchasing power of the Chinese consumer.