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'Bubbles' Greenspan gets more fan mail

by Jerome a Paris Sun Aug 7th, 2005 at 06:58:38 PM EST

Why Federal Reserve must raise interest rates (FT)

The writer [Stephen Cecchetti] is professor of international economics and finance, International Business School, Brandeis University

The story starts with the internet boom of the late 1990s. At the time, Fed policymakers concluded that since it was so difficult to identify bubbles as they are inflating, it is best to wait and clean up the mess after the crash. In 2001, that is what they did. The FOMC lowered the short-term interest rate from 6 per cent to 1 per cent.

The predictable result was a housing boom. The value of residential housing in the US is 55 per cent higher today than it was only five years ago. Since household consumption reacts quickly and strongly to increases in property wealth, a recession was nearly averted.

Fed policy replaced the internet bubble with a housing bubble.

Just another bitter guy?

The problem is that equity and property are very different. When stock prices rise, it signals improved future profitability. Faster growth means higher incomes and more resources to devote to current (and future) consumption.

Note this: the Clinton bubble (i.e. the dotcom bubble) came from real wealth creation as new technologies were harnessed. It was a bubble, because out of sheer enthusiasm, too much was invested in what ended up being silly or useless, but still, a lot was invested in businesses that thrived and created new industries, jobs, and wealth.

A pause to clean up the extra investment was needed, and by and large, that's what companies did.

The problem is that consumers were artificially shielded from that adjustment by Greenspan's aggressive interest rate reductions.

Housing is different. We all have to live somewhere. When housing prices rise it does not signal any increase in the quantity of economy-wide output. While someone with a bigger house could move into a smaller one, for each person trading down and taking wealth out of their home, someone is trading up and putting wealth in. A rise in property prices means people are consuming more housing, not that they are wealthier.

That's an important distinction, because it is linked to the next item - these higher housing prices are not caused by increased wealth, they are caused by increased debt, made possible by the lower interest rates.

(...) an increase in housing wealth has about twice the impact on consumption of an equivalent increase in stock market wealth.  For the US economy, the $6,500bn increase in housing wealth since 2000 amounts to a $200bn rise in consumption - enough to push GDP up 1.5 per cent and drive the household savings rate to zero.

The $200 billion increase in consumption is very real, and that's what makes the current economy appear sound, but it is is pretty small bang for the buck - one thirtieth of the apparent wealth increase. The problem is that such increase comes at what is also a very real price:

Much of this added consumption has been financed by increased borrowing. This means that as interest rates rise, an increasing portion of household incomes will have to be devoted to repaying the $4,000bn in additional debt incurred during the first half of this decade. Low interest rates have encouraged borrowing from the future. And the more we borrow, the larger the debt and the bigger the adjustment.

With long term rates at 4%, the interest burden on such new debt is only about $160 billion per year. But each 1% increase on the long term rates will cost the US economy $40 billion on that chunk of the debt (and another $50 billion or so on the debt which was previously incurred) per year, or about 1% of GDP in all ...

The most troubling aspect of this is the Fed's reaction. The minutes tell us that the FOMC spent a portion of their June meeting discussing housing, concluding that since there is no way to know if there is a housing bubble, there is nothing to be done. These conclusions bear an eerie resemblance to comments made at the height of the internet bubble in the late 1990s.

Greenspan in denial... Whodda thunk?

But to be fair to him, the Fed has at least been increasing rates for the past year or so (from 1% to 3.25%, with another 0.25% increase expected this week). The problem is that these increases are still too slow, and come from such a low base that the world is now, after several years of incredibly cheap money, awash in dollars. Hence the incredible amounts spent by Americans on imports, the incredible amounts of reserves held by Asian countries, and the desperate attemps by the financial world to invent new (and riskier) products, like CDOs or massive high-yield bonds, that pay just a little bit more than US Treasuries.

There is so much money sloshing around that the long term rates have actually gone down (by about 1% in the past year) even though the Fed has raised the short term rates by more than 2%. That means that markets are either pricing in deflation, a nasty recession, or both (or that they don't listen to Greenspan anymore, i.e. they don't know what to do anymore - invest - with all that money in the real economy, and are simply parking it in the safest place, i.e. the US government, which nevertheless gayly blows that money in the Iraq grinder).

Household spending levels are simply unsustainable and something has to be done. The policy prescription is simple: raise interest rates. Higher interest rates both make borrowing more expensive, reducing household demand, and raise returns on alternative assets for yield-chasing financial institutions.

Following this lead, the FOMC should (1) increase interest rates at the coming meeting; (2) signal that they are far from done; and (3) warn people that the best we can hope for is that housing prices stop rising, but that there is a real risk of collapse.

We are seeing an economy with unprecedented imbalances, and the amazing thing is that there are several very different parameters which are at very unusual levels today, each of which threatens the whole edifice:

  • unprecedented levels, both absolute and relative, of debt, both for the private sector and the government;

  • unprecedented levels, both absolute and relative, of the trade deficit;

  • the starkest increase in commodity prices, starting with oil, in at least a generation, and the prospect of more to come, starting, again, with oil, where we see, for the fisrt time ever, a lack of spare production capacity;

  • unprecedented increase in inequality in the US, with the biggest increases in 150 years in the absolute and relative income and wealth of the top 1% of the population.

