A Closer Look At Home Price Increases

Is the Case-Shiller Home Price Index a good representation of actual home prices? The following post from The Mess That Greenspan Made, explains some of the possible flaws in the calculation of the index and why we should take the numbers with a grain of salt. Continue reading to learn more.

Mark Hanson's comments on the recent upswing in real estate prices as indicated by the highly regarded S&P Case-Shiller Home Price Indexes. It seems that, almost every few months now, there's a new wrinkle in how home price changes are reported and, coming as it does amid what millions of people think is a bottom for home prices, this one's a doozy.

Mid-to-High End Sales – Very Important.
Not Representative of True Market

More mid-to-high end sales are occurring this year than last. They are not anywhere close to the bubble years due to the catastrophic loss of affordability through exotic finance but they have increased as prices fell. They are occurring at significant discounts to list prices and previous year’s sales as I have highlighted many times. At the same time, foreclosure-related resales are falling as demand from first-timers and investors who have carried the market for a year has peaked.

This seasonal mix-shift is almost exclusively responsible for the significant house price appreciation in any CA MSA’s over the past 90-days. Mid-to-high end sellers and buyers are the most seasonal of all. As soon as the summer warm months are over and kids are back to school these sales will drop considerably allowing foreclosure resales, which are not seasonal, to reclaim this mix. This will drop reported median and average house prices as early as September, which will be reported in October.

Here's the interesting part.

At this point, you might be thinking that Mr. Hanson has the calculation of median prices confused with the paired-sales methodology used by Case-Shiller, but he does not.

While I haven't read the details of how the index is calculated recently, one can immediately understand how the index values can be affected by how long the seller has owned the home after reading the following:

Who is the Mid-to-High end Seller? Why Is This Important?

Now, think about those that are selling these mid-to-high priced houses. It is not the person who bought from 2005-2007 on a Pay Option ARM with 5% down because they can’t sell. It is the person who bought years ago that has enough equity to dump the price, sell, and have enough left over for the down payment on the house they plan to steal in the desert.

Even with the price dump, a person who bought in 1999 for $450k — who saw their house price rise to $1.5 million by 2007 and subsequently drop to $700k — realizes a price gain and so does CS. Even though CS reduces the weighting of pair sales the longer ago they occurred — when this is all you have selling — it carries most of the weight.

The bottom line is that Case-Shiller reports what sold, period. It is my opinion that the real estate market is so thin and bifurcated that what is selling today is not representative of the true real estate market.

It likely is not accurately representing properties purchased during the bubble years that are now worth a fraction of their purchase price because they are not transacting.

This is apparently part of a private letter to clients. If anyone has a copy and would like to share some more details, please feel free to do so in the comments section or via email.

Maybe, I'll drop Mark a line and ask him if he would like to share any more details about this because my interest is piqued. Then again, I haven't checked Calculated Risk yet today and Bill might already have an analysis on this subject posted.

Anyway, this all makes a good deal of sense to me - aside from a few price ranges in a few areas of the country that may have hit bottom, there is much more work to do to get home prices back to more normal levels - and then there's the typical "overshoot".

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

How An Idea That Spreads Could Lead To Global Economic Recovery

Economist Robert Shiller offers that the economic recovery may be more influenced by ideas that spread, rather than typical economic metrics. For instance the idea of "green shoots" spread throughout the world as a symbol of renewed confidence that could become a self-fulfilling prophecy. For more on this see the following post by Mark Thoma from Economist's View.

Robert Shiller says the global recovery in economic confidence is being driven by a social epidemic, the contagion of ideas, and huge feedback loops:

An Echo Chamber of Boom and Bust, by Robert Shiller, Commentary, NY Times: The global signs of a recovery in economic confidence seem puzzling.

It is a large and diverse world, after all, so why should confidence have rebounded so quickly in so many places? ... Economic analysts often turn to indicators like employment, housing starts or retail sales as causes of a recovery, when in fact they are merely symptoms. For a fuller explanation, look beyond the traditional economic links and think of the world economy as driven by social epidemics, contagion of ideas and huge feedback loops that gradually change world views. These social epidemics can travel as swiftly as swine flu: both spread from person to person and can reach every corner of the world in short order. ...

The popularity of the term “green shoots” shows the kind of social epidemic underlying our changing thinking. The phrase was propelled in Britain by Shriti Vadera, the business minister, in January, and mutated into a more contagious form after Ben Bernanke, the Federal Reserve chairman, used it on “60 Minutes” on March 15.

The news media didn’t need to change the term for different cultures around the world. With nothing more than a quick translation — brotes verdes, pousses vertes, grüne Sprösslinge, etc. — it is now recognized as a symbol of a revival coming soon.

All of this suggests that a social epidemic is supporting renewed confidence. This confidence can keep growing by contagion, as a kind of self-fulfilling prophecy, and we may see the markets and the economy recover further.

But in an economy that is still unstable, the stories could also morph into different forms, the price feedback could turn downward and the dynamic could turn ugly again — just as it has in the past.

It seems quite reasonable that the spread of information (wrong or right) can reinforce trends in economic activity, and hence magnify and propagate shocks, but as noted in a part of the article not included above, this doesn't help us much with the problem of predicting turning points in economic activity. Predicting when the stories suddenly "morph into different forms ... is actually very complex. And even when feedback mechanisms are straightforward, they can produce very strange outcomes, not predictable very far into the future..."

This post has been republished from Mark Thoma's blog, Economist's View.

Why Fundamentals Of The Housing Market Are Ridiculously Strong

Dr. Steve Sjuggerud from Daily Wealth points out some keen insights about the fundamentals of the current housing market. He suggests that supply hasn't been this low is a long time, and yet housing is very affordable. These are some of the reasons that real estate could be one of the best places to put your money right now. Continue reading to learn more.

$800,000.

That's about what the median home in San Francisco sold for at the height of the boom three years ago. Then the bust came, and prices fell 45%, according to the Case-Shiller home price index.

But a funny thing has been happening lately... something people haven't really noticed...

Home prices in San Francisco actually bottomed in March. According to the Case-Shiller Index, they've been up every month since... up nearly 4% in the latest month.

On my side of the country in Florida, the same thing is happening. Again, people are almost refusing to notice... But for 11 consecutive months, home sales in Florida have INCREASED over the same period last year.

Meanwhile, homes in Florida are now ridiculously affordable.

The median home price in Florida is now $147,600. That's a mortgage payment of about $650 a month (at current mortgage rates with 20% down). The median household income in Florida is about $50,000, roughly $4,000 a month before tax. That's about 16% of your household income – way below any rules of thumb about how much to put toward a house.

From coast to coast, housing affordability is better than it's ever been, getting a big boost from two things: the housing bust and super-low mortgage interest rates. The pile of government incentives has helped, too.

As an investor, I'm seeing what I love... It's an ideal situation that's rare, but incredibly important if you can recognize it. It's when people's emotional opinions are clearly at odds with the reality of the numbers.

The numbers for housing are really great right now. But after three years of losses, people are sour on housing. Perfect!

Three years ago, we had the opposite situation... The numbers for housing were terrible. Housing was completely unaffordable, and builders were building at a frantic rate. But people were incredibly enthusiastic.

Today, the value is there. What will cause prices to climb again? When the supply of homes available for sale shrinks. It's Economics 101. And guess what? We're there...

Right now, fewer homes are available for sale than at any time in the last 40 years (adjusting the supply for the growth in the U.S. population). If I hadn't crunched the numbers myself, I wouldn't believe it. Take a look:

Economics 101: When the Supply Is Low, Prices Go Up



Even better, when you do the simplest, dumbest comparison – the price of homes versus the supply of homes – you get exactly what you'd expect: When the supply of homes gets low, home prices rise.

David Dreman agrees... In 1980, he literally wrote the book. It's called Contrarian Investment Strategies. In it, he recommended going heavily into stocks. In the current issue of Forbes magazine, Dreman recommends U.S. residential real estate:

If inflation hits hard, the chief culprit of the bear market – real estate – is likely to be one of the best investments in the years ahead. Buy a home if you don't already have one or a second home if you can afford one.

Time to buy a house. (Or two!)

This post has been republished from Daily Wealth, a contrarian investment analysis and advice site.

How The Inflation Monster Could Spoil The Party

The stock market has rallied, job losses are cooling down, and housing prices swung higher this summer. Just when it seemed like we might make it out of the recession, the inflation monster may arrive with a vengeance. Tim Iacono explains why multiple factors may conspire to summon the inflation monster in the not-so-distant future.

You hear a lot of talk these days about what could possibly stop the current stock market rally given that we've clearly passed the "acute" phase of the financial crisis and, quite literally, there is no place to go but up for many economic indicators.

The term "statistical recovery" is bandied about quite a bit by doubters of the recent move up for equities and for many very good reasons such as the following:

• home prices seem to be going up when they're probably really still going down
• consumers have dramatically cut back on their spending but no one seems to care
• current quarter GDP will print at +2 or +3 percent but it is completely unsustainable
• bank balance sheets appear healthy when they are really still loaded with bad loans

But, none of this really seems to matter when you have a chart that looks like this.




A 50+ percent move up over a period of five-and-a-half months will eventually make a believer out of almost anyone, a point that is proven again and again, day after day.

But, aside from some big new financial market brush fire developing somewhere that, having learned the lessons of 2008 well, the Treasury Department and Federal Reserve will no doubt quickly hose down with another few hundred billion dollars in money and credit (more if needed), is there anything out there on the horizon that might dampen the enthusiasm of the stock-buying public?

Well, the obvious one is housing.

