The Sluggish Recovery: Fiscal Drag Continues to Hold Back the Economy

Recessions - GDP Around Peak, 12Q before to 22Q after

I.  Introduction

The recovery from the 2008 economic collapse remains sluggish, with GDP growing in the first half of 2013 at an annualized rate of only 1.4% (according to recently released BEA estimates).  And based on fourth quarter to fourth quarter figures, GDP grew by only 2.0% in 2011 followed by just 2.0% again in 2012.  As a result, the unemployment rate has come down only slowly, from a peak of 10.0% in 2009 to a still high 7.4% as of July.

Conservatives have asserted that the recovery has been slow due to huge and unprecedented increases in government spending during Obama’s term, and that the answer should therefore be to cut that spending.  But as has been noted in earlier posts on this blog, direct government spending during Obama’s term has instead been falling.  This reduction in demand for what the economy can produce has slowed the recovery from what it would have been.

This blog will update numbers first presented in a March 2012 post on this blog, which compared the paths of GDP, government spending, and other items in the periods before and after the start of each of the recessions the US has faced since the 1970s.  That earlier blog post looked at the paths of GDP and the other items from 12 quarters before the business cycle peak (as dated by the NBER, the entity that organizes a panel of experts to date economic downturns) to 16 quarters after those peaks (when the downturns by definition begin).  The figures were rebased to equal 100.0 at the business cycle peaks.  We now have an additional year and a half of GDP account data, so it is now possible to extend the paths to 22 quarters from the start of the recent downturn in December 2007.  This has therefore been done for all.

The conclusions from the earlier post unfortunately remain, but are even more clear with the additional year and a half of observations.  GDP growth remains sluggish, government spending has fallen by even more, and residential investment remains depressed (although it has finally begun to recover).

II.  The Path of Real GDP

The graph at the top of this post shows the path followed by real GDP in the periods from 12 quarters before to 22 quarters after the onset dates of each of the recessions the US has faced since the 1970s.  The sluggish recovery from the current downturn is clear.

The economy fell sharply in the final year of the Bush administration, and then stabilized quickly after Obama took office.  GDP then began to grow from the third quarter of 2009 and has continued to grow since.  But the pace of recovery has been slow.  By 22 quarters from the previous business cycle peak, real GDP in the current downturn is only 4% above where it had been at that peak.  At the same point in the other downturns since the 1970s, real GDP was between 15% and 20% above where it had been at the previous peak.  This has been a terrible recovery.

 III.  The Path of Government Spending

How has this recovery differed from the others?  To start to understand this, look at the path government spending has taken:

Recessions - Govt Cons + Inv Expenditures Around Peak, 12Q before to 22Q after

Direct government spending has fallen in this recovery, in sharp contrast to the increases seen in the other recoveries.  Real government spending was 26% higher by 22 quarters after the onset of the July 1981 recession (the green line) during the Reagan presidency, and 13% higher at the same point in the recovery from the March 2001 recession (the plum colored line) during the Bush II presidency.  While both Reagan and Bush claimed to represent small government conservatism, government spending instead rose sharply during their terms.

In contrast, in the current downturn direct government spending is now 1.2% below what it had been at the start of the recession in December 2007.  Furthermore, it is worth noting that while it rose in the final year of the Bush presidency and then in the first half year after Obama took office (a major reason why the recovery then began), it has since fallen sharply.  Government spending is now almost 7% below where it had been in mid-2009, a half year after Obama took office.  Such a decline (indeed no decline) has ever happened before, going back at least four decades, as the economy has struggled to recover from a recession.  The closest was during the Clinton years, when government spending was essentially flat (a 1% increase at the same point in the recovery).

Note that the measure of government spending shown here is that for total government spending on consumption and investment (i.e. all government spending on goods and services).  This is the direct component of GDP.  Government spending can also be measured by including transfer payments to households (such as for Social Security or unemployment insurance), but as was noted in the earlier blog post from March 2012, the results are similar.  Note also that the government spending figures include spending at the state and local levels, in addition to federal spending.  While we speak of government spending as taking place during some presidential term in office, the decisions are made not simply by the president but also by many others (including state and local officials, and the Congress) in the US system.  But the president at the time is typically assigned the blame (or the credit) for the outcome.

IV.  The Path of Residential Investment

The current downturn and recovery also differs from the others by the scale of the housing collapse, and consequent fall in residential investment:

Recessions - Residential Investment Around Peaks, 12Q before to 22Q after

The build up of the housing bubble from 2002 to 2006 was unprecedented in the US, and the collapse then more severe.  As the graph above shows, there has been a start in the recovery of residential investment from the lows it had reached in 2009 / 2010, but it is still far below the levels seen in previous downturns.

Housing had been overbuilt during the bubble in the Bush years, leaving an oversupply of housing once the bubble burst.  And while supply was in excess, demand for housing was reduced due to the severe recession.  As was discussed in an earlier blog post on the housing crisis, the result was a doubling up of households as well as delays in household formation as young adults continued to live with their parents.  Residential investment therefore collapsed, and has recovered only very slowly.

V.  The Path of Household Debt

The housing bubble also led to over-indebtedness of households.  Nothing of this sort at all close to this scale had ever happened before in the US.  With the lack of regulation and oversight of the financial sector during the Bush administration, banks and other financial entities launched and aggressively marketed and sold financial instruments that led to a bidding up of home prices.  But these new financial instruments were only viable if housing prices continued to rise forever.  When the housing bubble burst, widespread defaults followed.  And those households who did not default struggled to pay down the debts they had taken on, for assets now worth less than the size of the debts tied to them.

The result was a sustained fall in household debt (three-quarters of which is mortgage debt) in the period of the downturn:

Recessions - HH Debt Around Peak, 12Q before to 22Q after

This pay-down of debt had never happened before, and is in stark contrast to the rise in household debt seen in all the other downturns of the last four decades.

