October 2005

Economy Watch

At an October 13 AEI panel discussion, economists considered current economic policy issues, including the effects of hurricanes Katrina and Rita, tax reform, and the state of the U.S. economy.

Lawrence B. Lindsey
AEI

Lawrence B. Lindsey, president and chief executive officer of the Lindsey Group and a visiting scholar at AEI, emphasized the importance of flexibility in the U.S. economy. Drawing from Alan Greenspan’s analysis that flexibility facilitates nominal GDP growth, Lindsey prescribed flexibility as a key to managing the energy market, the housing market, and globalization.

With respect to energy, Lindsey holds inflexibility responsible for high energy prices. An inadequate energy infrastructure, specifically a lack of refinery capacity, has left consumers vulnerable to infrastructure damage that causes prices to rise dramatically. Lindsey blames the shortage of infrastructure on non-price barriers and warns that history has proven inflexibility to be a cause, not a cure, for energy crises.

Lindsey is optimistic with regard to the housing market because of a general increase in housing finance flexibility. The Community Reinvestment Act of 1977 served as a catalyst for such flexibility by providing credit for disadvantaged communities and increasing homeownership rates and liquidity. While the housing market is currently liquid, inherent liquidity concerns still apply. Mainly, houses are not easily divisible, housing transactions are time-consuming, and the public good side of homes is illiquid.

Lastly, Lindsey espoused Ricardian economics, believing globalization has increased real living standards, helped real incomes, and lower world prices on average. Lindsey urged politicians to not create artificial barriers that will hinder flexibility and impede growth.

Kevin A. Hassett
AEI

Kevin A. Hassett, the director of economic policy studies and a resident scholar at AEI, focused his speech on the report of the president’s tax reform panel, which is due on November 1. Hassett believes the market is underestimating the likelihood of tax reform because it has not understood the impact of the alternative minimum tax (AMT). The alternative minimum tax has disproportionably affected blue-state voters, inciting Democrats to push for tax reform. Bush thus has a perfect opportunity to open up the tax codes and restructure the system. Hassett predicts that such reform will likely be in the form of an X tax, which is effectively a progressive consumption tax.

The X tax would remove mortgage interest deductions and significantly impact the booming housing market. Removing mortgage interest deductions would eliminate the deadweight loss caused by highly subsidized housing; however, it would also reduce demand for homes and decrease prices. Because consumers are forward looking and risk adverse, the knowledge that mortgage interest deductions will decrease in the future will adversely affect the housing market in the short term. Therefore, the tax reform panel is unlikely to suggest a pure consumption tax but will instead move in the direction of an X tax as to gradually eliminate the mortgage interest deduction.

Hassett added that he does not believe the resignation of Alan Greenspan will produce market panic.

Mark M. Zandi
Economy.com

Mark Zandi, the chief economist and co-founder of Economy.com, discussed the impact of hurricanes, inflation, and the housing market on the U.S. economy. Zandi predicts the impact of the hurricanes will be temporary, short-lived, and modest. Citing the strength of job markets outside the damaged area, Zandi does not see GDP falling more than half a percentage point for the year and rising in the future as a result of the rebuilding effort.

On the other hand, Zandi is concerned with inflation. With a strong economy, a rising labor force participation rate, and energy prices threatening to become embedded in wage structure, it seems apparent that interest rates will rise. Zandi predicts that interest rates will be between 4.5 and 5 percent by next spring.

Unlike Lindsey, Zandi calculates that increased interest rates will adversely affect a housing market that is “literally through the roof.” He estimates that housing caused output to increase by approximately 1 percentage point in the first half of this year. The boom in the housing market is due to many factors. Fundamentally, interest rates have been low, transaction costs are a fourth of what they were ten years ago, people travel less after 9/11, and there has been widespread rational portfolio shifting. Furthermore, exotic mortgage lending has increased demand for housing above manageable levels and has encouraged speculation. Such overvaluation, which Zandi estimates to be around 15 percent, could cause prices to drop starting in late 2006 and consequently retard job growth. Zandi foresees late 2006 through early 2007 as a potentially problematic time for the U.S. economy.
 
AEI intern Ben Hamlin prepared this summary.