While a growing number of pundits have all but declared the housing market healed, the latest evidence being offered the other day in the S&P Case Shiller Home Price Index, there is still clearly a ways to go before real estate stops being a drag on consumer psyches and far too many still believe that, somehow, we'll revert to our 2005 spendthrift ways.

There are millions of foreclosures still to come over the next year or two and most people seem all too willing to take their $8,000 tax credit and bid on a property, not seeming to know or care that home price bottoms are long drawn out affairs and that five percent 30-year fixed rates are the exception, not the rule.

As for the Case Shiller Home Price Index, as noted here previously, there's a pretty good chance that seasonal factors will result in the resumption of negative monthly price changes in another few months, though, with the sea-change in prices recently, anything could happen.



The reversal in home prices from a February-March decline of more than two percent to a May-June gain of almost 1.5 percent was the largest three-month swing in more than 20 years of data for the 10-city index - more than double the previous record.

Is that what's really happening in the housing market and, if so, how long can that possibly continue with the deluge of sellers that will now be entering the market, most importantly banks with their huge inventory of foreclosed homes?

Another month or two of rising home prices and then a swift return to negative numbers could dampen confidence very quickly later this year and millions of shareholders might realize that home prices have not yet hit bottom, despite the optimism everyone felt over the summer.

Turning to the labor market picture, it remains a bleak outpost where stock market bears can still gather to compare notes, however, it is not likely to scare off any bulls at this point.

Who would have thought that we'd ever "cheer" a quarter of a million jobs lost in just one month? But, that's what happened last month and it might happen again next week.

There is much more pain to come in the labor market but, from here on out, except for the low-profile, long-term unemployment statistics, it will continue to be a case of being "less bad" than what we've already seen.

In a world where "less bad is the new good", that's reason alone to bid stocks higher.

There is one thing, however, that could put the kibosh on investors' enthusiasm a few months down the road - inflation.

Inflation?

Hasn't inflation morphed into deflation - an annual rate of minus 2.1 percent as of July - and isn't everyone looking for consumer prices to be tame for the next year or two if, as it appears now, we are lucky enough to avoid that dreaded Great Depression malady of "de-flation"?

Surely, the now-docile CPI won't be spooking any shareholders this year.

Well, maybe it will...

Here's why.

Recall that the consumer price index breaks down into eight major categories as shown below, the two categories that contain energy costs - housing and transportation - both broken out into energy and non-energy components.

Here's the way things stand today, energy prices being the clear driver in the current negative annual rate of inflation which reached a 50+ year low last month.



Notice that, even through the distortion of hedonic adjustments and other nefarious measures that the Bureau of Labor Statistics uses to ensure that prices don't rise too much, nearly all non-energy categories are still up from a year ago, some of them a lot.

Though economists may still favor the dubious "core rate" of inflation, it is the year-over-year change in the "overall" rate of inflation that garners all the headlines and elicits concerned looks from investors of all stripes.

So, what happens later this year when, instead of comparing energy prices against $140 crude oil or even $100 crude oil, energy costs are compared to $40 or $50 crude oil?

Well, it may not be pretty.

Even though all energy components account for less than eight percent of the overall index, they have quite a large impact on the headline figure when you get changes of 30, 40, 50 percent or more and, importantly, this works in both directions.

According to Energy Department data, U.S. gasoline prices reached a low at about $1.61 a gallon last December and stayed below $2 a gallon until the spring. Today's average retail price of $2.62 represents a whopping 63 percent increase over last year's low, a full 30 percent above the two dollar mark. With the prospect that crude oil prices may not go down and, perhaps, might just head toward $100 a barrel between now and the end of the year, this sets the stage for some surprisingly high inflation rates.

Keeping all other categories in the CPI unchanged from year-over-year readings and throwing in a healthy increase for heating oil, piped gas, and electricity (which is something of a stretch for natural gas prices, but, anything's possible these days), all of a sudden you come up with three or four percent inflation again before Christmas, perhaps higher.



After the huge success of the Cash for Clunkers program, many now expect car prices to rise which could push that last red bar hanging below the x-axis into positive territory.

Now, I don't know about you, but it seems to me that inflation rates this high might set off all sorts of chain reactions in financial markets, especially with interest rates at zero percent and the Fed printing money furiously, and none of this is likely to be good for equity markets.

As the world learned painfully in the 1970s, stocks and inflation don't get along too well together and, while this surge in consumer prices might only last four or five months, it will nonetheless have the media talking about inflation again and those poor seniors who are getting no cost of living adjustments in their Social Security checks will again be calling their Congressmen to complain.

Believe it or not, a curve like the one you see below is quite possible as we enter 2010.



Now, the really bad news here is that, since the recent wave of liquidity has pumped up nearly every asset class, the price of oil is not likely to go down (making for tame inflation later this year) unless stock prices go down.

But, based on the much higher year-over-year rates of inflation that will show up later this year if oil prices do not go down, that, in itself may be enough to send the price of stocks down.

Either way, it looks like something has to go down.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Is The US Financial System Worth The Trouble?

One result of the US financial meltdown is that it has more people questioning whether the free market financial system is worth the costs. Here's a startling fact- in the first half of this decade the finance sector accounted for 34 percent of US corporate profits. This seems like far too much of our economic resources going into something that produces a relatively small economic output, even before you consider the mountains of tax dollars required to bail out the financial system when it failed. The following post from Economist's View discusses this important question.

Does the total cost of our financial system exceed the total benefits at the current scale of operation? Like Benjamin Friedman, I wish I knew the answer, though I suspect that much of the recent innovation would be difficult to justify on the margin:

Overmighty finance levies a tithe on growth, by Benjamin Friedman, Commentary, Financial Times:

...The crucial role of the financial system in a mostly free-enterprise economy is to allocate capital investment towards the most productive applications. The energetic growth and technological advance of the western economies suggest that our financial system has done this job pretty well over long periods. ... The financially triggered Great Recession of 2008-? blemishes this record but does not wipe it away.

Aside from the recession, it is important to ask what this once-admired mechanism costs to run. If a new fertilizer offers ... a higher crop yield but its price and the cost of transporting and spreading it exceeds what the additional produce will bring at market, it is a bad deal for the farmer. A financial system, which allocates scarce investment capital, is no different.

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. ... The misused resources and the output foregone due to the recession are ... part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system. ...

One part of that cost is ... much of the best young talent in the western world [going] to private financial firms. ... At the individual level, no one can blame these graduates. But at the level of the aggregate economy, we are wasting one of our most precious resources..., much of their activity adds no economic value.

In the US, both the share of all wages and salaries paid by the financial firms and those firms’ share of all profits earned have risen sharply in recent decades. In the early 1950s, the “finance” sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent.

These wages and profits – and the office rents, utility bills, advertising and travel expenses – are all parts of the cost of running the mechanism that allocates our economy’s capital. To recall, what makes a new fertilizer a good deal for the farmer is not just that it delivers greater production per acre but that the added production is sufficient to buy the fertilizer and increase the farmer’s own return.

What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. The more the financial system costs to run, the higher the hurdle. Does the increased efficiency our investment allocation system delivers meet that hurdle? We simply do not know.

Economic decisions are supposed to turn on weighing costs and benefits. It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that.

This post has been republished from Mark Thoma's blog, Economist's View.

Will Economic Recovery Be Behind Door V, U, or W?

Economist's say that there are three major possibilities for how the economy will exit the current recession, but the outcome remains highly uncertain. Some new information on the leading indicator of new orders for manufactured durable goods may provide some clues on what to expect. The following post from The Capital Spectator describes some factors that may shed light on the type of recovery that is most probable.

Is today's update on new orders for durable goods a sign of an approaching V, U or W? Translated: Is the economy poised to rebound sharply and deliver strong growth—a V recovery? Or is a U-type future, with slow to negligible growth, approaching? Even worse, could an imminent rebound be little more than a prelude to a second recession, a.k.a. the W cycle?

That summarizes the great questions that prevail as the world attempts to handicap the winding down of the Great Recession. As always, the central challenge is that we're left with a great unknown, even if today's news on durable goods suggests otherwise.

As monthly numbers go, July's update for the series is undoubtedly encouraging. New orders for manufactured durable goods in July increased 4.9%, the U.S. Census Bureau reports. That's the third increase in the last four months and the largest percent gain in two years.



No one can deny that such news constitutes progress. Ditto for the accumulating evidence in other economic reports that the economy, if not quite on the mend, is no longer contracting. A number of clues have been suggesting no less for months, as we've been discussing on these digital pages for some time, including the all-important weekly updates on initial jobless claims. Additional support for thinking the economy's stabilizing arrived in yesterday's upbeat news on consumer sentiment and housing prices: both are rising.

None of this is particularly shocking, although the timing was always in doubt. But surely no one expected the U.S. economy, still the world's largest, to remain in downsizing mode indefinitely. The emotional bias in the dark days of this year's first quarter may have convinced us to see a continually dire future. But the recession at that point was already more than a year old, by NBER's accounting, and the natural economic order tells us that recovery arrives eventually. Meanwhile, the massive countercyclical efforts of the Federal Reserve, plus the fiscal stimulus embraced back in February, was sure to have an impact. In fact, one might argue that President Obama's reappointment of Fed Chairman Ben Bernanke to a second term is formal recognition of the success in the central bank's aggressive actions intent on slowing if not ending the downturn.

What's more, the financial and commodity markets have reacted by elevating prices, in effect offering additional corroboration that the business cycle was turning. But while it's tempting to see us headed for a V recovery, the odds seem to favor a U. We've been forecasting just that future for some time by emphasizing that the "technical" end of the recession was imminent if not already here but it would be followed by a tepid recovery.