VI.  The Path of Personal Consumption Expenditure

Households struggling to pay down their debt have to cut back on their consumption expenditures.  This brings us to the last element of the current recovery I would like to highlight:  the especially slow recovery in household consumption.  That path of consumption during the current downturn stands out again in contrast to the paths followed in the other downturns and recoveries of the last four decades in the US:

Recessions - Personal Consumption Around Peaks, 12Q before to 22Q after

The difference is stark.  Households could spend more in the prior recoveries in part because they could continue to borrow (see the graph on household debt above).  In this recovery, households have instead had to pay down the debts they had accumulated in the housing bubble years, and could increase their household consumption only modestly.

VII.  Conclusion

The recovery in the current downturn has been disappointing.  GDP has grown since soon after Obama took office, but has grown only slowly, and has been on a path well below that seen in other recoveries.

There are a number of reasons for this.  Household consumption has kept to a low path as households have struggled to repay the over-indebtedness they had accumulated during the housing bubble years.  Residential investment collapsed as well following the bubble, is only now starting to recover, and remains far below the levels seen at similar points in other recoveries.
And government spending has been allowed to fall during Obama’s term.  This had never happened before in the previous downturns.  Indeed, while real government spending rose by 26% at the same point in the economic recovery during the Reagan presidency, it has been reduced by over 1% in this recovery (and reduced by 7% from what it had been a half year after Obama took office).
The reduction in government spending reduced the demand for what the economy could have produced.  In this it was similar to the reduced demand resulting from lower residential investment or lower household consumption expenditure.  All these reductions in demand reduced GDP, reduced the demand for workers, and hence increased unemployment.  But while residential investment and household consumption can only be influenced indirectly and highly imperfectly by government policy, government has direct control over how much it spends.  That is, government can decide whether to build a road or a school building, and doing so will employ workers and will lead to an increase in GDP.  Hence government spending is a direct instrument that can be used to raise growth and employment, should the government so choose.
Sadly, and in stark contrast to the sharp increase in government spending during the Reagan period that spurred the recovery to the 1981 downturn, US politics during the Obama presidency have instead led to a cut-back in government spending, with a resulting drag on growth.  The disappointing consequences are clear.

New Housing Starts, While Better, Are Still Depressed

US housing starts, private single family homes, January 1980 to August 2012The US Census Bureau released this morning its regular monthly report on US housing starts.  News reports were positive, noting that housing starts are rising and are now well above where they were.  Starts on private single family homes in August grew by 27% over what they were a year ago to a pace of 535,000 (at a seasonally adjusted annual rate), while starts on all private housing units, including multi-family units such as apartments, grew by 29% over the year ago figure to a pace of 750,000.

Such growth rates are substantial.  But looking at the figures over a longer period than just a year shows that the increases, while welcome, are not as strong as they would appear.  The housing market remains depressed, with housing construction still far below what a more normal level might be, and even further below where it was during the 2002 to 2006 housing bubble.  The graph above puts the recent figures in the longer term context.

The graph shows how new private housing starts (monthly, but at seasonally adjusted annual rates) have moved since 1980.  Housing starts can be volatile, but they have never been so volatile (going back to 1980) as the recent boom and collapse.  The housing bubble started to build in early 2002, and new starts reached an annualized (and seasonally adjusted) peak of over 1.8 million new units in January 2006.  They then fell steadily, and the collapse in the housing market was the major underlying cause of the overall economic collapse in 2008, in the last year of the Bush Administration.  They reached a trough of 358,000 in January 2009, the month Obama was inaugurated, a fall of 80% from the peak.  Since then they have increased, to 535,000 last month, but remain far below what they had been.

A recovery to the previous bubble peak would be unwarranted (on a sustained basis), as it was the build-up of an excess supply of housing which led to the bubble collapsing.  But the American population continues to grow and needs housing, and it is clear that the current pace of construction is insufficient (based on historical patterns).  Prior to 2002, new housing starts was on an upward trend, but at a moderate pace.  But to keep things simple and conservative, one can take as a reasonable floor of where housing starts need to be as the average in 2001, when 1.27 million units were started.

Based on this conservative benchmark, the new housing starts of 535,000 single family homes in August 2012 would need to increase by a factor of  almost 2 1/2 to return to a more normal level.  While this is better than where it was last year in August (when it would have had to triple to reach the benchmark), it still has a long way to go.

But as has been noted previously in this blog (see the posts here and here), the shortfall in home construction since the collapse of the bubble indicates suggests a substantial potential, once housing begins to recover.  (Note that these earlier blog posts focused on new home sales, while the current post focuses on the broader concept of new home starts.  The starts figure includes starts of home units that would not only be sold, but also those which would eventually be rented, whether by original intention or because the new home could not be sold, plus homes which were built by or for a specific owner.)  The need for new homes remains, as the population continues to grow.  In the short-run, families double up, or adult children continue to live with their parents, as was discussed in the blog posts cited above.  But as soon as they are able, these people want to buy their own homes.

Based on a 1.27 million units per year norm, the graph above shows the excess of new homes (shaded in blue) between 2002 and late 2006, and then the deficiency (shaded in red) since then to now.  Based on this norm, the excess of housing started during the bubble totaled 1.3 million units over the full period.  This excess has now been more than worked off.  The cumulative shortfall (shaded in red) comes to 3.9 million units, or triple the previous excess.  Stated another way, there is now a shortfall of a net 2.6 million single family housing units.  There will be pressure to catch up on this once the economy, and the housing market, begins to recover.

