When the U.S. gets a cold, the rest of the world.....

Stephen Jen tries to complete that sentence in an interesting note that reviews the academic evidence on contagion. Historically, U.S.-based shocks have had very different impacts on the rest of the world. For instance, the 1990-1991 recession hardly affected Europe or emerging markets, while the 2000-2001 shock certainly did.

While trade is the most obvious channel for contagion, evidence suggest that confidence and financial markets have a greater, and certainly speedier, impact.

In the end, Jen believes that any U.S. slowdown will only have a limited impact on the rest of the world. I hope he's right.

Bwana, me no understand that swap thingy

The World Bank has a problem. Its list of clients is rapidly diminishing as many middle-income emerging economies have put their financial house back in order and, in any case, prefer no-strings-attached financing from the capital markets to heavily-conditioned loans form the World Bank.

Under new president Robert Zoellick, the Bank is looking to for a new line of business: getting emerging nations to use more extensively risk-management tools, such as insurance, futures, swaps, etc. Examples cited are risk pooling among Caribbean nations for hurricane damage and currency swaps.

Pretty tame and sensible stuff, much along the lines of what Robert Schiller, he of bubble-busting fame, has promoted for helping individuals hedge macro risks like, say, falling real estate markets (see here).

But that's not how Andrew Leonard of Salon sees it. He links these products, stangely, to the current subprime meltdown. This makes no sense, as derivatives haven't really played much of a role in it, as it has been a case of bad lending practices, misjudgin risk and excessive leverage. With a very, very patronizing attitude --quite unbecoming in a liberal, I must say-- he questions the capacity of emerging nation governments to understand and properly use these financial products. (One would hope the World Bank can provide adequate advice on this, in an case).

Talk about throwing out the baby along with the bathwater. But it does remind one of the seemingly innate suspicion that even smart lefty types (such as Leonard, whose work I admire most of the time) have regarding financial markets. Sure, derivatives can be abused and misused, but they haven't been around for hundreds of years for nothing.

That said, it doesn't help the World Bank's case at all to have a treasurer named Kenneth Lay (any relation to Enron's disgraced founder?).

How low will house prices go?

According to an FT/Thomson poll of economists, median house prices will fall a total of 3% between 2006 and 2009. This is an unprecedented fall.

Unusually for the FT, the article is very confusing. Median house prices is a statistic put out by the National Association of Realtors, not the government as they imply. In addition, the figure they give on median house prices for 2009, 235 K, makes no sense, as it is substantially higher than current or past levels.

Anyway, the point stands. Of course, this is only one out of a series of house price measures (see my guide). For example, the Case-Shiller index has already posted a decline of over 3%.

Not all bubbles have popped

At least modern art seems to be going strong, judging by the $100 million paid by an unidentified investment group for Damien Hirst's famous diamond-studded platinum skull (which I like, truth be told). It will be interesting to see whether these prices hold up, as Wall Street bonuses are set to drop sharply in the coming months.

Woe is carnivorous short persons

At least as far as intelligence is concerned. Steve Levitt of Freakonomics refers us to a paper which "establishes"* a clear link between height and intelligence, which would explain the long-observed correlation between how tall you are and how much you make.

But here's hope for the vertically-challenged. You may not be able to do much about your height, but according to this research, you can be smarter if you become a vegetarian!


*Skepticism is always warranted in these studies, even if the authors are academics in good standing

Comparing real estate cycles

Today's news form the housing front is rather grim. The Case-Schiller national index fell 3.2% in the second quarter versus the same year-ago period, the steepest drop in the index's 20 year history (write up here, PDF press release here).

What does the future hold? I don't have a formal forecast model, but I believe it's useful to compare the current cycle (with a peak in the second quarter of 2006) to the previous one (rising prices in the late 80's, reaching a peak in the 2nd Q 1990).



Comparing the periods before and after the peaks clearly shows that during this cycle prices rose much more steeply. Interestingly, after a moderate decline, prices moved laterally in the previous cycle before starting the definite uptrend began in 1994. I doubt that this will be the case now. The price curve shows every sign of taking a nasty parabolic shape.

Inexistent sales of existing homes

Forgive the exageration, but no amount of NAR (National Association of Realtors) spin could soften the grim existing home sales numbers published today. In July, sales fell 9% year-on-year, couples with a 0.6% fall in the median price of homes sold and a rise in unsold home inventories to 9.6 months supply (compared to 7.3 months in July 2006). Notwithstanding, these numbers were in line with market expectations.

To give some perspective, here's the annual series of existing home sales:



Clearly, this series has seen extraordinary growth, expanding at an annual clip of nearly 3% since 1987, far above population growth. How sustainable is this? I don't have a good answer, but a good starting point is adjusting those sales by population growth (existing homes sold per 1,000 persons).



