Lessons from Leamer: Part 2

Continuing from previous post.

1. Housing shows up in the GDP accounting via employment generation. Price appreciation of houses is not part of GDP; and more importantly, increased land prices today if booked as an asset, a liability has to be entered. Where? Liabilities for future buyers. This is transfer of wealth from future generations to present generations!
2. The stickiness of housing prices downwards means, most importantly, price cycles follow sales volume cycle. Also, the volatility of the housing volumes is much higher than the price.
3. Sellers develop their expectations of prices from a backward perspective (“what did I pay for it compared to the offer price?”). Buyers have forward looking price expectations (“what will I get for the house 5 years from now”). So, sales only happen when there is a high bid price by sellers.
4. In a housing boom, the fastest appreciation happens for small houses with low-income zip codes (and smaller square footage = condos and small homes). Predictably, during a bust – they get hit the most.
5. To avoid business cycle fluctuations – one must avoid housing cycle fluctuations and job-losses in consumer durables.
6. Monetary policy that acknowledges the two factors – must face up to the fact that if real interest rates fall temporarily, then for equilibrium level of housing stock will return to “normal”, only if production and sales fall and allow a return to the mean. In contrast, if real interest rates fall permanently, then equilibrium levels of housing stock will rise.
7. Monetary policy that accounts for housing investment is a difficult inter-temporal resource allocation issue.
8. Today, one observes the presence of weak housing starts (new houses being built) and increased inflation – resulting in a conflict for what the “right” policy prescription ought to be.
9. In case of policy choices to be made between housing starts and inflation – there is no real conflict.
10. The best predictor for Fed Funds rate is the 10-year Treasury bond yields.
11. Its the Housing Cycle!
    

Lessons from Leamer (Part 1)

Professor Edward Leamer has written a very interesting paper; and was presented at the Jackson Hole conference. I have been going through it in detail -- and I must admit it is a remarkable piece of analytical detective work. Following two posts are dedicated to his work. Although the original is nearly 70+ pages -- it is written in a very reader friendly style. So, worth the effort. For the rest, here is a quick summary. Caveat Lector!

1. Conclusions can be drawn of effects of policy X, if there are control and treatment groups. In macroeconomics, we only have non-experimental data. So, we rely on “story-telling”.
2. Monetary policy affects economy via housing-related decisions. Tempering business cycles means figuring out how housing-related choices are affected.
3. Inflation is a “daily” phenomenon, while housing is reinforced by a “wave”.
4. Monetary policy at different stages of the housing cycle – can exacerbate or diminish the extent of hurt that happens when a boom declines.
5. Housing booms are very susceptible to interest rate changes at the end of the boom, rather than in the early and middle stages.
6. Historically, the US economy has been growing at 3% over the past 30 years – despite all kinds of real, monetary and technological shocks. Monetary and fiscal policy must restrict itself to smoothening out the cycles (the amplitude and the frequency).
7. Contributions to long run growth are led by, in order of importance from a 2005 perspective, Consumer services, Non Durable Consumer Spending, Durable Consumer Spending, Equipment, State and Local Expenditure, Defense expenditure, Residences etc., i.e., Residences do not contribute substantively in long term growth.
8. For business-cycle fluctuations, Residences are very important. Typically, Residences contribute to the weakness in GDP growth before the “recession” starts and contribute above normal before the “recession” ends. This is in contrast to equipment and software sales. i.e., Residential spending is a pro-cyclical predictor of GDP growth. Equipment sales just mirrors GDP growth rate.
9. To address decline in GDP growth, one must address the “consumer” side of the equation and not the business side. So, Monetary policy must explicitly take into account Residential and Durables levels and volatilities.
10. There have been 10 U.S. recessions. Only two were driven by “production” side (i.e., by lack of demand on the business side) – post-Korean war and 2000/01 internet bubble collapse. Rest of the recessions have been caused by lack of consumer demand.
11. Housing prices are sticky downwards – i.e., prices don’t fall all that much. So, the natural way the market clears is by massive reduction in demand. This reduction is demand affects GDP/employment.