Such a catch-up on the accumulated short-fall in new home construction of recent years could serve as a significant stimulus to the economy, as was discussed in the blog posts cited above.  Other commentators, such as Paul Krugman recently, have noted this as well.  But while such a stimulus to demand would be welcome, one needs also to recognize that fiscal drag has been quantitatively more important than the collapse in residential construction in explaining the lack of a strong recovery from the 2008 collapse.  This was discussed in a posting on this blog from last March.  Residential construction is only 2.4% of GDP currently, down from over 6% of GDP at the peak of the bubble, and about 4% of GDP in more normal times.  Government consumption and investment (as in the GDP accounts) is about 20% of GDP, and total government spending (including transfer payments, such as for Social Security or Medicare) is 36% of GDP.  Government is a much larger share of the economy than is residential construction.  Because of this, reversing the fiscal drag resulting from the scaling back of government expenditures in recent years (particularly at the state and local level) and allowing it to grow as it had during the Reagan years, would add more to the economy than a recovery in housing, welcome as a recovery in housing would be.  Numbers are provided in the March post cited above.

In summary, while there have been recent positive signs, housing construction remains depressed.  However, because housing construction has been so depressed for so long, there is now a shortfall in housing units relative to what is needed for a growing population.  Hence a recovery in new home construction should be expected as the economy begins to recover, and could lead to a doubling or tripling of new home construction from where it is now.  This would be a welcome stimulus to the economy.  But welcome as this would be, allowing government expenditures to recover would make an even larger contribution.

Recent Data on Home Prices and New Home Sales: Still Far To Go

Case - Shiller Home Price Index, 10-city composite, January 1987 to April 2012

US new home sales, 1980 to May 2012, annual data

A pair of new reports on housing released yesterday and today have sparked positive reports on conditions in the housing market.  Both indicate that conditions have improved.  But comparisons to the recent past can be misleading as conditions have been so miserable.  It is important to look at the data also in a long-term context.  This blog post updates two which were posted on this site last December (here and here).

Yes, compared to the recent past, conditions have improved.  But viewed over a longer term context, one cannot yet say that the changes are significant.  The recent data might ultimately turn out to have marked a turning point.  But it is too early to say that.  Plus there is far to go before one can say there has been a meaningful recovery from the downturn in US housing that started in early 2006 when the housing bubble burst.

The top graph shows the Case-Shiller 10-City Composite home price index for the period from 1980 to April 2012, where the April figures were released this morning.  The Case-Shiller numbers are three month moving averages (so the “April” numbers represent an average over February, March, and April in their raw data).  The index is calculated by looking at changes over time of individual home prices, comparing the price of the home when it was sold to the price when it was purchased.  There is also a broader 20-City Composite Index, but this index only goes back to 2000.

The Case-Shiller numbers indicate an uptick in prices in recent months.  But the upticks are small, with monthly increases of just 0.7% in April and also in March, no change in February, and negative before.  Compared to a year ago, the index was 2.2% lower.

But all these changes are small compared to the fall of one-third in prices from the peak of the housing bubble in early 2006 to now.  Prices were plummeting in 2007 and 2008, and then finally stabilized within a few months of Obama taking office.  But there has not been a significant change since then.  Nor is it necessarily likely that there will be a significant change anytime soon.  As one can see in the diagram, average home prices were fairly flat for almost a decade, from late 1988 to late 1997.

The New Home Sales figures, released yesterday by the Census Bureau, were somewhat more positive.  Estimated new home sales in May reached 369,000 at an annualized rate.  This was almost 20% higher than the 308,000 figure for May 2011.  The January to May, 2012, average pace of new home sales was 352,800, which was 17% above the 300,400 pace of new home sales over January to May 2011 (with all figures at annual rates).

These increases are more encouraging.  But they are still small compared to the pace of new home sales that reached close to 1.3 million in 2005 at the peak of the housing bubble, as seen in the graph above.  The high rate of new home construction and sales during the bubble was clearly excessive.  As was discussed in the earlier blog post, annual sales of about 900,000 a year in the US right now might be considered roughly what is needed, on average, given the US population and its growth.  Sales at a pace of 369,000 units a year is still far below this.  An increase of 17% over the pace of 300,400 in the January to May 2011 period is good, but sales would need to almost triple (an increase of 200%) to reach 900,000 a year.

Over time, one should expect home building to recover to this roughly 900,000 level.  When this happens, it will serve as a significant spur to the economy.  And it might well start soon.  Taking the 900,000 figure as a rough benchmark, there was excess home construction during the bubble years of the Bush administration from 2002 to 2006.  This is shown as the area in blue in the figure above.  The excess during this period (i.e. the excess over the 900,000 benchmark) totaled 1.1 million housing units between 2002 and 2006.  Construction and sales then plummeted as the bubble burst.  With the continued depressed state of the economy, new home demand has remained low, and the cumulative shortfall from 2007 to now (calculated again relative to a 900,000 home unit per year pace as the “normal” demand) has come to 2.5 million units as of May 2012.  There is therefore now a net shortfall in housing units of 2.5 million minus the 1.1 million previous excess, for a net of 1.4 million units.  And at the current rate of 369,000 units per year (at annualized rates), the net shortfall is growing at a rate of 900,000 – 369,000 = 531,000 units per year, or about 44,000 units per month.

All this is consistent with recent published reports (see this Census Bureau report, or this Washington Post article based on it, from June 20) on how households are “doubling up” in record numbers, particularly with adult children in their 20s continuing to live with their parents.  The Census Bureau estimates that the number of doubled up households increased by 2.0 million between 2007 and 2010, with the number of “additional” adults (over and above the household head and his or her spouse or partner, and excluding students) in such households increasing by 3.8 million over this period.

Many of these additional adults will seek their own homes as soon as they can.  This will happen when the economy improves, and the home purchases will then in turn serve to spur further improvement in the economy.  When this happens, the impact on growth will be significant.  A rough calculation in the previous blog post suggested that new home construction and sales returning to a pace of 900,000 per year would add about 1% of GDP, or 2% of GDP assuming a multiplier of two.  The Congressional Budget Office estimates that GDP is about 5% below potential, so such growth in new housing construction could act to make up a significant share of the gap.

