The CapCom Debate: Final Round


Bloodied, perhaps, but unbowed, the combatants in the inaugural Capital Commerce debate emerge from their corners for one last round. The two economists landing and dodging verbal blows this week are Donald Luskin, chief investment officer at Trend Macrolytics, an economics and investing consulting firm, and Barry Ritholtz, proprietor of Ritholtz Research & Analytics. Luskin blogs at The Conspiracy to Keep You Poor and Stupid, and Ritholtz writes The Big Picture.

Donald Luskin: The Recession's Lurking on the Grassy Knoll

What can I say? When it comes to mortgage equity withdrawals (MEW), Barry and the bad MEWs bears have their story, and they're sticking to it. I, on the other hand, have the facts.

I keep asking Barry why it is that–if MEW is such a powerful force behind consumption–consumption growth didn't surge when MEW soared after 2002–or, for that matter, why consumption did surge in the late 1990s when MEW wasn't doing anything in particular.

But I get no answer from him. Instead, he tells me that Goldman Sachs has a model and that one dares not question it because Goldman Sachs is Goldman Sachs. Reality be damned, or at least ignored. And then he calls me dishonest–name-calling instead of economic reasoning.

Again, what can I say? Barry and all the rest of the bears have been embarrassingly wrong for the past four-plus years. Think of all the rationales they've offered, one after another. Rising interest rates. Federal deficits. Trade deficits. Indebted consumers. High oil prices. Hurricanes. The housing bubble bursting. The subprime blowup. And now this absurd MEW story. There's been a recession around every corner and under every bed.

I thought the depth of absurdity was reached when Bill Gross said we were headed to Dow 5000 just before the October 2002 stock market bottom–off which the S&P 500 has more than doubled, when dividends are included.

But I was wrong. The bears just keep coming up with more, bigger, and better ways to sell every correction along the way.

Oh, they've all been good stories. They've all been cleverly based on a grain of truth, just as all great conspiracy theories are. I mean, there really is a grassy knoll at Dealey Plaza in Dallas–but that doesn't mean that there was a CIA conspiracy to kill JFK.

There really have been high energy prices. There really is a record trade deficit. There really has been record MEW, and now it has pulled way back.

But the economy and the stock market just keep right on going. Are we supposed to get all freaked out by fourth-quarter 2006 growth of 2.5 percent? Is that a harbinger of recession, as the bears seem to think? It's not the most red-hot growth number in the world–but hey, if most European nations could consistently grow at that rate, they'd think they'd died and gone to heaven.

And as I keep saying, and Barry keeps ignoring, that 2.5 percent result was really 3.7 percent if you take housing out. I'm not saying you should ignore the reality of housing. I'm just saying that the core economy–absent one rogue factor–is very, very strong.

But those are just facts. Silly me. I should be listening to Goldman Sachs. Sell everything! Run for the hills!

Bill Gross was right! And so is Barry Ritholtz!

Barry Ritholtz: The Likelihood of Recession Is Real

The inexplicable misunderstanding of pedantic rhetoricians notwithstanding, the impact housing has had on the economy has been clear to sober observers. We can debate precisely what portion of the nearly $3 trillion in home equity withdrawal over the past six years was spent on consumption–51 percent, 68 percent–but to claim it insignificant is too frighteningly misinformed to waste further time on.

Instead, let's move on to last leg of the cyclical slowdown: corporate capital expenditures (CapEx).

Talk of a pickup in business CapEx has been around for years: It began life as a rationale for why big-cap tech was such a good buy (it wasn't). It then morphed into a response to any questions about the slowing consumer. Last year, it became the standard answer for what was going to replace housing's contribution to the economy.

But it hasn't. The past few quarters have made it all too clear that businesses are being exceedingly cautious with their cash. CapEx has begun to roll over.

Instead, we have seen a big increase in stock buybacks and dividends. Mind you, this is not a complaint–a hefty percentage of my annual income is from dividends. Rather, this is an informed observation about the significant future consequences of this economic reality.

Why has CapEx not materialized the way the bulls had promised? Some of the risk aversion to spending can be explained by just-in-time delivery and better control of inventories. But only some.

