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The Honolulu Advertiser
Posted on: Sunday, March 30, 2008

Tax rebate advice, optimism in face of doomsday

Advertiser Staff

Hawaii news photo - The Honolulu Advertiser

Paul Brewbaker | Senior vice president and chief economist for Bank of Hawaii

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Each week Editorial and Opinion Editor Jeanne Mariani-Belding hosts The Hot Seat, our opinion-page blog that brings in elected leaders and people in the news and lets you ask the questions during a live online chat.

On The Hot Seat last week was Paul Brewbaker, chief economist and senior vice president for Bank of Hawaii, who answered questions on the economy, the housing market and more.

Here is an excerpt from that Hot Seat session. To see the full conversation, go to The Hot Seat blog at www.honoluluadvertiser.com/opinion and click on "The Hot Seat." (Names of questioners are screen names given during our online chat.)

Lisa: What's your take on the tax rebate the government is sending out? Do you think it will be beneficial to the economy? I think a lot of people will be paying bills or buying gas rather than splurging on something unnecessary.

Brewbaker: Well it seems certain that the breadth and anticipated duration of a U.S. economic slowdown following the extended housing recession (since 2005) and the more recent credit crunch, arising from the subprime mortgage meltdown and its financial fallout, warrant both monetary and fiscal countercyclical policy interventions.

The tax cut is the federal government's (fiscal) response. We saw similar responses, under different circumstances with difference in design and for different political reasons, in 2003 and 2001 under the current Bush administration. In this instance the Congress acted quickly to mobilize the response I say "quickly" recognizing that the execution lag is substantial for fiscal policy. In this case the checks come out late in the second quarter, were decided upon early in the first quarter, in response to a macroeconomic risk that began to emerge in the third quarter of last year. So much for Quick Draw McGraw (that's for all the boomer cartoon nerds).

The monetary policy response is, of course, ongoing and is executed by the Federal Reserve, the nation's monetary authority, which is nominally independent of the government. Congress acted quickly for another reason: it really had one shot at this issue. By summertime and the convention season, presidential electoral politics would have made reaching a decisive consensus much more problematic. Will it work? Well, more than nothing, yeah. Remember that even paying down your debt with a tax rebate means you aren't sacrificing current consumption that you would have had to otherwise, even if it isn't increasing your consumption per se. However, there is good literature to suggest that temporary tax cuts don't provide a beneficial impulse to consumption as large as permanent tax cuts (owing to the fact that consumption is really a function of so-called "permanent" income). So this impulse may end up a little weaker than hoped, plus it widens the federal budget deficit dollar for dollar.

Mel: We are hearing all of these doomsday predictions from leading economists regarding the economy and particularly the financial sector and the credit tightening. What would your advice be to investors? Is there significant risk in equities?

Brewbaker: Anybody who knows me would tell you that I am not a doomsday-type economist, so you have to take everything I say with a grain of eternally optimistic salt. My advice to investors is to consider whether, in the long run, the values you see in the stock market today are compelling to you, and whether their prospective returns based on today's prices, which are low and the idea that prices might hook back up to something like the prior trends will sufficiently reward you for the risk that you are going to bear in the short term by investing at these prices. If you can't take the heat, stay in cash for the moment until the dust settles, but there are certainly some bargains out there. All you can do right now is your homework and gauge whether the return-versus-risk calculation for you personally makes it worth getting back in. Then ask yourself: would I rather go to Las Vegas with this money or buy the S&P 500 Index?

Me, personally, I'm feeling more confident about equities this week, but as I disclosed at the outset I'm eternally optimistic. I know that's a stock answer (no pun intended) but you just have to do your homework and reckon whether prospective returns offset the potential risks and your tolerance for risk.

BP Prescott: With the value of the dollar falling, resulting in higher prices, especially on gasoline, do you think we will see an increase in homelessness? Are there any solutions?

Brewbaker: This is a microeconomic problem, mostly, not a macroeconomic one (although it has transitory macroeconomic implications).

The thing is this: Global petroleum really is more expensive now than it was before. Period. No way around it. For one thing, we're running out of it. For another, everybody else on the planet wants their share of what's left. So, much of the recent increase in petroleum prices isn't going away. This means that the relative price of petroleum-fired energy, whether it's liquid fuels or household fuels or the pass-through impact to transport costs of items on the grocery store shelf, that relative price is now higher and people just have to make the substitution responses that will mitigate the impact on their budget. Substitute away from the more expensive, petroleum-fired behaviors and toward the alternates. That substitution is not easy (it's nearly impossible in the short run), but it must and will occur over time. It means giving up that SUV eventually. It means changing all the lamps in your household. Maybe it means installing photovoltaics on your rooftop, I don't know, people tend to work this out on their own, people and businesses. But there's nowhere to hide from it. I wouldn't co-mingle the homeless problem with the energy problem, analytically or from a policy standpoint, but I would recognize the latter (homelessness) as worthy of both (analysis and policy intervention).