This pent up housing demand could therefore act as a significant spur to the economy once the process starts.  This serves to underscore again how important it is to end the fiscal drag that is holding back the economy, and instead allow fiscal growth such as that which acted as a significant spur to the economy during the Reagan years (as was discussed in this earlier post on this blog).  Once growth starts, the recovery of housing construction and sales to a more normal level will act to reinforce the recovery.

It is, however, premature to claim that the recent housing data provides an indication that this recovery is underway.  While positive, the changes are still too small, when seen in the longer term context, to bear much weight in drawing such a conclusion.

Recovering from the Recession: Fiscal Drag Can Explain the Slow Recovery

I.  Introduction

Economic recovery from the 2008 financial collapse and economic downturn has been slow, with unemployment still high in 2012.  Republican political officials, whether the presidential candidates or the Republican leaders in Congress, have charged that this has been due to an unprecedented explosion in government spending during the Obama administration, and that the way to a fast recovery would be to slash drastically that government spending.  Senator Mitch McConnell, the Republican Leader in the Senate, for example, has repeatedly harped on what he has called the “failed stimulus package” of Obama, and has successfully blocked any effort to extend any fiscal stimulus to address the continued weak state of the recovery.

They point to the recovery during the Reagan years from the downturn that began in July 1981.  This was the sharpest downturn the US had suffered until then since the Great Depression, and the Republicans point to the subsequent recovery as an example of how (they assert) cutting back on government spending will lead to a strong recovery.  Unemployment reached a peak of 10.8% in the Reagan downturn in late 1982, surpassing even the peak of 10.0% reached in the current downturn.  But the unemployment rate then fell to 7.2% by election day in November 1984, and Reagan was re-elected in a landslide.

Recovery from the 2008 downturn has indeed been slow.  But it is simply false to say that fiscal spending has exploded during the Obama years, while it was contained during the Reagan years.  In fact, it was the exact opposite.  Understanding begins with getting the facts right.  And once one does, one sees that fiscal drag can fully explain the slow recovery from the 2008 downturn, while the recovery during the Reagan years was helped by the largest expansion of fiscal spending in any downturn of at least the last four decades.

II.  The Path of Real GDP

Start with the path of real GDP at each of the downturns since the 1970s (with the data here and below from the Bureau of Economic Analysis of the US Department of Commerce):

The graph shows the path of real GDP in the three years (12 quarters) before each business cycle peak since the 1970s (as dated by the NBER, the recognized entity that does this for the US), to four years (16 quarters) after the peak.  Recessions start from the business cycle peaks, with negative growth then for varying periods (of between 6 months and 18 months in the recessions tracked here) before the economy starts to grow again.  Six recessions have been called by the NBER in the US over the last four decades.  The NBER stresses that it concludes whether or not the economy went into recession based on a wide range of indicators, and not simply real GDP decline, but generally, negative GDP growth of two quarters or more is commonly associated with a recession.

As the graph shows, the downturn that followed the business cycle peak of December 2007 was the largest of any of those tracked here, with most of the decline occurring in 2008, before Obama took office, and in the first quarter of 2009, when Obama was inaugurated.  The economy stabilized quickly under Obama, and then recovered but only slowly.  By 16 quarters after the quarter of the business cycle peak (i.e. by the fourth quarter of 2011, the most recent period for which we have data), real GDP was barely above where it had been at the peak.  This was the worst performance for GDP of any downturn of those tracked here, and indeed the worst since the Great Depression (other than the fall in output after 1945, which is a special case).

The recession that began in July 1981 (shown in green in the figure) at first followed a strongly negative path, but after five quarters began to recover.  The economy then recovered faster than in any other US downturn of the last four decades, and by 16 quarters out, real GDP was over 14% above where it had been at the pre-recession peak. Republican officials argue that government cut-backs under Reagan account for this strong recovery.

III.  The Path of Government Spending

But what was in fact the path of government spending?  There are a couple of different measures of government expenditures one can use, but they tell similar stories.  First, one can look at direct government expenditures, for either consumption or investment.  This is the concept of government spending which enters directly as one component of demand in the GDP accounts:

In the downturn following the December 2007 peak, government expenditures rose in the first six quarters following the business cycle peak in the middle of the range seen in the other downturns.  But then it flattened out, and then it fell.  By the 16th quarter following the peak, real government spending was barely (less than 1%) above where it had been at the business cycle peak, four years before, and was the lowest for any of the six downturns of the last four decades (although close to that following the 1990 downturn, which was then into the Clinton years).  In contrast, government spending in the 1980s, during the Reagan years, continued to grow rapidly, so that by 16 quarters out it was almost 19% above where it had been four years earlier.  This growth in government spending during the Reagan period was by far the most rapid growth in such spending seen in any of the downturns.  Government spending growth following the March 2001 business cycle peak (i.e. during the Bush II years) was second highest after Reagan, but only a bit over 10% higher rather than 19% higher.

If one believes in the Republican assertions that fiscal spending will restrain growth and that fiscal cuts in periods of high unemployment will spur growth, then one would have seen slow growth during the Reagan period and rapid growth during the Obama period.  In fact, one saw the opposite.  Fiscal austerity is bad for growth, while fiscal expansion when the economy is in recession will spur growth.

It should be noted that government spending considered here is total government spending, at the state and local level as well as federal.  State and local spending is on the order of 60% of the total in recent years.  The cut-backs in recent years in total government spending has been driven by cut-backs in spending at the state and local levels, many of whom have followed conservative fiscal policy either by statute (balanced budget requirements when revenues are falling) or by choice.  In the four years following the December 2007 cyclical peak, state and local spending indeed fell by 6%.  This was offset to a degree by growth of 13% in spending at the federal level (of which 8.8% occurred in the last year of the Bush administration, while 4.1% total occurred over the three years of the Obama administration).  A similar breakdown during the Reagan years following the July 1981 downturn shows that state and local government spending rose by a total of 13.6% in the four years, while federal spending under Reagan rose by a total of 25.4% in those four years, for overall growth in government spending of 19%.  This large increase in federal spending does not support the common assertion that Reagan followed a policy of small government.  Federal spending grew almost twice as fast under Reagan as it did in the Bush II / Obama period following the 2008 downturn.

