The CapCom Debate, Round 3


It's Round 3 of the inaugural Capital Commerce debate. The pugilists: Donald Luskin, chief investment officer at Trend Macrolytics, an economics and investing consulting firm, and Barry Ritholtz, proprietor of Ritholtz Research & Analytics. The bullish Luskin writes a popular blog, The Conspiracy to Keep You Poor and Stupid, while the bearish Ritholtz has an equally popular blog, The Big Picture.

Donald Luskin: Bears Can't Explain Why Housing Hasn't Tanked the Economy

Barry says I "shrugged off" the housing slowdown. It's the economy that has "shrugged off" the housing slowdown, not me.

In my previous post, I showed that as housing has cooled, the rest of the economy has not declined along with housing but instead has accelerated. I don't think Barry has an explanation for that fact.

Instead, Barry has a story about "mortgage equity withdrawal," or MEW. I've heard it a thousand times from the bears. It's the idea that consumption has propped up an otherwise mediocre economic expansion and that consumption was made possible only by mortgage refinancing, which unlocked cash from appreciated housing.

It's one of those stories that sound good if you say it fast, but there really aren't any facts to back it up. But there's no shortage of arithmetic that produces authoritative-sounding numbers.

In Barry's latest post, he calculates how low real gross domestic product would have been in this expansion if you subtracted MEW. But this exercise is meaningless. First, there are no authoritative statistics on MEW; no reliable agency really claims to know what fraction of mortgage volume went into cash extraction. Second, even if we overlook that, nobody knows what fraction of that cash went into consumption. Third, even if we overlook that, we have no idea what consumption funded by other sources would have been if there had been no MEW.

For the MEW analysis to have any meaning, it has to connect to consumption. It's consumption that is a component of GDP–MEW is not, any more than the stock market is. MEW is nothing more than a hypothetical explanation for consumption.

If it were a good explanation, you'd expect personal consumption growth to have surged when MEW started rapidly expanding in 2002. But it didn't. Here's a chart in which I've overlaid growth in nominal personal consumption expenditures on top of Barry's chart of MEW. PCE growth dipped in the two recessions captured in this time frame, but other than that it has just motored along at a pretty consistent rate regardless of what MEW did. Where's the connection? There is none.

Best case would be for Barry to resort to the academic models that institutions like the Fed use to estimate how "wealth effects" like MEW affect consumption. These models typically assume that only 3 to 5 percent of a wealth increase goes into consumption. Yet Barry just lops 100 percent of MEW out of GDP. What does that really prove? Nothing.

You don't need MEW to explain consumption. Mostly, consumption is a function of personal income. A second chart plots real PCE growth against growth in real disposable personal income. The shapes of the two lines track each other almost perfectly, with DPI growth more than explaining PCE growth. Who needs MEW to explain anything?

Sorry, but the bears are going to have to come up with a better story than MEW.

Barry Ritholtz: The Numbers Are Clear, and the Economy Has Slowed

Had space permitted yesterday, I would have included more details about the conversion of mortgage equity withdrawal into consumer spending. Since Don's take on the data is all wrong, let's postpone our discussion of employment for a day and go over the MEW details further.

Don asserts there are no "authoritative statistics on MEW."

This is wildly incorrect. The impact of mortgage equity withdrawal on consumer spending was calculated via the "Greenspan-Kennedy" method, a statistical system developed by Fed economist James Kennedy and former Fed Chair Alan Greenspan. Kennedy/Greenspan determined that 51 percent of MEW flowed through to personal consumption.

There is also a small Wall Street shop–Goldman Sachs–whose methodology calculated that 68 percent of mortgage withdrawals was converted into consumer spending. (See Jan Hatzius's "Housing Holds the Key to Fed Policy," Global Economics Paper No. 137, Goldman Sachs, February 2006.) I used 50 percent as a nice round number (that's reflected in our charts)–not, as Don claimed, 100 percent. There is also a recent analysis by the Congressional Budget Office.

So choose your economic sourcing on this data point: the CBO, a former Fed chair, or a top Wall Street firm. Don may not like what the data suggest, but to claim there are no "authoritative statistics" on MEW is ridiculous.

Don's next statistical foible was to confuse the "academic models" to estimate how "wealth effects like MEW affect consumption. These models typically assume that only 3 to 5 percent of a wealth increase goes into consumption."

The "wealth effect" is the psychological tendency of consumers to increase their spending as their assets increase in value. Don's error was conflating the "wealth effect" with actual money. But MEW isn't an abstract number–what can I get for my house? What is my 401(k) worth?–that is typically associated with the wealth effect. It is cold hard cash.

I'll bet my neighborhood is not much different from Don's–we had lots of extensions added, along with new kitchens, bathrooms, HD plasma screens, and new cars–all paid for by home equity lines of credit. Beyond home remodeling, the cash was also used to travel, pay down bills, and finance college tuition. That's good for the economy, but it has since slowed and is likely to slow much further in the future.

Finally, I do not see data supporting Don's contention the economy has accelerated. All of the usual measures of growth are showing fatigue. GDP has slipped from more than 5 percent a few years ago to 2.3 percent in the fourth quarter of 2006, and we will most likely see less than 2 percent growth in GDP in the first quarter of this year.

Corporate profit growth has dropped from 28 percent year over year to last quarter's 8.9 percent–and this quarter is expected to be even worse. ISM's Manufacturer's Business Activity Index has softened, durable goods have disappointed, capital expenditure has been negative four of the past five months, and retail sales have failed to meet consensus expectations each of the past three months. These are not the data points you see in an accelerating economy.

Tomorrow: Jobs