As welcome as that revised outlook is relative to what preceded it, there's a danger of overlooking the risk that follows this time around. Namely, a series of generational adjustments that threaten to conspire by leaving the economy in a weakened state for an unusually lengthy stretch. The most conspicuous risks: the likelihood that consumer spending growth will remain subdued for some time and the labor market will be slow to respond to so-called recovery.

There are any number of other challenges looming as well, starting with the nuances tied to the timing and magnitude of the Fed's so-called exit strategy. The challenge looks unusually bland at the moment, but it won't stay that way. Indeed, to the extent the economic recovery is stronger than expected, the exit strategy problems will be that much bigger.

Perhaps then the principal question is: Has the crowd priced in the post-recession risks that await? The first half of the business cycle has been unusual on a number of levels, as the last two years remind. We're probably just about midway, perhaps a bit more, through this extraordinary period. Thinking that the second half will be any less rocky and risky is asking for too much.

Still, it's easy to remain complacent. Looking at positive short-term changes in economic measures that are cut in half over longer stretches is reassuring. But climbing out of this hole will take time and the task faces many pitfalls. It's only human to minimize the potential hazards, but strategic-minded investors can't afford such luxuries. As we've arguing in The Beta Investment Report, the time for aggressive portfolio decisions was in this year's first quarter. From here on out, the money game is about to get much tougher.

This post has been republished from James Picerno's blog, The Capital Spectator.

Fed May Be Forced To Release Details Of Bank Bailout

Should the Fed be forced to release details of the $2 trillion bank bailout? That is what may happen if Bloomberg wins their lawsuit against the Fed. The following from The Prudent Investor discusses the implications of this landmark case.

Ben Bernanke did not have time to celebrate his reappointment for another 4 years as Federal Reserve chairman on Tuesday. The day before US president Barack Obama decided to keep Bernanke as Fed head information provider Bloomberg dropped a new bomb shell regarding a lawsuit initiated by the news agency under the Freedom Of Information Act (FOIA) against the Fed.

Bloomberg requires the Fed to publish who got the $2 Trillion in bank aid. Find all the details of the pending lawsuit in this post from November 7, 2008.

The Fed appealed this FOIA request last December, citing concerns that this information would endanger the borrowers of the $2 Trillion.

In a response to Bloomberg it then said,

"The U.S. is facing "an unprecedented crisis" in which "loss in confidence in and between financial institutions can occur with lightning speed and devastating effects."

But on Monday Bloomberg scored a second goal against the Fed:

Manhattan Chief U.S. District Judge Loretta Preska rejected the central bank’s argument that the records aren’t covered by the law because their disclosure would harm borrowers’ competitive positions. The collateral lists "are central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression," according to the lawsuit that led to yesterday’s (Monday) ruling.

The secretive Fed, a constitutionally questionable institution due to its hybrid public-private status has also come under fire from Republican Congressman Ron Paul who tries to win a majority in Congress and the Senate for an official audit of the Fed.

Bloomberg editor-in-chief Matthew Winkler commented the court`s decision this way:

"When an unprecedented amount of taxpayer dollars were lent to financial institutions in unprecedented ways and the Federal Reserve refused to make public any of the details of its extraordinary lending, Bloomberg News asked the court why U.S. citizens don’t have the right to know," he said "We`re gratified the court is defending the public’s right to know what is being done in the public interest."

David Skidmore, a Fed spokesman, told Bloomberg the Federal Reserve Board’s staff was reviewing the ruling and declined to comment on it at this time.

This ruling is certainly a milestone in the possible end game of the Fed which has come under fire from all sides due to its policy of showering irresponsible institutional lenders with Trillions while the rest of the economy is teetering on the brink of a major depression, induced by more than 2 decades of loose monetary policy.

Astute observers will remember the blunders of the Fed which does not know where $9.55 Trillion in unbacked Federal Reserve Notes went.

I end this post with the most important question of all: Who Owns the Federal Reserve?

Resolving this question may become the most important task in the coming era where the world will see more economic and political turmoil than ever before in history.

After all Bernanke is only the figurehead. His captains are the unknown Fed shareholders and for the time being the world economy`s fate lies in their hands.

His thank you to president Obama is only a PR stunt; I`d prefer to know who else decided to keep the biggest money printer of all times in the pilot`s seat. Get involved in this: Use the multitude of Fed inquiry forms on the Fed`s website here and mail me any answers you get. My former requests did not lead anywhere, but I am not a US citizen who has a constitutional right to be informed about the government`s actions.

This post has been republished from Toni Straka's blog, The Prudent Investor.

Obama Makes Safe Bet With Bernanke Reappointment

President Obama chose to go with the status quo and not shake things up at the Fed by reappointing Ben Bernanke. Despite widespread criticism, Obama praised Bernanke for helping the US avoid another Great Depression. Tim Iacono discusses how investors can be take advantage of from this latest development.

President Obama made it official this morning by nominating Federal Reserve Chairman Ben Bernanke to a second four-year term as reported by MarketWatch.

In a short statement in Martha's Vineyard with Bernanke standing at his side, Obama said Bernanke's background, temperament, courage and creativity helped to prevent another Great Depression.

"Ben approached a financial system on the verge of collapse with calm and wisdom; with bold action and outside-the-box thinking that has helped put the brakes on our economic free fall," Obama said.
...
In a brief statement, Bernanke said the goals of his second term at the central bank will be fostering stable economic conditions and financial markets. "We have been bold or deliberate as circumstances demanded, but our objective remains constant: to restore a more stable economic and financial environment in which opportunity can again flourish," Bernanke said.

"Mr. President, I commit today to you and to the American people that, if confirmed by the Senate, I will work to the utmost of my abilities -- with my colleagues at the Federal Reserve and alongside the Congress and the Administration -- to help provide a solid foundation for growth and prosperity in an environment of price stability."

While Bernanke may face some testy questioning during his confirmation hearings this fall, a result of last year's bait-and-switch bank rescue package and other questionable dealings with giant Wall Street firms while standing at the side of former Goldman Sachs CEO Hank Paulson at the Treasury Department, approval for a second term is a virtual lock.

This is good news for financial markets in general and will likely spur even higher prices for many commodities, one commodity in particular.

You see, Ben Bernanke has been a veritable one-man gold price appreciation machine.

References to the government's printing press earlier in the decade and his eagerness to use it as Fed chairman apparently have a way pushing the gold price higher.

Since his initial nomination in 2005, when gold was trading at only about $465 an ounce, the yellow metal has more than doubled, besting just about any other asset class during that time, so gold bugs should welcome today's news.

Let's just hope that the next four years are as good as the last four - $2,000 an ounce gold in the year 2013 when it comes time for his next re-nomination sounds about right to me.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Bad Assets Could Lead To Japanese Style Lost Decade

Mark Thoma from Economist's View makes the point that we need to address the bad assets that large banks are still trying to put off dealing with. Simply ignoring the problem could result in a Japanese style lost decade according to economist Keiichiro Kobayashi. See the following post for more on this.

[More Side of the road blogging - stopped for a moment at the Great Salt Lake.] When I talked to the senate's COP panel, one of many things that I emphasized was the need to develop plans in advance to deal with various contingencies. Without such plans policy actions - even justifiable ones - appear ad hoc and also face resistance that delays their implementation or prevents them from being put into place altogether.

For example, we need a plan on the shelf and ready to go for dismantling large banks that have failed, something that has received a lot of attention. It has received much less attention, but I also think we need a plan for disposing troubled financial assets when the need arises. I still believe that the crisis would have been much less severe if very early, prior to Lehman for sure, the government had moved aggressively to buy bad assets from bank balance sheets. it took far too long, and when they finally decided to do this (i.e. the original Paulson plan), they had no idea how to value the assets, there was considerable political resistance because nobody knew how the program would work (allowing lots of false information to enter the debate), and so on, and this program never really got off the ground. The assets are still there waiting for the miracle of rising asset prices to restore their value.

Having a plan ready in advance that specifies how assets will be valued, how taxpayers will be protected if the government overpays (overpaying can help with recapitalization, but it shouldn't be a gift), and so on, a plan that has been approved in advance by legislators (at least implicitly) so as to reduce political resistance, will overcome many of the technical problems and objections that prevented the bad asset removal programs from being used effectively in this crisis.

Keiichiro Kobayashi believes these toxic assets, many of which are still hidden on bank balance sheets, are still a problem and could result in a Japan style lost decade if the government does not remove them, and he calls for a new macroeconomic paradigm that puts these issues front and center (On his main point about whether financial sector recovery is necessary before the real economy can recover, I think we will recover either way, but agree that recovery would be faster if these assets were removed once and for all - but I should get back on the road...):

Why this new crisis needs a new paradigm of economic thought, by Keiichiro Kobayashi, Commentary, Vox EU

This post has been republished from Mark Thoma's Blog, Economist's View.

Foreclosure Numbers Going In Wrong Direction

As long as foreclosures keep climbing, the housing market will be poisoned with bank owned properties. Now it's not just sub-prime or ARM borrowers that are defaulting but the average American with solid credit who are now driving up foreclosure numbers. See the following article from Mortgage Roadmap that discusses the worsening foreclosure epidemic.

The news on housing foreclosures isn't getting any better. In fact, it's getting worse.

According to a story in the Wall Street Journal, one in every eight U.S. households with mortgages was either in foreclosure or behind on its mortgage payments in the second quarter of this year.