We therefore find that government spending on consumption and investment grew sharply during the Reagan years following the July 1981 downturn, more than in any other downturn in the US over the last four decades, and that the economy then recovered well.  In contrast, overall government spending (including state and local) was flat in the most recent downturn (rising at first in the last year of the Bush administration, but then flattening out and then falling), and the recovery has been weak.

It could be argued, however, that the government accounts that appear as a component of GDP (as direct consumption or investment of goods or services) do not capture the full influence of government spending on the economy, as it leaves out transfers.  Transfers include amounts distributed under Social Security, Medicare, unemployment insurance, and similar programs, which are indeed a significant component of government expenditures.  The purchases of good or services (or the amounts saved) are then undertaken by households, where it will appear in the GDP accounts.  But including transfers in the total for government spending will not change the story:

One again sees government spending increasing over the initial periods in each of the six downturns tracked, including that following the December 2007 peak.  This continues into the first complete quarter during the Obama administration, after which it flattens out and then falls.  By quarter 16, government spending including transfers in the Obama period is tied for the smallest growth seen in any of the six downturns (all at about 9% higher), along with that following the 1990 and 2001 downturns.  Once again, sharply higher growth is seen following the 1981 downturn, with total government spending including transfers was 21% higher after four years in this Reagan period.

By either measure of government spending, therefore, with or without transfers, government spending rose rapidly during the Reagan period while it flattened out and then fell during the Obama term.  This has produced a strong fiscal drag which has harmed the recovery.  In contrast, strong growth in government spending during the Reagan period was associated with strong GDP growth.

IV.  The Path of Residential Investment

There will, of course, be many other things operating on the economy at any given time, so it would be too simplistic to assign all blame or credit for GDP recovery on government spending alone.  Government spending is powerful, and does have a major impact on growth, but there are other things going on at the same time.  In the most recent downturn, the most significant other factor affecting aggregate demand for output has been residential investment.

Residential investment had risen sharply during the Bush II presidency, as has been discussed previously in this blog (see here).  The housing bubble then burst after reaching a peak in prices in early 2006 (see here), housing construction fell to levels not seen in decades, and such construction remains stagnant.

The collapse in residential investment seen in the most recent downturn in unprecedented.  While residential investment has typically fallen at the start of the downturn (and indeed was often already falling before the start of the overall economic downturn), the falls had never been so sharp and extended as now.  Four years since the business cycle peak in December 2007 (and six years since the peak in residential investment), residential investment remains weak, with no sign yet of recovery.  There are two reasons:  1)  The housing bubble reaching a peak in 2005/06 was unprecedented in size in the past half century, with residential investment reaching 6.3% of GDP in the fourth quarter of 2005, and then collapsing to just 2.2% of GDP in 2010/11; and 2) The downturn that started after the overall GDP peak in December 2007 was fundamentally caused by this bursting of the housing bubble, which led to mortgage delinquencies, financial stress in the financial institutions who held such mortgages, and then to collapse of the financial system.

V.  The Impact on GDP Recovery of the Fiscal Drag and of Housing

Finally, it is of interest to see what the impacts on GDP recovery might have been, had there not been the fiscal drag seen in recent years, or if residential investment had followed a different path.  There are many counterfactuals one could envision, but of particular interest would be the path of government spending seen during the Reagan years, as this is often held up by Republicans as the example to follow.  The following table shows what the impact would have been, along with a counterfactual scenario which keeps residential investment flat at the level it had been in 2007Q4.

Counterfactual Scenarios    All figures as a share of GDP.  Note that the shortfall from Full Employment GDP was 5.8% of 2011Q4 GDP (CBO estimate) Direct Impact Multiplier of 1.5
Government Consumption & Investment increases                                   as in 1981Q3-1985Q3 3.4% 5.1%
Total Government Spending (incl. Transfers) increases                             as in 1981Q3-1985Q3 4.0% 6.0%
Residential Investment flat at 2007Q4 level 1.4% 2.1%

The results indicate that the fiscal drag in recent years can by itself account for the shortfall of current GDP from its full employment level.  The estimate of full employment GDP comes from the January 31, 2012, economic baseline forecast of the Congressional Budget Office (see here), and is 5.8% above where current GDP was as of the end of 2011.  That is, if GDP were 5.8% higher, we would be at full employment (or “potential”) GDP, as estimated by the CBO.

In the first line of the table, government consumption and investment expenditure is increased by how much it was in 1981Q3 to 1985Q3 during the Reagan years, rather than the much slower growth (indeed essentially no growth) of 2007Q4 to 2011Q4.  The direct impact would have been to increase GDP by 3.4%.  Assuming a very modest multiplier of 1.5 (many would argue that the multiplier when the economy is in recession as now, with Federal Reserve Board interest rates close to zero, would be 2 or more), the impact would be 5.1% of GDP.  This is close to what would be needed to make up for the 5.8% gap.

In the scenario where total government spending (including transfers) is increased as it was during the Reagan years rather than the slow growth that has been chosen in recent years, GDP would have been 4.0% higher by the direct impact alone, and by 6.0% with a multiplier of 1.5.  This would have fully closed the gap.

One can also look at scenarios for residential investment.  Given how high the housing bubble had gone in 2005/6, it would be unrealistic to believe that housing would bounce back up quickly, and certainly not to the bubble levels.  But in a scenario where housing had simply recovered in real terms to the level seen in the fourth quarter of 2007 (when it was 4.0% of GDP), the direct impact on GDP would have 1.4%, or 2.1% assuming a multiplier of 1.5.  While still quite significant, these impacts are less than that resulting from the slow growth of government spending in recent years.