We did see a nice bounce in CapEx before the accelerated depreciation of capital spending rule expired in 2004. But even then, there was very specific spending on efficiency improvements with strong return on investment. Business intelligence software became a hot seller, as did management software and other related, measurable purchases.

My own theory (back in 2003) was that shell-shocked CEOs were afraid to spend on anything that might hurt their quarterly numbers. They had become so very short term in nature–even more so than usual–because they were still stunned by the carnage of the 2000 crash. Every general fights the previous war, and the brutal destruction of share prices and the turmoil caused by mass layoffs is not something any CEO or CFO wants to live through again. Hence, there has been a skittish cautiousness when it comes to spending the corporate cash hoard.

Why does this matter so much? According to Dallas Fed economist Evan Koenig, "when orders for durable goods–which include capital goods and other long-lasting items–fall, as they have been, it often presages a drop in factory employment."

It is not just factory employment. As this chart reveals, a vastly disproportionate amount of job creation was in the housing sector from 2000 through 2006. That former positive is now a negative.

Adding the CapEx issue to the housing downturn and weakening job market, we end up with a slowing economy, increasingly at higher risk of recession over the next 12 to 18 months. That is rarely good for the markets.

James Pethokoukis: Final Words

My take: Two of the biggest issues argued in the Luskin vs. Ritholtz debate have been 1) the impact of the housing slump on the U.S. economy, particularly the role of declining mortgage equity withdrawal on consumer spending; 2) the state of Bush boom. On the housing issue, I shot an E-mail off to economist Joel Prakken, chairman of Macroeconomic Advisers, an economics consulting firm in St. Louis and a guy who has done a lot of work on the role of MEW on consumer spending. Here is what he wrote back:

"Just because one liquidates home equity doesn't necessarily mean that one uses the cash to buy consumer goods; liquidation could be for asset reallocation. Only econometrics can reveal which it is. Good econometrics suggest little or no link between MEW and consumer spending. MEW has fallen dramatically over the last year, but the personal saving rate has fallen, and consumers remain a bright spot in the economy. This contradicts some "Street" analysis (poor econometrics) that argued the decline in MEW would be associated with a large and quick increase in the saving rate and a corresponding weakness in consumer spending."

Now I am not saying that Prakken is the definitive word on this, only that it is certainly open for debate. It's also good to keep in mind that the economy–which consists of millions and millions of free-acting humans–is not a machine where causality, such as the impact of MEW on consumer spending, is something fairly easy to determine. I am reminded of the MONIAC–short for Monetary National Income Automatic Computer–created by economist A. W. Phillips in 1949 to model the U.K. economy. MONIAC was a 7-foot-high, 5-foot-wide hydraulic computer consisting of various tanks and pipes representing various aspects of the U.K. economy, such as savings and investment. Resurrection, the bulletin of the Computer Conservation Society in the U.K., described MONIAC's legacy this way:

"Economic theory has moved on, and Phillips's theoretical model, though still relevant, is no longer complete. ... It suggests that economic behavior can be described by mechanistic models and that economic modeling might submit to control theory. We have been spoiled by science and engineering. We expect from economists the same degree of certainty offered by physicists and engineers. Despite the sophistication of economic theory, it is not nearly as effective in predicting economic events as is control theory, for example, in predicting the behavior of physical systems. Uncontrollable decline, an obstinate recession, and currency crises are not the best advertisements. Economists now embrace chaos theory and increasingly use statistical models, and this tends to obscure the failure of mechanistic determinism. But perhaps we are wrong to see the Phillips machine as a symbol of predictive certainty. When operated, the machines were sometimes temperamental and prone to spring leaks. Phillips was repeatedly called away to a repair an incontinent machine which had disgraced itself during a class. It may be that the machine, like the economy, is defying our efforts at control, by flaunting the irregularity of its ways, and giving us a cold shower in the process."

Phillips, of course, is better known as the conceptual author of the "Phillips Curve," which postulates the trade-off between unemployment and inflation. This theory fell apart during the "stagflation" of the 1970s, when the United States and many other nations experienced both high inflation and high unemployment. As for the Bush economy, there has been a lot of chatter this week–prompted by the White House–about the strength of the Bush economic expansion vs. that of the Clinton economic expansion. I'll give my take on this one next week.