The most frightening thing about these new numbers is that many of these foreclosures on on households with good credit that took out safe, conservative mortgage loans.

The national economy, of course, is the culprit here. Too many people have lost their jobs during this economic slump. And they're not able to find new ones. Suddenly, a mortgage payment that was doable during good times is an impossibility.

The bottom line, unfortunately, is that the foreclosure crisis won't ease until the nation's unemployment rate starts seriously dropping. Homes became far too expensive during the recent housing boom. This means that mortgage loans, and the monthly payments that come with them, took up a greater percentage of homeowners' monthly income.

We are now seeing the results: When the economy is sailing along, and jobs are plentiful, homeowners can make their mortgage payments. When a bump occurs, though, and jobs start disappearing? Those mortgage payments are far out of reach for too many homeowners.

This article has been republished from The Mortgage Roadmap.

Letting The Stimulus Run Its Course

Local governments that cut their budgets may be undermining the efforts of the federal government to stimulate the economy and may kill the momentum that the stimulus has generated. The following post from the Economist's View discusses Cornell economist Robert Frank's argument on why we can't afford to let the stimulus fizzle.

Robert Frank makes two points. First, state and local governments facing budget problems due to the recession need more help from the federal government. Second, those who object to federal help for states, or to government spending to stimulate the economy more generally, "have not offered persuasive arguments":

Don’t Let the Stimulus Lose Its Spark, by Robert Frank, Commentary, NY Times: Encouraging economic news has been reanimating the critics of President Obama’s stimulus program. But heeding their admonition to end the program would be a grave mistake. We need more stimulus now, not less.

Even if the economy is improving, it is still very weak. Another quarter-million jobs were lost last month... Now we face an ominous new threat to recovery from sharp cuts in state and local government spending. ... These cuts were mandated by laws meant to stop politicians from spending beyond their means. While such measures may be beneficial on balance, sharply reduced government spending is exactly what the economy doesn’t need right now.

Through its legal authority to run deficits to stabilize the economy, the federal government can keep recovery on track by transferring revenue to states and cities. Of course, opponents of the original economic stimulus program have no desire to see it extended this way. Yet they haven’t made a persuasive case. The flaws in their arguments don’t rise to the absurd heights seen in recent town hall meetings on health care reform. But it is a difference in degree, not kind. ...

In a recent column in Forbes magazine, the economist Lee Ohanian of the University of California, Los Angeles, a stimulus opponent, explained why he believes that increased government spending wouldn’t help... The problem, he says, is that “the higher taxes on incomes or expenditures that ultimately accompany higher spending depress economic activity.” ...

His argument, and that of stimulus opponents generally,... boils down to this striking contention: As the government spends borrowed funds, consumers will start to realize that the resulting debt spells higher taxes in the future, which will lead them to curtail their current spending. Those cuts will offset increased government spending, leaving no net stimulus.

Although there may be people who would actually spend less now to hedge against uncertain future tax bills, it’s unlikely that you know any of them. As behavioral economists have been saying for decades, that’s just not the way most people act. Hardly any consumers even know how ... the national debt ... will affect future taxes.

More important, there are good reasons for believing that stimulus spending will make people’s future tax payments lower, not higher. Yes, government borrowing adds to the national debt. But if the stimulus also hastens the downturn’s end, it will accelerate the growth of future incomes and tax revenue. In that case, the net effect would be to reduce future taxes, compared with what they would have been without the stimulus. ...

The recent state and local spending cuts are a major setback to the stimulus program, which many economists have argued was much too small to begin with. A small minority disagrees but has not offered persuasive arguments.

The downturn threatens every goal we care about. Doing everything possible to limit state and local spending cuts will help end it faster.

Helping states is a good idea, and more help is needed. But that's not enough by itself to bring aggregate demand up to the necessary level, other types of spending are also needed (think of it this way - saving every state and local job that would be cut without federal aid is not enough to solve the employment problem).

However, a state that knows the federal government will step in and help if it gets into trouble may be unwilling to take steps to smooth the state's business cycle such as creating a rainy day fund (i.e., build the fund during boom times bringing output closer to its long-run trend, and spend the fund during the bad times also bringing output closer to its long-run trend). Because of this, if the federal government stands ready to backfill state budgets during recessions, we may want to require that states meet certain restrictions (such as having a rainy day fund of a particular size) before they can receive help.

Allowing state government to contract during a recession makes things worse, and I believe this recession will teach us that the federal government needs to provide much more help than it did this time around. But if the federal government does explicitly take on the responsibility to prevent state governments from contracting when the economy turns downward, then the obligations of local, state, and federal governments need to be clarified. We also need to make sure, as much as possible, that the states cannot game the system to their advantage.

Update: Brad DeLong adds, in reference to Lee Ohania's argument:

This is, as I say every day, simply wrong as a matter of very basic economic theory. Increased nominal government spending financed by future taxes is crowded out by a reduction in nominal private consumption spending if and only if what the government spends money on is a perfect substitute for what private consumers spend money on. That just is not the case.

This post has been republished from Mark Thoma's blog, Economist's View.

The Changing Face Of Distressed Homeowners

With the majority of distressed homeowners shifting from subprime borrowers to prime borrowers, Blown Mortgage asks whether the Loan Modification Program is focusing on the wrong group. With as many as 13.2% of mortgages near foreclosure, do these troubled homeowners have the help that they need?

Loan Modification figures right now are scary. According to one survey one in eight U.S households that have a mortgage are in foreclosure or will be soon. This puts great pressure on Government Institutions that are trying to help ailing home owners while the numbers just add up. It is like trying to build a dam while the river is still flowing.

As it often happens the problems Loan Modification Programs face are changing. While the focus of Loan Modification programs is on subprime loans (high interest loans generally purchased by people with low credit rating) a new demographic of struggling home owners is appearing.

Foreclosures of Sub prime borrowers that by some accounts ignited the banking crisis are actually slowing down while borrowers with good credit records are deteriorating faster due to falling home prices and job losses.

The MBA (Mortgage Bankers Association reported last week that 13.2% of mortgages on homes with one to four units were at least a month overdue or actually undergoing foreclosure. This a rather steep rise from 12.1% in the first quarter.

These figures are disappointing as many expected foreclosures to drop as home sales have picked up in the last months. However some analysts have commented that we shouldn’t expect significant improvement until 2010 when the economy really starts to improve.

This shift from the decline of sub prime borrowers to prime borrowers is illustrated by the percentage of prime and subprime foreclosures in the last year. Last year 44% of foreclosures were from prime mortgages, now the figure is around 58%. Last year 49% of foreclosures were from sub prime mortgages, now it is 33%. While sub prime mortgages are recovering, prime mortgages are suffering even more.

What can we learn from this?

It could be good news for the measures the administration. We could read this shift as proof that the demographic the administration has chosen to focus their energies on is benefiting from that help and digging itself out of the whole while the demographic that is not highlighted in the programs measures continues to fall.

It is interesting that more than 235,000 borrowers have started a three month loan modification trial under the current administration under the effort of the administration to reduce monthly mortgage payments. But do these loan modifications target the real problems.

Most of these loan modifications target loans that reset to higher interest rates or to home owners with high debt to income ratios. In other words these loan modifications seek to help people who fell for high interest mortgages when the housing industry looked like it was going to soar forever. The idea behind the loan modification programs is to allow borrowers to benefit from the current low interest rates.

However prime borrowers that have gone through dire straits struggle to receive the benefits of this program.

This post has been republished from Blown Mortgage.

Bailout Nation: A Scathing Critique Of Greenspan's Fed

For a book that explores how we got into the current financial mess, check out Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy. Author Barry Ritholtz casts former Fed Chiarman Alan Greenspan as one of the villains for his flawed leadership and misguided policy. Tim Iacono from The Mess That Greenspan Made reviews the book:

For some time now, I've known that Barry Ritholtz's new book Bailout Nation was definitely not going to be kind to former Federal Reserve Chairman Alan Greenspan, but, had I known that it would offer the most damning critique of his term at the central bank, I certainly wouldn't have let the book sit on my desk for the last few weeks before finally picking it up the other day and polishing it off in record time.

With the subtitle How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, it was natural to think the focus might be more on greed than easy money, but that's really not the case.

Greed is a constant on Wall Street and, for that matter, in most of the rest of the world, but financial systems don't implode unless generously lubricated with easy money, bailouts, and moral hazard - key elements of the Greenspan legacy.

Ironically, Fed economists and assorted hangers-on are meeting in Jackson Hole this week to deliberate on what's changed in the world of finance and monetary policy over the last year.

It was four years ago at that same gathering (i.e., before the housing and credit bubbles met their respective pins) that some were still lauding the former Fed chief as "the greatest central banker of all time" in something of a "going-away" party.

I wonder if his name will come up at this session...

Anyway, the book is not only fun-filled, thanks to the inimitable writing style of Mr. Ritholtz, but it's chock full of interesting little bits of information and perspective that, even to me, cast new light on what will surely be looked back upon as a disastrous period for central banking.

For example, it is common knowledge that Alan Greenspan was much more interested in asset prices than were his predecessors - they didn't coin the term "the Greenspan put" for nothing - but this passage gives the concept a bit more color.

History teaches us that the development of Bailout Nation, Wall Street edition, was not done in secret meetings. Rather, it occurred in the very public functions of the Federal Reserve, and the subsequent results of its policy actions.