VI.  Conclusion

In summary:

1)  The recovery of GDP in the recent economic downturn has been slow, with unemployment still high.  Not only is a vast amount of potential output being lost, but long periods of unemployment is particularly cruel to the lives of those who must suffer this.

2)  Prominent Republican leaders have repeatedly asserted that the slow recovery has been due to an explosion of government spending under Obama.  This is simply not true.  Growth in government spending since the onset of the recession in December 2007 has been slower than in any other downturn of the last four decades in the US, and has been far less than the growth seen following the 1981 downturn during the Reagan years.

3)  Growth in government spending following the 1981 downturn during the Reagan period was in fact the highest by a substantial margin of any of the six downturns.

4)  If government spending had been allowed to grow in the recent downturn as it had during these Reagan years, the economy by the end of 2011 would likely have been at or close to full employment.

5)  Residential investment has also collapsed following the housing bubble that reached its peak in 2005/6, and has contributed substantially to the current downturn.  Its impact, while significant, is however quantitatively less than the impact of slow government spending, since residential investment is normally (and even at its peak) well less than government spending as a share of GDP.

A Comprehensive Mortgage Refinancing Program


The US economy is stuck, with only weak growth.  While the 2008 economic collapse was stopped and then partially reversed through a number of bold government programs (including TARP, the Troubled Asset Relief Program launched under Bush, and the Obama stimulus package), the economy is now growing at too slow a rate to see a significant and sustained reduction in the still high rate of unemployment anytime soon.  The economy is operating far below potential, with a consequent huge loss in what living standards could be.  And the personal human cost of high unemployment is severe in itself.

A primary reason for this continued slow growth is the badly functioning housing market.  Housing prices (see this post) built up in a bubble in the middle of the last decade, reaching a peak in early 2006, and then collapsed.  With the collapse of that bubble, losses built up in US banks and in the US financial system more broadly, leading most spectacularly to the bankruptcy of Lehman Brothers.  The TARP program as well as very aggressive actions by the US Federal Reserve Board succeeded in stabilizing the banks.  But homeowners also lost when the housing price bubble burst, with many now owing more on mortgages than the current value of the mortgaged house itself.

These mortgage holders cannot refinance at the lower interest rates now available on the market, unless they can come up with cash at the time of the refinancing to pay off the balance of the old mortgage in excess of what their new mortgage could be (now normally only 80% of the current home value).  If they do not have such cash, they must struggle to pay the mortgage at the old, higher, interest rates that were obtained when they bought their house during the bubble years (or when they may have refinanced at that time to a higher mortgage amount, or taken out a home equity line of credit on the then higher home value).  Similarly, they cannot sell their house and move to a new location (perhaps in pursuit of a new job opportunity) without bringing cash to the table at the time of closing.

Hence such homeowners remain stuck.  As a consequence, the housing market is not performing as it normally would.  To be blunt, the housing markets, and as a consequence the economy more generally, are constipated.  Economists refer to this as a balance sheet recession, as households (in this case) face financial obligations (their mortgages) in excess of the value of the assets they hold (their homes).  Households hunker down, and try to service their expensive mortgages while trying to save enough to get out of their negative net worth position.  But this can take a long time, and meanwhile the overall economy stagnates.  Japan suffered such a balance sheet recession following the bursting of its asset bubble in 1989 (although for Japan the problem was centered in the corporate sector).  It took more than a decade to recover from this, and to a degree the problem in Japan continues.

One can take a fatalistic approach and say there is not much that can be done.  The Treasury Secretary Timothy Geithner, in an interview with the Wall Street Journal published in its November 21, 2011, edition, appears to take this view.   Asked by the interviewer: “Which happens first?  The economy picks up and housing recovers, or a bottoming and slight recovery in housing helps the economy?”  Geithner responded:  “You can’t engineer a recovery in housing that can lift the broader economy.  It has to be the other way around.”

If true, this would be unfortunate, as the economy will not recover as long as housing is in difficulty.  The purpose of this note is to set out a program which, while ambitious, would be feasible, and which would help unlock those households now facing mortgages that are greater than their homes are worth, and with this unlock the housing markets and the economy more generally.  The scale of the program, as will be detailed below, would be similar in scale to TARP and related programs, which succeeded in stabilizing the banks.  There is a need now to stabilize the households who have similarly suffered from the bursting of the housing bubble, with a similar commitment.

I have labeled the proposal the Comprehensive Mortgage Refinancing Program (CMRP).  The first section below will present the basics of the program, through a simple numerical example.  The section that follows will then elaborate on some of the specifics in how it would work.  I will then present the numbers on how many mortgages would be eligible and the savings these homeowners would enjoy, and aggregate figures on the total costs.  Finally a concluding section will discuss the impact on each of the various entities that would be affected (the households, the lenders, and government), and how each would benefit from the program.  There is a shared interest by each in participating, but leadership by government will be necessary to make it happen.

CMRP in Summary

The program would be built around a government loan (not a grant) to the home owners to allow the mortgage balance to be brought down to 80% of the current estimated home value.  Specifically, all household borrowers with a mortgage balance in excess of 80% of their current home value could participate, if they choose.  It would not be compulsory.  If they do, the house would be appraised, and their existing mortgage balance would be refinanced at a 4% interest rate (approximately the current market rate for 20 or 30 year fixed rate mortgages), for 80% of the home value by the existing mortgage holders and for the remaining amount as a loan on the same terms from the government.  Should the home owner decide to sell his property, perhaps some years hence, the mortgage holders would be repaid (as long as the home is sold for more than the mortgage, which was set at 80% of the value of the home when the program was launched).  The government would be repaid half of any gain above the 80% (half in order to preserve an incentive for the home owner to try to get a good price), while the remaining amount would be treated as a personal loan on the same terms, to be repaid over time.

