From a small northwestern observatory…

Finance and economics generally focused on real estate

Housing Finance — Take 2

with 2 comments

Again, from the Wall Street Journal, we find reasons for concern. The “Ahead of the Tape” column in today’s Journal, we find an excellent — but troubling — article by Kelly Evans titled “Economy Needs a Borrower of Last Resort.” It really follows my theme from yesterday, and I couldn’t agree more.

Graph courtesy The Wall Street Journal

The first line of the article says it all: “A lack of funds isn’t hampering the U.S. Economy right now. It is a lack of demand for them.” The FED has been pumping billions into the money supply by buying bonds from banks. In a healthy economy, this should drive up the money supply by a multiple of the face amount bought. Why? An old equation from Econ 101 called the “Velocity of Money.” When I was teaching, I explained (or tried to, for the C students) that when the FED injects money into banks, the banks loan it out. The borrowers in turn buy stuff and the money goes back into the banks, minus a little. That happens several times over. Thus, a dollar of money “injection” by the FED should usually result in at least $2 of net M2 money creation.

Imagine a dollar (or a hundred thousand dollars) injected into the system which is loaned to a family buying a new home. They pay the builder, who deposits the money in the bank (actually, paying off the construction loan) and then that money can be loaned back into the system. Some of it bleeds off into taxes, exports, and such, with each iteration of the deposit-and-loan cycle, but still, the money cycles thru the system. Since each subsequent deposit and loan doesn’t happen instantly, there is a little bit of a lag. Nonetheless, over a short period of time, the system should work. The math behind this is called the “Cambridge Velocity Equation” and it’s been known to economists for hundreds of years.

So, since November, the FED has purchased $684 Billion in bonds, which SHOULD have resulted in trillions of dollars in new money creation. Instead, M2 (the abbreviation for the money supply, defined as all of the cash, bank deposits, and money market funds in the system) has only increased by $326 Billion, suggesting that the velocity of money is about 0.5. Note that it SHOULD be 2 or 3 or more in a vibrant economy. This means that for every dollar injected into the system by the FED, half of it has dissipated.

As the article points out, this is why the recovery has remained so anemic. I would posit that a big problem is in the home loan business, which is far weaker than merely “anemic” — it’s on life support with the undertaker waiting in the lobby.

Kelly Evans posits that the market needs a lender of last resort, which is exactly what I was saying yesterday. Unless and until the system starts turning into the skid, by fixing the totally busted mortgage market, a double-dip recession seems inevitable.

Written by johnkilpatrick

June 2, 2011 at 4:05 pm

2 Responses

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  1. Dr. Kilpatrick,
    I enjoy your insights and your blog, as well as your comments on LinkedIn.

    You said, “I would posit that a big problem is in the home loan business, which is far weaker than merely “anemic” — it’s on life support with the undertaker waiting in the lobby.”

    May I point out that current lending policy has merely reverted to what it was in the 60’s and 70’s? Back then, in order to get a loan, you had to have a source of income–a means of repayment. You needed some skin in the game in the form of a 20% down payment unless you were a veteran. A bank would not lend more than could be amortized by about 25% of your before-tax income. And you needed additional cash to cover closing costs. Interstate lenders can no longer pass their risk on to the taxpayers, so naturally everybody has slowed down to a safe speed.

    We’ve just gone through one session of monetary hypervelocity with disastrous results. Fraud and theft were institutionalized, and “Thou shalt not steal” was an archaic sentiment with no place in modern business. Do you really think we should return to an era in which a bond purchase by the Fed presents itself to M2 multiplied by 2 or 3? We’d need a comparably increasing GDP for that to work.

    Jim Plante

    June 4, 2011 at 5:31 am

  2. Mr. Plante —

    Thanks for the comments. I concur that we’re returning to a lending market similar to the 1960’s, but unfortunately we have an economy set up to supply 2000’s housing. As such, there will be a whole lot of pain — with unemployed construction workers, etc. — getting back to those levels. I would also add that there are a whole host of public policy concerns. Just for one, numerous studies confirm that “owner occupied” neighborhoods are healthier vis-a-vis schools, crime, public engagement, and such. Even at the margin (that is, moving from 69.5% home ownership to, say, 64%) will have significant sociological implications.

    As for a bond purchased by the FED “…presents itself to M2 multiplied by 2 or 3…” this is one of the important ways that FED monetary policy works. A given dollar works its way through the economy via multiple purchases. If the velocity of money was 1, then the aggregate amount of transactions in the economy would be limited to the amount of currency in circulation. One role of financial intermediation (among many others) is to multiply the purchasing power of a given dollar. Empirically, down-turns in the velocity of money are coincidental with recessions, and up-turns are synonymous with non-inflationary economic growth.


    June 7, 2011 at 4:19 pm

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