The Greenspan Fed created an endemic culture of excessive risk taking. The U.S. central bank created moral hazard not by targeting inflation or the business cycle, but instead by focusing on asset prices. From the squishy focus on psychology, it was a short hop to asset prices. After all, when price go down, it negatively impacts sentiment, right? This was the Fed's fatal flaw under Greenspan's leadership.
...
The Fed's previous rate cuts had only implied a concern over asset prices; now, the chief explicitly affirmed the fact. The Fed was not concerned just about inflation and employment; asset prices were an "integral part" of its calculus, too.

This was revolutionary. Fed chiefs didn't usually care so much about stock prices; they were more concerned with the bond market. After all, it was the fixed-income traders - known as bond ghouls for their morbid affection for bad economic news - who set interest rates. Worries about deficits, inflation, and trade balances all found a receptive audience among the bond traders.

Once Wall Street figured out Greenspan was concerned about equity prices, it wasn't too long before it learned how to play the Fed like the devil's fiddle. When rate cuts did not materialize, the Street would have itself a hissy fit. It is always ill advised to anthropomorphize markets, but observing the market kick and scream when cuts weren't forthcoming was akin to watching a two-year-old throw a tantrum. It may be illegal to manipulate the markets, but no trader will ever got thrown in jail for manipulating Greenspan.

Unfortunately, the current Fed chairman seems to share this same trait.

Well worth reading...

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

How To Avoid The Coming Tax Bomb

One of the major consequences of the record federal deficit is that it will likely lead to a massive tax bomb in the future. And since the top 25% of American earners pay 87% of the taxes, you may want to pay close attention to the following article. Dr. Steve Sjuggerud from Daily Wealth explains how you can save thousands upon thousands by understanding a simple tax-saving tip.

A massive tax bomb will land on us soon...

You are foolish not to protect yourself from it. Today, I'll show you how to beat it.

Look, you know all about it... Our government has spent too much money. According to public awareness firm the Peterson Foundation, the government's debt was $184,000 per person in 2008. For my little family of four, that's $736,000 of government debt. And it keeps growing.

Take a look at the breakdown in 2008:



The government has to raise this money by taxing us, as citizens. But it doesn't tax all citizens, of course... Do you believe 43% of those filing returns pay no taxes at all? It's true.

So who does pay taxes? The top 25% of taxpayers (those with an income of $66,000 or higher in 2007) paid 87% of the taxes. Basically, the top 25% of taxpayers will be the ones paying this enormous debt.

In short, my "burden" is not just the $736,000 for my family... The government will use my taxes to cover its debts on three other families, too. So the government needs A FEW MILLION DOLLARS in taxes from me to pay its debts. Don't think it's just me... If you make $66,000 or more, you're in the same boat!

And that's just the old debt... New debts are ringing up every day. Literally. The national debt grows by a few billion dollars every day. I don't know about you... but I find it sickening.

So what can you do?

One big simple thing we can do to beat the tax bomb is convert our IRA to a Roth IRA...

The biggest difference between a Roth IRA and other IRAs is this: You put after-tax money into Roth IRAs... And because you've already paid taxes on that money, your future withdrawals, including gains, are tax-free.

Well recently, the rules have changed. Between the new rules and the coming tax bomb, you have to consider converting to a Roth IRA.

The government needs big tax dollars right now. So it's changed the rules on Roth conversions, in favor of big investors. Soon, regardless of your income, you will be allowed to convert your IRA to a Roth IRA. This is a foolish move for the government, but it raises money in the short term because you have to pay taxes upfront, so it's doing it.

The list of Roth IRA benefits is huge...

With a Roth IRA, your withdrawals are TAX-FREE. There are many positives to this:

1) If the government raises taxes (which it will), it doesn't hurt you.
2) You can pass it along to your kids or grandkids tax-free, where the assets will continue to grow tax-free.
3) You don't have to make any mandatory withdrawals like with a traditional IRA.

Heck, to me, the biggest risk – and I hesitate to even think about this – is that the government will change the rules again in the future. It shouldn't be able to... But hey, it's the government.

The rule change kicks in for 2010. The timing could be perfect...

You see, in order to convert your traditional IRA to a Roth, you do have to pay income taxes on the amount of the IRA for the year you convert. (That's what allows you to have it non-taxable forever.) You can convert under 2010 taxes, hopefully before tax rates go up. And at the same time, your tax bill for this could be smaller this year, as the stock market is still off of its highs.

Lastly, the government is giving you a special deal here (it needs your money!). If you want to convert, it'll let you stretch out the tax bill to convert over three years. So if you had a $100,000 IRA to convert, and your taxes due on that were $30,000, then you could stretch that $30,000 payment out for a few years.

I hope I didn't make it sound too complicated. Because it's not. In short:

Convert your traditional IRA to a Roth IRA. Pay the income tax at the current lower tax rates on that money. And then you (and even your heirs) will never have to pay taxes on that money again. Inflation won't hurt you, nor will higher taxes, and you get to keep all your profits, tax-free. Good stuff!

This post has been republished from Daily Wealth.

Preparing For The Consequences Of The Great Stimulus

While the aggressive action by the government may have prevented a depression, Warren Buffet is one of the many who are concerned about the future side effects on the economy. Is now the time for the Fed to start tightening monetary policy to prevent economic fallout? James Picerno from The Capital Spectator discusses why we should be shifting more attention to the future.

Warren Buffett advises in today's New York Times that the Great Stimulus must one day be clipped as the Great Recession fades. As the Oracle of Omaha explains, the "enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects."

We've been making a similar argument for some time, although the cause seemed lost when we advised in May that the crowd should recognize that the Federal Reserve must begin raising interest rates at some point. That future has been easily ignored, and perhaps for obvious reasons, given the economic events of the past year or so. But the arrival of Buffett's warning suggests that sentiment may be set to turn by focusing the crowd's gaze on the inevitable. If so, that's healthy, if only because recognizing the risks that loom, as opposed to the ones that just passed, is always a productive exercise in managing money and otherwise boosting one's odds of survival.

As we wrote in May, "At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard. We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming."

If more pundits and policymakers are on board with this outlook, chalk up another win on the side of progress. But lurking behind this rise in enlightened thinking is another problem, which can be summed up as the expectation that the central bank will begin tightening at a time when it's clear that the economy is on a sustainable path to recovery. A nice idea, but like fairy tales and campaign promises, danger lurks in accepting such notions without question.

For the same reason that mere mortals can't hope to sell exactly at market peaks or buy at bear-market bottoms, the Fed is destined to be early or late at the start of the next great change in monetary policy. This is a critical point because it belies the notion that the Fed will be able to tighten monetary policy at just the right time and keep everyone happy in the process. Wrong. Not only does the Fed face a tough challenge in purely monetary policy terms, the potential for political and even economic fallout are commensurately large as well.

Central banks, like the rest of us, are making real-time decisions with lagging data. Even worse, it takes time to assess if the decisions were timely, or not. The folly or fortune of policy choices made today will be evident a year or two hence. It's a bit like a surgeon working in the dark and then finding out a year later if the patient survived.

So be it. That's how running fiat currencies works: it's a job that's highly subjective in real time. The question is whether the crowd understands what's coming. Normally, the margin for error is relatively wide in the highly subjective business of central banking. These days, that margin has shrunk considerably, even if the ramifications won't be obvious for several years.

No one will ring a bell at the ideal moment for tightening. The fact that the Fed's timing wasn't perfect in the years running up to the Great Recession reminds that fallibility infects the institution, just as it does every other area of human decision making.

What's more, when the Fed launches the new monetary era, the criticism is likely to be deep and broad, from politicians and investors, businesses and the people on the street. No one has perfect information and insight, but that doesn't stop anyone from thinking (and speaking) as if they did. The net result: lots of noise and confusion.

With the benefit of hindsight at some point, it's a virtual certainty that we'll recognize that the Fed was too early, or too late. Heck, maybe they'll get it exactly right this time, although we're not holding our breath. In any case, such things can only be determined after the fact.

The stakes are high, perhaps unusually high compared with previous business cycles of recent vintage. But at least we know what the two main threats will be. On the one hand, the central bank runs the risk of choking off the incipient recovery by tightening too early. At the other extreme, the central bank may wait too long and thereby give inflationary pressures a foundation to pester the economy for some time after.

No, these risks aren't absolute. One or the other may arrive but in moderate form, which still leaves the natural forces of inflation-adjusted growth to dominate eventually. Nonetheless, let's not forget that one or the other still looms. Markets and economies are forever evolving, as are the embedded hazards and opportunities. Perhaps the biggest risk of all is thinking otherwise.

This post has been republished from James Picerno's blog, The Capital Spectator.

Chinese Investment In Silver Could Push Up Prices

Now that Chinese citizens are not only allowed to invest in silver, but encouraged to, there is reason to believe that this could push up silver values. The Chinese are savvy investors and are skeptical of the security of American dollars, which may mean a shift to greater investment in precious metals like silver and gold. The following article from Daily Wealth explains why an increase in Chinese demand for silver can have a significant impact on prices.

Two years ago on August 21, China's government allowed its citizens to invest in an entirely new asset. It allowed them to invest in Hong Kong-listed stocks.

Hong Kong is a special region of China. It's one of the most dynamic, capitalistic places on Earth. The move from the government was a move toward "investment freedom" for the Chinese people.

On that day, Hong Kong's benchmark stock index rose 8.74%. Over the next two and a half months, it skyrocketed from 11,000 to over 20,000. It was a chapter in a story that you should get used to over the coming years: When the Chinese decide to invest in something, it causes giant ripples across the world.

This sort of situation is starting to happen again: This time it's happening in precious metals... especially silver.