There are many details still to be covered, but it would be helpful first to present this with a simple numerical example.  Assume that the current value of the home is $200,000, but that the mortgage on it is $250,000.  In common usage, the homeowner is “underwater” by $50,000.  Eighty percent (80%) of the home value is $160,000.  Under CRMP, the mortgage would be refinanced with the existing mortgage holder (or holders, if there is a second lien or a home equity line) providing a new 30 year mortgage at 4% on the $160,000, while the government would provide a loan on the same terms (4%, 30 years) of $90,000.

If the house is then sold for $200,000, the $160,000 mortgage would be paid off, while the government would receive $20,000 (half the difference between the sale price and the $160,000 mortgage), with the remaining $70,000 balance on the government loan to be repaid on the same terms (30 years, 4%) as if it were now a personal loan.  The homeowners could take out the $20,000 and use it as a downpayment on a new home, or could prepay the government if they wish.

Elaboration on the Program

Some of the specifics:

  1. The lender with the first lien on the home (and normally the largest single lender) would cover all the closing costs involved (including the cost of the appraisal by an independent professional firm, chosen by the government) as well as all the administrative costs involved both initially and over time.  No points would be charged on the new mortgage either.  The lenders will benefit greatly by this program, and can absorb such costs.
  2. The program would only be for households where the mortgage is for their principal residence.  The program is not designed to rescue businessmen or others who speculated on a continual rise in home prices during the bubble, nor for the lenders to such speculators.
  3. The program is also not designed for borrowers who cannot cover the debt service on these loans.  It is designed for those households who are servicing their debt, perhaps with difficulty but servicing it nevertheless.  They will gain as the new mortgage terms will be at 4%, versus the higher rates that they currently pay (probably normally in the 6 to 7% range, as these rates were typical during the bubble, or possibly even higher if they took out loans at low initial rates which then stepped up after a few years to higher rates).  There are, unfortunately, also households who cannot afford the homes they moved to even at a 4% rate.  Such cases need to be addressed on an individual basis, where there will be foreclosures as well as major losses to the mortgage holders who made such irresponsible loans.  Other programs exist to help in such cases, but this is not the objective of the proposed CRMP.
  4. The new loans from the government ($90,000 in the example) would be for 30 years at a fixed 4% rate, with the same level payments as for a 30 year fixed rate mortgage.  But one might include an incentive to pre-pay such loans, so that they do not last for decades unless truly needed.  One might include an automatic increase in the rate by say 1% point in year 10, 1% point again in year 15, and so on.  Even with a modest 2% annual inflation in home prices on average from their current level, prices would be 22% higher in 10 years and 35% higher in 15 years.  Homeowners could refinance at that point with a regular commercial mortgage, if beneficial to them, and repay the government obligation.
  5. The seniority of the creditors (i.e. the holders of the first lien, the second lien, any home equity credit lines, etc.) would be kept as they are now.  In the initial refinancing to 80% of the current home value (i.e. to the $160,000 in the example, from the $250,000 initial exposure), each lender will have a proportional reduction in their exposure.  But then if the house is sold for less than $160,000 (or whatever the current mortgage balance would be at some future date, after some period of repayment), there would be losses taken by these mortgage holders, in the order of their seniority as now.  That is, the mortgage holder with a first lien would be paid first, then those with a second lien, and so on.  The holders of these second liens and home equity lines will still benefit a great deal under this program, as the government has in effect already paid them the difference between the initial total mortgage exposure and the 80% home value ($90,000 in the example).  Plus there will not be further losses unless home prices fall by a further 20% from where they are now (as the new mortgages will be 80% of the current value).  But to the extent there are such further major losses, they will bear this.

The Overall Magnitude

An important question to address is what might be the scale of such a program, in terms of the amounts to be refinanced and what the government share of this would be.  The best data from which one can compute this is provided by CoreLogic, a private firm that provides analytical and consulting services on real estate.  They maintain a comprehensive state-by-state data base with estimates of the numbers of mortgages that are underwater, and by how much.  The figures can be worked out from numbers quoted in their most recent press release, available here.

Specifically, CoreLogic estimates that as of the third quarter of 2011, 22 million mortgage borrowers in the US have loans which are greater than 80% of their current home values.  This would define the pool of potential participants under CRMP.  Of the 22 million, CoreLogic estimates that 10.7 million face a mortgage loan greater than 100% of their current home value (i.e. are underwater), with 6.3 million of these having only a first lien on the home, while the remaining 4.4 million have a first lien as well as a second lien (or more).

For the 6.3 million underwater with only a first lien, the average mortgage balance was $222,000, and they were underwater by an average of $52,000, thus implying that their average estimated home value was $170,000.  For the 4.4 million with also a second or other liens, the average mortgage balance was $309,000, and they were underwater by an average of $84,000, implying an average estimated home value of $225,000.  I assumed that the average home value of those 11.3 million with loans between 80 and 100% of their home value, was the same as the weighted average of the homes underwater (equal to about $192,600), and that on average the mortgage balance outstanding on these homes was halfway between the 80 and 100% bounds.

From these numbers, one can calculate that the total mortgage balance outstanding in the US in excess of 100% of the underlying home value, is $699 billion.  In addition, a further $630 billion is outstanding on the mortgage amounts between 80 and 100% of the home values (including all of the 22 million homes with mortgages in excess of 80% of the home values).  Hence the total amount that the government might possibly need to lend, if there is 100% participation by all such eligible mortgage borrowers, would be $1,329 billion.  And the amounts that the lenders would need to provide (for the uniform 80% mortgages) would be $3,390 billion, down from their current exposure of $4,719 billion (where the government share makes up the difference).