Thomas: What is the outlook on the housing market on O'ahu? Are mortgage rates expected to drop significantly?

Brewbaker: I expect home prices on O'ahu (at the median) to drift downward slightly, from $625,000 to just over $600,000, during the next several years. See the March 2008 construction forecast at www.uhero.hawaii.edu for details. Mortgage rates went higher this quarter because the risk premium from the recent financial turbulence widened relative to yields on the benchmark 10-year U.S. Treasury Note. I expect that risk premium to narrow, but ultimately I expect the 10-year T-Note yield to increase from today's 3.50 percent to something (in 2009) closer to 4.50-5.00 percent. Which comes faster is an open question. The risk premium, I bet, narrows faster than the 10-year T-Note yield rises, but that guess and $4.50 buys you a mini-plate lunch so that's what that's worth.

James in Makiki: Isn't Hawai'i's housing market artificially high? Have we felt the subprime fallout yet and to what degree can we expect to? Can anything be done, economically speaking, to get prices back to reality so regular folks can afford even the most basic housing without going so deep into debt?

Brewbaker: The price of a home is what the seller is willing to receive and the buyer, simultaneously, is willing to pay. If you observe a price it means both were true. It is what it is, is what I mean, it isn't artificial. If you look at home prices on O'ahu since the 1950s, for example, they rose at about a 7 percent to 8 percent rate of appreciation annually through the early-1980s, and they rose at about a 4 percent to 5 percent annual rate of appreciation since then. It's not fake, it's not artificial. Housing is an asset, and housing on a small island is an unusually scarce asset, so its total rate of return (capital gain the price appreciation plus dividend the housing services consumed or rented) should arbitrage to the return on other risky asset classes, like stocks and bonds. It turns out that on O'ahu at least, for which I have the most data, this is approximately true.

So, I wouldn't be waiting around for the "artificial" prices to get real. With respect to subprime, etc., sure there are problems, but they didn't fundamental depart Hawai'i home prices from their expected trajectories. A deeper issue is whether the amplitude of the Hawai'i housing valuation cycle could be diminished by appropriate housing policy. Of that I'm sure it is the case, but my answer is politically incorrect. To smooth out the rate of home price appreciation in Hawai'i policymakers would have to allow more of it to be built each cycle, and the politics of NIMBY says that will never happen.

Jon: Do you think that the response from the federal level is an effective countermeasure to this economic downturn or should more be done? Ideally, what needs to be done in order to turn the corner and get the economy moving up again?

Brewbaker: I think all parties the Fed, Congress and the administration are playing it based on how it is unfolding. I'm convinced all the interventions to date are appropriate to the circumstances. I think it is notably extraordinary that the Fed has stepped outside the commercial banking sandbox and directly into the primary dealer space, the investment banking space, where it has no supervisory responsibility and, traditionally, no channel for the execution of monetary policy. This is a new and innovative approach to a new problem borne of financial innovation, and seems appropriate and decisive to me. Congress and the administration are focusing on the medium-term, regulatory reform, for example, or certification of mortgage brokers a la stock brokers, and I think that is an appropriate response at the moment. We all hope the federal government will not have to intervene directly as in the S&L crisis (forming the Resolution Trust Corp. at taxpayers' expense). I think global capital markets are sufficiently sophisticated that the measures extant will restore investor confidence and, with that, normal sources of liquidity. Time will tell.

Neal: What might be the perception of a buyer coming into the Honolulu (Manoa-Makiki) single-family home market ($1 million-plus)? Would a seller (do) better to wait a year or so?

Brewbaker: So here's the thing Neal: You have to think in "dog years." If you are a prospective investor from Alberta, Canada, and it turns out that ranch you've been scraping a living off of for the last three decades is sitting on top of a huge reserve of oil shale or oil sands, and you reach Waikiki on your annual "snowbird" vacation and the value of your Canadian dollar is up substantially against the U.S. dollar, so that everything in Hawai'i looks cheap for a change, well ... that means real estate looks cheap from your perspective (in dog years), even though it looks expensive to us kama'aina (in people years).

Right now, what I'm hearing in the real estate market is that that combination of natural resource-based wealth plus the currency effect is turbo-supercharging the buying power of certain foreign investors. For Aussies and Canadians, the two forces are complementary higher natural resource wealth (from higher commodity prices) and strong currencies. For Europeans it's just a strong, strong, ultra-strong euro, but that's if they can get a seat to Hawai'i. Right now it's easier for them to get to New York City than Honolulu, so they're spending their euro there. In Hawai'i, however, (South) Koreans are a new, re-emerging class of investors. Korea's economy is rock-solid and their currency has regained most of the loss since the 1990s financial crisis. Your mileage may vary, but in Manoa your new neighbor may soon be a foreigner.