The Chinese have a centuries-old affinity with silver. It began in the 1500s with the explosion of trade with Mexico via the Spanish galleons. These sailing ships were the super-tankers of their age. They made one voyage per year, carrying tea, silks, and spices from Asia to Mexico. The ships returned to Asia with gold and silver. After the Chinese threw off imperial rule in 1912, the country used silver money. Today, the Chinese word for "bank" means, "silver movement."

And now that China is becoming one of the richest, most dynamic capitalistic countries on Earth, this story is about to take a modern twist. The Chinese want silver again.

Thanks to a decade of wealth accumulated by regular Chinese citizens, there is plenty of cash to chase good investments. As the famed global investor Jim Rogers points out, these people are the best capitalists in the world. They are great savers. Chinese people want their money to work for them... so they invest.

I recently watched a China Central Television piece on gold investing... According to the program, there are some 400 million households in China, with an average ownership of about 0.1 ounces of gold. The average gold ownership in most emerging countries works out to about 1 ounce per household. The Chinese are beginning to make up that gap. From 2006 to 2007, domestic demand for gold rose 60% to around 700,000 ounces. Experts continue to urge citizens to put 3% to 5% of their net worth in precious metals.

Chinese government statistics show the average urban Chinese household has about $1,300 in disposable income to invest. While that doesn't seem like much, when you add up all those households, there's about $36 billion that could move into the next big investment opportunity – precious metals.

The government is now actively encouraging its citizens to buy gold and silver. They recently unveiled silver bullion for investing (you can see the video here). The premise is that gold was 50 times more expensive than silver in 2007... but is now 70 times more expensive.

The government is promoting silver bullion as an investment for regular citizens. And remember, a bunch of Chinese students laughed at U.S. Treasury Secretary Tim Geithner this year when he claimed the dollar was safe. The Chinese know the value of real assets... real money like gold and silver.

What does this mean for silver prices? It's impossible to say. But here's a little math that interests me. According to the Silver Institute, demand for silver in 2008 (for industry, jewelry, and investing) was 832 million ounces. At today's price, that's an $11.5 billion market... or about 1/3 the capital available in China alone.

The most important thing to understand about this situation is the Chinese people become freer every time the government loosens up a restriction. These people couldn't legally buy silver bars before. Now, they can. They're becoming richer... and they will continue to do so for decades.

Add this to a world already waking up to the grand currency debasement you've read about in DailyWealth (like here and here), and you have a recipe for the continuation of the big bull market in silver and other precious metals.

This post has been republished from Daily Wealth, an investment analysis and advice site.

Why Mortgage Loan Modification Is Not Catching On

The government has invested a lot of political capital, in addition to actual capital, to help struggling homeowners stay in their homes through mortgage modification. However the government is finding little success with this program for a variety of reasons. The following post from Blown Mortgage explains some of the reasons for this.

Home loan modifications have been presented as the silver bullet that will kill the evil wolf scaring the living daylights out of investors and homeowners. The government does seem to be willing to place its money (or own money) where their collective mouth is. The White House has invested $75 billion of our hard earned bucks into the Making Homes Affordable with the hope that it will prevent 3 to 4 million Americans from losing their home to a bank foreclosure.

Unfortunately the plan is not exactly burning rubber and is off to a slow start. At the moment only 9% of eligible homeowners are taking advantage of the loan mod plan and have modified their loan terms. The government is not happy with these figures and have begun to pressure and arm-twist banks and lending institutions to get their finger out and start modifying. In a recent report the government named and shamed banks that were not pulling their corporate weight behind the mortgage modification program and are not facilitating the modifications borrowers need.

Why is this the case? Why are banks so slow to act?

There are various reasons, most of which we have already discussed in articles here at blownmortgage.com. These include:

1) Banks are not currently set up for loan modifications. They are set to sell loans and then collect the payments not reduce principals and reduce interest.
2) The large volume of loan mod applications in such a short period of time.
3) Lack of information and understanding about the program and how it works.
4) Mortgage backed securities.

Why mortgage backed securities?

Mortgage backed securities are products like futures and stocks companies can buy or sell. Obviously just like with the purchase of the stocks of a company the purchase of mortgage backed securities provides the owner with a say on how the mortgages are managed.

This is well illustrated by the story of many homeowners that cannot modify their loans because the company that has bought a security backed by their mortgage will not allow them. For instance Wells Fargo may say no to a loan modification you request even though they don’t own your mortgage.

This is caused by ambiguous rules and a rather shady web of interests and ownership. This is rather sad because it means that the group that is more likely to need help, those whose mortgages were sold or used as a security cannot receive the loan modification they need to stabilize their situation.

This article has been republished from Blown Mortgage, a mortgage news and analysis site.

Why We Should Regulate Banks Immediately

Despite the banking sector's large role in crashing the economy there are still some who oppose increasing bank regulation. Harvard Economist Kenneth Rogoff, discusses why we need to regulate banks as soon as possible. Mark Thoma summarizes his commentary below.

Kenneth Rogoff warns us not to believe those who argue that the crisis was largely due to government failure, and hence that regulating the financial sector is counterproductive and unnecessary:

Why we need to regulate the banks sooner, not later, by Kenneth Rogoff, Commentary, Financial Times: When in doubt, bail it out,” is the policy mantra ... after the ... collapse of Lehman Brothers. With the global economy tentatively emerging from recession, and investors salivating over the remaining banks’ apparent return to significant profitability, some are beginning to ask: “Did we really need to suffer so much?”

Too many policymakers, investors and economists have concluded that US authorities could have engineered a smooth exit from the bubble economy if only Lehman had been bailed out. Too many now believe that any move towards greater financial regulation should be sharply circumscribed since it was the government that dropped the ball. Stifling financial innovation will only slow growth, with little benefit in terms of stemming future crises...

Certainly the US and global economy were already severely stressed at the time of Lehman’s fall, but better tactical operations by the Federal Reserve and Treasury, especially in backstopping Lehman’s derivative book, might have stemmed the panic. Indeed, with hindsight it is easy to say the authorities should have acted months earlier to force banks to raise more equity capital. The March 2008 collapse of the fifth largest investment bank, Bear Stearns, should have been an indication that urgent action was needed. Fed and Treasury officials argue that before Lehman, stronger measures were politically impossible. There had to be blood on the street to convince Congress. ...

[C]ommon sense dictates the need for stricter controls on short-term borrowing by systemically important institutions, as well as regularly monitored limits on oversized risk positions, taking into account that markets can be highly correlated in a downturn. ... There should also be more international co-ordination of financial supervision, to prevent countries using soft regulation to bid for business and to insulate regulators from political pressures.

...The view that everything would be fine if Hank Paulson, then US Treasury secretary, had simply underwritten a $50bn bail-out of Lehman is dangerously misguided. The financial system still needs fundamental reform...

I think that even if Lehman had been bailed out the economy would still have been bad, just not as bad, so either way there are substantial economic costs and a case for regulation.

This article has been republished from Mark Thoma's blog, Economist's View.

Things To Look For In An Economic Tipping Point

Economist Mark Thoma from Economist's View discusses what to look for in an economic tipping point. He describes the specific conditions that will need to occur that will demonstrate that the economy is on solid footing and has the legs to generate self-sustaining growth. However, if these conditions do not occur, we may be looking at a double-dip recession. Continue reading to learn more.
One question I am asked fairly often is how we will know when the economy turns the corner and we are on our way to a solid recovery. My answer is that we will be able to detect upticks in the data, though this may come with a bit of a lag, the important but harder task will be to understand why the data are showing improvement.

In order to be convinced that the economy is on solid footing and headed to better times, I will want to see several things. First, though not necessarily foremost, that banks are being recapitalized with private sector funds, and that this is happening without the aid of government guarantees or other such programs that encourage capital infusions (which is hard to determine while the government programs are in place). Second, I will want to see private sector non-residential investment improving, another sign that private sector funds are moving back into circulation. Presently, this hasn't even started heading back upward, though there are signs the decline is slowing:



And there are other important factors too, e.g. consumption rebounding (though not to pre-crisis debt sustained levels), stabilization in housing markets, and so on. The point is that a self-sustaining recovery will require that the private sector be the primary driver of new economic activity, and that is what I will be looking for.

Once the economy does start to recover, the hard but critical part will be to determine how much of the recovery is self-sustaining (as it will be if private sector funds are driving the activity), and how much is being driven by government stimulus programs. If the recovery is self-sustaining, and we are fairly certain of that, then we can begin to carefully wind down the government programs supporting the economy. But if the recovery is mostly due to government stimulus and there is little sign that the financial and real sectors are attracting robust levels of private sector funds, then pulling back on government programs could be disastrous and plunge the economy right back into recession. In fact, in such a case, we may need to provide even more stimulus to fully bridge the gap until the private sector can support the economy on its own.

So, in answer to the question, we will have a pretty good idea when the economy turns the corner, but it will take awhile to determine why, and we cannot risk pulling back on government programs until we are sufficiently certain that the private sector can support normal economic activity without the government's help.

Update: Nouriel Roubini:

A Phantom Economic Recovery, by Nouriel Roubini, Commentary, Project Syndicate: Where is the US and global economy headed? ... Data from the US ... suggests that the US recession is not over yet. A similar analysis of many other advanced economies suggests that, as in the US, the bottom is quite close, but it has not yet been reached. ...

Moreover, for a number of reasons, growth in the advanced economies is likely to remain ... well below trend for at least a couple of years.

The first reason is...: Households need to deleverage and save more, which will constrain consumption for years.

Second, the financial system ... is severely damaged. Lack of robust credit growth will hamper private consumption and investment spending. Third, the corporate sector faces a glut of capacity... As a result, businesses are not likely to increase capital spending.