These would be the maximum exposures.  However, it is doubtful that 100% of home mortgage borrowers would participate.  The reasons would be various, but would include the requirement that only mortgages on principal personal residences would be eligible.  In addition, CoreLogic noted that in its data, only 69% of the 22 million home mortgage borrowers with outstanding loans greater than 80% of their current home value, have mortgages at interest rates of 5% or more.  It would be these home owners, with high interest rate mortgages, who would gain the most from participation in the proposed program.

While it is impossible to say with any certainty how many mortgage borrowers would choose to participate (a reasonable guess might be somewhere in the 50 to 75% range), for the purposes here, I will assume that 69% do.  Therefore, the outstanding loans to be made by the government to the households would total $917 billion (69% of $1,329 billion), while the new 80% mortgages from the private lenders would total $2,339 billion (69% of $3,390 billion).

A $917 billion program from the government to benefit homeowners and unlock the housing market is of course huge.  But it is similar in scale to the potential exposure the government took on under TARP and related programs to stabilize the banking system.  TARP itself was approved for up to $700 billion, although substantially less was in the end used.  Similar US Federal Reserve Board support to AIG and to JP Morgan for the Bear Stearns purchase totaled $140 billion.  There has also been approved purchases by the US Treasury of equity in Fannie Mae and Freddie Mac of up to $400 billion.   These programs have thus totaled $1,240 billion, plus there were a number of smaller programs.

But it should also be noted that while the potential government losses totaled this $1,240 billion, the actual losses so far have been small.  The US Fed has not lost anything on its programs, including programs that provided massive liquidity support to the banks.  The current estimate of the net cost of TARP to the government is only $19 billion, mostly on programs to support housing where recovery of the funds was never anticipated.  The Government in fact made a significant profit on TARP funds lent to the banks.

Indeed, the main anticipated cost to government of these programs to stabilize the financial system is expected to come from losses in the support provided to Fannie Mae and Freddie Mac.  The Congressional Budget Office expects that these losses will total $389 billion over the next ten years.  To the extent the CRMP proposal being made here is implemented, these losses to Fannie Mae and Freddie Mac would likely be reduced.

One also needs to note that while the government would make loans to the home owners of an estimated $917 billion, these loans would be made at an interest rate of 4% initially (and then possibly bumped up by a percentage point in years 10, 15, and so on, until the loans are paid off).  But the current cost of a 10-year US Treasury bond is less than 2.0%  (indeed only 1.90% as of this writing).  Thus the US Treasury will be earning a positive spread on these loans, where one should note that all administrative expenses under this program would be covered by the primary mortgage lender.  But there will still be defaults, and it is not possible to predict with any certainty how large these will be.

Overall, however, the positive spread the government will earn on the loans that are repaid, plus the savings in terms of reduced losses by Fannie Mae and Freddie Mac, make it possible that the final net cost to government will be small, as it was on TARP.  Plus there will be the broader benefits to the economy from a program to unlock the housing markets, which will in turn lead to more tax revenue to the government.

Finally, the individual home owners will benefit from the lower interest rates on the refinanced mortgages.  While no portion of the loan is being forgiven, they will now pay at a uniform 4% rate rather than the higher rates they are paying currently.  The savings to them will depend on what their current mortgage rates are, and these will vary.  The rates will also be higher on second liens and on home equity lines than on mortgages holding a first lien, and will vary based on whether they have fixed or floating rate loans, step-up payments due, and so on.

But to illustrate, for an average mortgage outstanding of $214,400 (the weighted average in the CoreLogic data cited above), and assuming their current interest rate is 6 1/2% on a 20 year fixed rate loan, the savings would be $6,900 per year in moving to a 30 year fixed rate loan at 4%.  This is a savings of 36%, and would total $152 billion (about 1% of GDP) for all the households.  This in itself would provide a substantial boost to the economy, as much of this will likely be spent.  And for the households that are underwater, and who have second liens and/or home equity lines in addition to a first mortgage, where the average mortgage is $309,000, the savings would be $9,950 per year.

Conclusion:  The Impact on Each Party

It is important to recognize that each of the major groups involved in CRMP would benefit from its implementation:

  1. The home owners who cannot now refinance their mortgage because the mortgage is greater than 80% of the current value of their home, will be able to refinance at 4%, the current market rate.  They will not only realize regular monthly savings compared to what they currently often have to struggle to pay, but they will also be able to sell their house, should they now wish, perhaps to move to a different part of the country to pursue a job opportunity.  This will also help unlock the housing market, with attendant broader benefits to all the home owners in the country.
  2. Mortgage lenders would with CRMP face fewer mortgage defaults and losses from foreclosures.  And losses from foreclosures are normally much more than simply the excess of the mortgage amount over the estimated current home value, as foreclosed homes typically sell at a significant further discount, plus there are substantial legal and other costs in going through the foreclosure process.  Hence they will welcome a government program where the government provides a personal loan to cover the amount of the mortgage in excess of 80% of the current home value.  It is true that such lenders would prefer the home owners to continue to pay at the above market interest rates of perhaps 6 1/2% or so that they are locked into, but they also recognize that many such borrowers will soon choose to walk away from these mortgage commitments.
  3. And while the Federal Government will take on substantial new debt to fund the loans it will make, the net cost in the end is likely to be small.  It will lend the funds at a positive spread, and while there will be costs from defaults, government will also gain from lower losses incurred by Fannie Mae and Freddie Mac.  There will also be higher tax revenues from a better functioning economy, due to a better functioning housing market and as consumer spending rises in a sustainable way.

But while a program such as CRMP makes sense, it is difficult to see in the current political environment that something of this nature will be implemented.   The country’s vision has become too narrow, with no willingness to take bold actions.  As a result, it is much more likely that one will see the slow and unsteady recovery typical of balance sheet recessions where little is done to cure the underlying structural problems.