Taking the latest figure, sales per 1,000 persons stand at 19. If they fall closer to the 14-15 level seen in the early 1990's, sales could still fall another 20% or so (maybe the equilibrium level is higher due to demographic and income factors, but there's bound to be an undershoot and this was another period with soft market conditions).

This ain't over yet.

Behind the numbers: House prices

House prices have never fallen since the government started keeping records in 1950, according to this NY Times piece. Actually, they have never fallen since the Great Depression, according to the National Association of Realtors. But they have, in the early 1990’s and since June 2006, according to the Case-Shiller composite index. Confused?

I am (and so is the Times, as they confuse the NAR and OFHEO measures, see below). This is not surprising. The various home price measures differ greatly in coverage and methodology. Here’s a handy guide to the main ones:

OFHEO House price indexes

Calculated by the Office of Federal Housing Enterprise Oversight (the folks who regulate Freddie Mac and Fannie Mae), this index starts in 1975 and has national coverage. It geometrically weighs changes in the price of single family homes on which at least two mortgages have been taken out and bought by Freddie Mac and Fannie Mae. These This helps ensure that the houses included have comparable characteristics over time, avoiding biases resulting from changes in the composition of sales.

It does have two main limitations. VA and FHA mortgages are not included, as are those that exceed the federal loan limit of $417,000. More info can be cound here.

Case-Shiller indexes

Methodologically, they're very similar to the OFHEO indexes (weighted repeat transactions on single family homes). However, they're based on transactions as recorded in county assesor and recorder offices. The geographic coverage is much more limited, as only the largest 20 metropolitan areas are included. It does have the advantage that it covers high-end homes. More info can be found here.

New Home Prices

Published by the Census Bureau, these prices are by definition not comparable to the previous two indexes, as they only cover new houses (a small part of the total real estate market). Information can be found here.

NAR Indexes

The National Association of Realtors publishes information on median and mean prices of existing homes sold (for both single-family houses and condos/co-ops), based on a sample of national transactions. It is subject to biases resulting from changes in the type of units sold and does not adjust for quality (comparable characteristics, as the C-S and OFHEO do by using repeat transactions). The methodology is presented here.

Summary

The Case-Shiller indexes seem to offer the most accurate measure of trends in house prices. However, it does have the drawback of having limited geographical coverage. OFHEO indexes don't have this problem, but the exclusion of high-value housing is a very big flaw. Lack of quality adjustments clearly makes the NAR median home price indicator a much inferior alternative. In the end, they're fairly complementary and should all be analyzed. The following graph shows that the NAR and OFHEO measures produce similar results that are very different from the Case-Shiller index.



This Fed paper (PDF) provides much more information on this topic.

Greece burns

The recent tragic forest fires in Greece got me thinking. Yes, global warming is playing a part in this. For instance, two years ago there were huge, deadly fires in Portugal, Spain and Greece.

But surely there are other, economic factors at play. This article in The Economist lays out some of them. Developers are under suspicion for starting some fires to clear forest for construction, a result of the inefficient justice systems and weak property rights in many Mediterranean nations. It even seems that "productivity pay" for firemen may not be a good idea, as some seek to "encourage" demand for their services.

There is another intriguing angle. While the word "forest" conjures images of untouched wilderness, in reality forest in many parts of the world (and certainly in the heavily populated Mediterranean basin) have been shaped by man for ages. People cleared undergrowth for pasture and fuel, which in turn greatly reduced the risk of fires. However, rural depopulation is cutting this link between man and tree (see here), increasing the risk of fires.

Of course, the European Unions policies often don't help. Its generous agricultural subsidies are oriented to large-scale intensive farming and reforestation schemes often involve non-native species that involve highly flammable trees (eucalyptus, certain pines).

In the end, what do you do? Encourage once again the traditional agricultural practices to reestablish the previous equilibrium? I doubt that many people would like to be shepherds, even if heavily subsidized. Or do you just let the fires burn and wait until a truly wild native forest slowly establishes itself?

Biofuel madness

It's amazing how the biofuels bandwagon has kept gaining strength despite the fact that it's one of the main factors behind the steep rise in food prices. (Note to The Economist: remember that oil is used to grow crops!).

People have tolerated this because biofuels have a warm, green image (not deserved in many cases). Who can possible be against the environment?

But its pretty clear that biofuels serve mostly one purpose: to benefit incumbent politicians. On production cost grounds, biofuels make no sense, with the possible exceptions of sugarcane and jatropha. Politicians love to subsidize non-viable industries with a good public image becase 1) not many objetct lest they be called anti-environment and 2) those subsidies come back as campaign contributions from agribusiness (which has no choice, given that it wouldn't exist without those politicians).

In other words, politicians subsidize themselves. Rent-seeking at its most perverse worst.