Fourth, the releveraging of the public sector through large fiscal deficits and debt accumulation risks crowding out a recovery in private sector spending. The effects of the policy stimulus, moreover, will fizzle out by early next year, requiring greater private demand to support continued growth. ...

There are ... two reasons to fear a double-dip recession. First, the exit strategy from monetary and fiscal easing could be botched, because policymakers are damned if they do and damned if they don’t. ...

A second reason ... concerns the fact that oil, energy and food prices may be rising faster than economic fundamentals warrant, and could be driven higher by the wall of liquidity chasing assets, as well as by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy... The global economy, barely rising from its knees, could not withstand the contractionary shock if similar speculative forces were to drive oil rapidly towards $100 a barrel.

So, the end of this severe global recession will be closer at the end of this year than it is now, the recovery will be anemic rather than robust..., and there is a rising risk of a double-dip recession. ...

This article has been republished from Mark Thoma's blog, Economist's View.

The Highest Real Yields For Treasuries In 15 Years

Treasury notes are looking very attractive due to the deflation of the consumer price index in the first half of the year. A nominal 10-year Treasury note at 3.5% would translate into a real yield of nearly 5.5%. However, if you believe that inflation is around the corner, treasuries may be a very unprofitable investment. James Picerno from The Capital Spectator explains.
The highest real (inflation-adjusted) yields in 15 years for Treasuries are boosting demand, Bloomberg reported at the end of last month.

Halfway through August, there's no reason to think otherwise. The 10-year's yield hasn't changed much in recent weeks, closing yesterday at roughly 3.59%. Meanwhile, inflation, as defined by the consumer price index, appears in no imminent threat of rising.

The July CPI report shows that inflation was flat last month, the Bureau of Labor Statistics tells us today. For the 12 months through July, CPI was negative to the tune of -1.9%, the steepest fall in 60 years.

On the surface, it looks like deflation is roaring. But this bite is worse than it appears. The year-over-year comparisons for CPI are troubling, but it's temporary. Recall that oil prices hit an all-time high in July 2008. The energy driven inflation wave, as it turned out, wasn't set in stone either. But the damage to the inflation numbers was done and that legacy remains intact. As a result, comparing overall prices today with those of a year ago is doomed to reflect sharp price declines.

Meanwhile, energy prices fell sharply after peaking in the summer of 2008, along with prices of virtually every thing else. A repeat performance isn't likely, or so the stabilizing global economy suggests. Indeed, the price of crude seems to have found stability too. The implication: inflation won't be falling on a year-over-year basis when we look at the numbers in the quarters ahead.

Barring a sudden reversal of the stability that seems to be settling into the economy, the year-over-year CPI change is likely to be showing more modest comparisons by the end of this year and through 2010. Why? Because, you may recall, the world fell apart in the second half of 2008, dragging broad price indices down the rat hole in the process. Once we get to December 2009's CPI numbers, however, we're likely to see the case for deflation on a 12-month basis looking a heck of a lot weaker if not evaporating completely, assuming we don't resume an apocalyptic decline, which looks unlikely at this point.

Meantime, adjusting the 10-year Treasury Note by 12-month changes in CPI makes for an alluring chart, as our graph below shows. For July, the 10-year's CPI-adjusted yield was 5.46%, up from September 2008's negative 1.25%.

By the available numbers, buying the 10-year looks like a no-brainer. Prices generally are falling by nearly 2% a year. Meanwhile a nominal 10-year Treasury offers well over 5% real. A great buy, right?

We're suspicious. Unless you're expecting deflation to roar on, which we don't, the real yield in nominal Treasuries looks like a trap. Here's our reasoning. First, only nominal yields are set in stone with nominal Treasuries, which means that real yields for this series of government bonds can and does fluctuate.

For instance, let's say you bought the nominal 10-year Treasury at last night's close of 3.59%. Using the latest CPI report for July, that translates into a real yield of 5.49%. Nice. But imagine a year from now that CPI's running at, say, a positive 2% year-over-year pace, which isn't beyond the pale. Net result: your current real yield of 5.49% evaporates to 1.59%. (Remember, the nominal yield of 3.59% at the purchase date is fixed; only the inflation rate changes.)

As it turns out, a 10-year TIPS currently offers a similar real yield—1.80% as of last night's close. The big difference: the 1.80% real yield for the TIPS is fixed whereas the real yield for nominal Treasuries changes.

The bottom line: unless you're expecting deflation to continue or get worse, the real yield in the nominal 10-year looks dubious. Does that mean you shouldn't own Treasuries? No, since government bonds serve various purposes in a multi-asset class portfolio. But buying solely for the high real yield of the moment is too speculative at this juncture, at least for this observer.

To be fair, no one can predict inflation with any certainty and so a passive investor would own TIPS and nominal Treasuries as a hedge. Otherwise, this is no time to bet the farm on conventional Treasuries. Sitting on huge gains over the past year—indeed, over the past generation, the hour is late for expecting continued success with "risk free" bonds sans inflation protection.

This article has been republished from James Picerno's blog, The Capital Spectator.

Deflation Risk Averted But Could Massive Inflation Be Around The Corner?

By creating nearly $4 trillion in new money and credit, representing the largest increase by the American federal government since the country's Civil War, the monetary system has been repaired and deflation is no longer an imminent risk. But a lack of political will and continued annual deficits in excess of $1 trillion through 2016, along with significant pressures in the economy, could likely lead to broad inflation over the next two years, with gold and strategic assets offering potential shelter from the expected storm. Porter Stansberry from Daily Wealth discusses this below.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.
– Ludwig von Mises

For most of 2009, I've had a friendly disagreement with several colleagues who believe a big deflation will be the end result of the 2008 financial crisis.

I knew they were wrong. I knew inflation would become a problem sooner, rather than later. And in the past several months, I've been proven right.

The mortgage and banking collapse of 2007-2009 saw total collateral values collapse between $5 trillion and $10 trillion. The response from our politicians and central bankers was massive: the largest creation of new money in credit since the Civil War.

The Federal Reserve created roughly $2 trillion in additional credit and loaned it against all kinds of dubious collateral, things like Bear Stearns' mortgage book. (There's a handy and simple guide to estimating the Fed's credit quality. The more acronyms in the lending programs, the worse it gets.)

The Federal government responded with a record annual deficit of at least $1.8 trillion. In the second half of 2008, the outstanding federal debt grew by roughly a 40% annualized pace (24% for the entire year). Thus, in only a few months' time, the roots – the money and credit – underlying our economy expanded at a record pace.

In the second half of last year and the first quarter of 2009, the main question in the world's financial markets was: Can the world's government print enough money, fast enough, to forestall a deflationary collapse?

I knew it was no contest. There is no way for an economy to outrun a printing press. The Fed has the power to create an unlimited amount of money or credit and the power to inject that money into the economy in any way it sees fit.

Let's look at the numbers. Let's assume the total collateral damage of the banking crisis turns out to be $5 trillion. Yes, that's a huge hit – roughly half the output of our economy each year. It's the equivalent of sending every American household a bill for $50,000 – due immediately. However, in less than a year, the Feds have already created nearly $4 trillion in new money and credit. The hole in the system has already been plugged. It only took a few months.

The fight between inflation and deflation is over. Deflation was knocked out in the first round.

The big risk is what happens next. Having turned on the presses to save the day, who will have the political clout and the desire to shut them off? Barack Obama's budget calls for annual deficits in excess of $1 trillion for the next eight years. Thus, by the end of this year, not only will all of the damage from the mortgage collapse ($5 trillion) be replaced by new money and credit, there will be significant inflationary pressures in the economy.

The good news in our economy this year, so soon after such a major collapse, means we will certainly have a massive inflation during 2010 and 2011. There's no such thing as a free ride. Bailing out the banks will carry a heavy price for anyone who doesn't have the resources or the knowledge to escape the dollar.

How can you "escape"? First off, make sure you own plenty of gold bullion. I also recommend owning assets that will run higher in an inflationary environment, like vital transportation and energy assets. Also, own some good farmland. Food and land prices will go higher.

Yes, the news is grim... but if you own gold and strategic assets, you'll survive and prosper in the coming inflation.

This article has been republished from Daily Wealth, a contrarian investment analysis and advice site.

Public Sector Versus Private Sector: Why We Need Both

The ongoing debates regarding private versus public service often references the presumed edge of the private sector regarding cost and innovation. This completely ignores times and ways the public sector can force the private sector to deliver innovation at minimal cost: a consideration integral to questions of health care in the US. Mark Thoma from the Economist's View discusses this very timely issue.

The public option for health care appears to be dead, so this is a bit late, but I keep hearing that there are no examples of public-private competition, let alone successful ones. But there are examples of this, and they have been successful.

We are used to the argument that the private sector can discipline and usually beat the government in terms of providing services at minimum cost (though I should note that is not always true). What is harder to find is anything written on how the government can do the same to the private sector, force them to provide innovative services at minimum cost (the point of the public plan in health care), partly because nobody ever seems to ask that question. Thus, an important part of this description of public-private competition to provide garbage collection services in Phoenix to note is that the discipline runs both ways, government forces the private sector to lower costs and be innovative, and the private sector forces the government to do the same (e.g. see the part at the end where the private firm loses the contract to the government and vows to win the next contract with its experimental truck).

This article was written in 1984, so it is untainted by the current debate, but this was also a time period when there was a lot of enthusiasm and interest in privatization. Hence, many of the articles written around this time are slanted toward examining how the private sector can discipline the government, not the other way around. Still, the story below makes clear that the city did force the private sector to continue to innovate and improve. Another interesting point is that the private sector contractor claims that the bidding process is much improved when the city is forced to participate (e.g. in specifying specs, see the full article for more on this point), a benefit of public-private competition that is often overlooked (I couldn't find much written on the Phoenix experiment more recently, so I don't know for sure how well the program has performed since the 1980s and 1990s when most of the articles on the Phoenix experiment appeared, but it does appear that currently the city won contracts in two of the three regions where private sector competition is present):

Entrepreneurs Can Do Everything Government Can Do, Only Better, by Eugene Linden, Inc., Dec. 1, 1984: Chuck Walbridge and Ron Jensen both see themselves as solid businessmen. There is a certain irony in this perception: Although both may be solid, Jensen is not a businessman at all, but a government bureaucrat.

That hasn't kept him from competing with Walbridge, however. Last year, for example, the two bid on the same contract, with Walbridge coming up the winner. Jensen has vowed that it won't happen again."We will be analyzing every cost to see where we might have gone wrong," he says. Walbridge, for his part, admits that Jensen is a tough competitor...

Jensen is director of the Public Works Department of Phoenix -- a city that regularly invites private companies to bid against its own agencies on various contracts. It was such a contract, the one for garbage collection, that was awarded in the summer of 1983 to Walbridge's company...

The ... concept behind privatization is not as new as it may seem. U.S. government administrations have long vacillated between providing services themselves and contracting them out. During the early 1800s, for example, privately operated bridges, tollroads, fire departments, and street lights were commonplace. Subsequently, gross abuses by both private contractors and public officials led to an outcry that caused governments to start providing the services themselves. Now the wheel has turned full circle, and privatization is seen as a solution to the problem of governmental bloat -- a way for governments to provide improved public services and reduce expenditures at the same time. ...

Walbridge's company, National Serv-All, is a 27-year-old, family-owned garbage-collection and -disposal business... It was Chuck Walbridge's father, Glen, who launched the family in the garbage business ... in Anderson, Ind...

Chuck Walbridge, who took over in 1979, concentrated on learning the business: how to deliver the service and how to keep the customers satisfied. ... Small as the company was, Walbridge was keenly interested in efficiency and innovation, and he constantly searched for ways to lower costs and improve service. Toward that end, he struck up a relationship with International Harvester Co.'s engineering division, which was located in Fort Wayne, and began testing Harvester's new trucks, making suggestions about improvements. He also began designing his own vehicles, trying out different bodies and control systems. In his quest to keep up-to-date with the latest advances in garbage collection, he made his first trip to Phoenix in 1975.

At the time, Phoenix had not yet begun to contract out its garbage collection, but it did use an innovative collection system designed to minimize labor costs and beat the desert heat. The system was built around a fleet of one-person trucks with mechanical arms that could pick up large, standardized containers. (Today, such containers are so big that transients occasionally take up residence in them, and Walbridge instructs his men to shake the containers before dumping them.) Walbridge was fascinated by the idea and inquired where it had come from. He was told that Phoenix was working with a system developed by a small Arizona company with the unlikely name of Government Innovators Inc.

Government Innovators is a story in its own right. Founded in 1971, it had grown out of the lunchtime bull sessions of a group of entrepreneurially minded bureaucrats in nearby Scottsdale, Ariz. For entertainment, they had often brainstormed about how they would improve their departments if they could keep the money they saved. Among the ideas they came up with was one for automated garbage trucks. The idea seemed like a natural -- so much so that they even designed the equipment and went looking for a company to produce the system. When they found no solid offers, they decided to do it themselves, building the nation's first automated garbage-collection system within the Scottsdale Public Works Department. Subsequently, some of them left public service and formed Government Innovators.

Curious about the possibilities of such a system, Walbridge purchased one of Government Innovators' trucks and took it back to Fort Wayne. Over the next few years, he experimented with various modifications, which he discussed with people at the company. They were duly appreciative. ... Walbridge's knowledge of equipment and systems stood him in good stead in 1983, when National Serv-All suddenly found itself competing nationwide against the giants of the garbage-collection industry. ...

Walbridge was ... impressed with the situation he encountered when he returned to Phoenix in 1982. There had been changes since his first visit seven years earlier. For one thing, the city had begun inviting bids for city contracts, largely in response to the budgetary constraints arising from the tax revolt of the late 1970s. That was a situation faced by government officials all over the country...

The center of privatization activity in Phoenix has been Ron Jensen's Public Works Department, which began inviting bids on garbage-collection contracts in 1978. From the beginning, the city stipulated that the Phoenix Sanitation Division would hold onto 50% of the business, to ensure that garbage collection would continue in the event that a private vendor proved unable to deliver service for one reason or another. The other 50% was put out for bidding, with the sanitation division competing against private vendors for two of the four available five-year contracts.

To keep the department's bids honest, Phoenix arranged to have them prepared by the city auditor, who made sure that they represented costs fairly on a basis comparable to those used by the private contractors. This task was easier in Phoenix than elsewhere because the city uses cost accounting. Thus, for example, the city's equipment fleet is centralized in one division of the Public Works Department and then "rented out" to various departments at a per-mile or per-hour rate calculated to reflect overhead. Management overhead is likewise apportioned among the department, right down to a fraction of the city manager's salary.

All of these systems were in place in 1982 when Walbridge returned to Phoenix... Walbridge believed National Serv-All would be in a strong position vis-a-vis other competitors, thanks to his own knowledge of the city's equipment and collection system. "I had helped to design the [Harvester] trucks Phoenix was using," he says."We knew more about them than anyone else. While Waste Management and the others buy their equipment, we custom design our own. . . . One of the reasons we beat [both the giants and the city] was that we planned to take their bodies off and put our [more efficient] bodies on." Although the city did have an advantage in knowing the actual costs of maintaining the equipment, says Walbridge, "I felt we had about a 15% advantage in productivity. Our system would load barrels faster, and our compactors gave our bodies more capacity."

In the end, that proved to be the difference. Walbridge's winning bid for contained garbage was a mere penny lower than the city's (on a unit-per-household-per-month basis). Waste Management came in third, SCA Services fourth, and Browning-Ferris Industries fifth. The thinness of the margin notwithstanding, the city conceded defeat and awarded the contract to National Serv-All. ...

National Serv-All might lose the Phoenix contract when it comes up for bid again in four years. Not that Walbridge expects to lose. "Phoenix is exceptional as far as cities go," he says. "They have a better understanding of business, and they are fair." But, in a fair contest, he believes he can usually underbid a government agency. "A city is hobbled by a low-bid requirement in the purchase of equipment, which sometimes forces them to take equipment that may not be the best. I can buy what I want." That means, for example, that a city might be unable to purchase Government Innovators truck bodies, which cost 10% more than other models, but reduce overall costs by about 20%. Adds Kevin Walbridge, "We're motivated, while cities are still cities. They will always be bureaucratic."

Marvin Andrews and Ron Jensen don't agree. They believe that government workers can be motivated to keep costs down, if only because they want to hold on to their jobs. "Quite frankly, we learn from the experience of going through the contracting process," says Jensen. "When we lose a bid, it's up to us to figure out why we lost it. Where were our costs too high? Was it equipment costs? Labor costs? And this whole feeling of competition gets to the unions, too."

This past August, Jensen's department demonstrated just how serious it was about the process, turning in the low bid on a major contract for both contained and uncontained refuse. The city's bid, moreover, was low by a substantial margin, thanks in part to its planned purchase of a fleet of new trucks. National Serv-All -- which came in fourth in the bidding -- was taken by surprise. "What they did," says Walbridge, "was to tighten up their specs on their trucks. It was smart on their part -- the new truck is a first-class piece of machinery." Walbridge says he is now working on an experimental truck that will allow National Serv-All to do better the next time around.

While stimulated by the competition, Walbridge is still not thrilled by the Phoenix approach to privatization. Granted, it works in Phoenix, but elsewhere -- he says -- it is subject to abuse. After all, many governments are less scrupulous than Phoenix's, and Walbridge would prefer not to spend $30,000 preparing a bid only to find that the competition is rigged, or that the process is so murky that he cannot figure out what is going on."I understand a private bid, but it is very difficult to know how a city formulates its bids."

Walbridge's cautions notwithstanding, it is precisely the competitive discipline imposed by Phoenix's system that makes the city an attractive place for National Serv-All to do business. Only by applying private-sector standards to its employees and departments -- and by subjecting them to competitive pressures -- is the city government able to keep track of its real costs, and thereby to come up with detailed job specifications. Without competition, privatization in Phoenix would be subject to all the problems and pitfalls that Walbridge encountered in other cities.

From that perspective, the Phoenix system -- a system of sound management leavened with a touch of entrepreneurism -- may well hold the key to the future of privatization in America. If it does, Chuck Walbridge is liable to find himself competing with government bureaucrats like Ron Jensen for years to come.

Update: I meant to include this 2003 article as an example of government's ability to innovate:

Ron Jensen, Phoenix's public works director, was the driving force behind the development of the first automated collection truck system “He actually is the one who started the privatization effort here as well,” Franklin says.

Tinkering with Equipment

Obviously, automation relies on equipment, which Franklin remembers vividly as the biggest hurdle. “I started as a mechanic in 1979 and worked on the stuff that the city was running. Most of the equipment was farm machinery hydraulics and stuff built in the basement,” he says. “We had a hydraulics shop that had eight or nine people working internally, building a lot of components. We built our own lifts and did those things to support ourselves because the industry wasn't mature enough.”

This article has been republished from Mark Thoma's blog, Economist's View.