I know I am beginning to sound like a broken record on this, but we are literally like the coyote over the abyss - still running hard, not having realised yet that they is no ground beneath our feet anymore.

A couple of factors I would add to this analysis. LIBOR is heavily influenced by US rates but if you compare it to the Fed Rate, it doesn't track precisely. In the period in question (2001-2004) LIBOR actually decreased even more precipitously than the Fed Rate.

The Housing Bubble in the United States also preceded the drop in interest rates. The period from 1996-2000 coincided with large increase in proerty values in hot urban areas all over the US. San Fran, Silicon Valley, Seattle, Portland, Denver, Los Angeles, San Diego, Phoenix, Dallas, Miami, New York, Dallas, Raleigh/Durham, Washington, Philadelphia, Ann Arbor, Minneapolis, Boston, NY, in fact NJ and Connecticut as well. The smaller cities only started to benefit after the rates were dropped.

There is definitely a housing bubble in many of the areas I just menioned. However, I would note that economists in the US forecast interest rates will go down in the second half of 2006, so the artificial inducements may remain. Furthermore, the pollyannas--after a decade of low rates--are beginning to think this is a blueprint for the future (apprarently they've forgotten the 1960s).

Lastly, I'd like to see population density included in these figures. Is there a corresponding rise in population and housing costs in the "hot" urban centers? One would think so. But I contend this is not the case. One phenonmenon that's occurring is that people are moving out of shared housing situations and owning their own places, so you have fewer people under roofs. In fact, Boston and San Fran had skyrocketing housing costs at the same time they experienced a net loss in population. This is very true in the old industrial city where I live. This town had 1 million inhabitants 30-40 years ago, and now there are only 300,000 people here, and yet the homes are still occupied.

by Upstate NY on Sun Aug 7th, 2005 at 08:18:53 PM EST
The dropping population combined with rising housing prices is most likely the result of families leaving the city. I know that Portland is closing schools in some of its most popular areas because the people being attracted are single, newly married, or retired. The "hot" industrial apartment is not as attractive when you have a couple of kids. Medium sized housing is truly expensive in the city, and many people feel that once you have a family everyone needs their own room and bathroom.
  What you have is expensive "small" condo's in the cities, and gigantic houses in the suburbs. Prices in both locations are increasing, but population growth is in the suburbs.
  Another aspect of the main post is that for many people the rising value of their home is meaningless. If you don't want to incur more debt by pulling out equity, and you don't intend to sell there is no benefit. Indeed, in many places there is a downside because you will be hit by rising property taxes. In California homes are only re-appraised when sold or expanded, but that is not true everywhere.
by toad on Sun Aug 7th, 2005 at 09:13:40 PM EST
[ Parent ]
too as national debt stands at 7.8 trillion and consumer debt at 2.1 trillion = almost 10 trillion. Looks like Greeny will need to be a little more aggresive in whacking up interest rates if he wants to keep th world servicing that debt. Funny how China seems to now be a little less willing to blithely fund all this US spending. Oh what a good time to upset them with all that "unjustified" political interference in the CNOOC/Unocal deal.  
by observer393 on Mon Aug 8th, 2005 at 12:52:01 AM EST
Jérôme, first-rate article giving those of us who are not financial specialists a clear idea of how the housing boom/bubble/boomble (call it what you will) fits into the current and recent-past workings of the US economy. Thanks.
by afew (afew(a in a circle)eurotrib_dot_com) on Mon Aug 8th, 2005 at 02:49:45 AM EST

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet
by Melanchthon on Mon Aug 8th, 2005 at 05:27:35 AM EST
Celui qui chute ne s'arrête jamais, allant de glissement en glissement par des glissements sans fin.

Though Wile E. Coyote always does hit bottom...

Afew Snark Technology ™

by afew (afew(a in a circle)eurotrib_dot_com) on Mon Aug 8th, 2005 at 11:29:42 AM EST
[ Parent ]
... and always starts trying again!

Just like George W(ile Coyote) Bush...

"Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet

by Melanchthon on Mon Aug 8th, 2005 at 12:45:09 PM EST
[ Parent ]
An article in the Guardian by Ashley Seager entitled Hold on, this could get bumpy chimes rather neatly with Jérôme's post while discussing the UK property bubble.

You may think that the housing market, whose foundations having been looking increasingly shaky over the past year, would be shored up by last week's interest rate cut from the Bank of England.

After all, you may say, rising interest rates did for the housing market last year and so the cut, the first for two years, must have the opposite effect. If money is cheaper, people might borrow more and start buying property again.

That is a dangerously complacent view. The house price bubble, the biggest this country has ever seen, was pricked last summer and has been losing air ever since. But it has barely begun to deflate in a serious fashion.


The Royal Institution of Chartered Surveyors' monthly survey of surveyors - one of the most reliable housing market indicators - is still pointing to sharp price falls. And now, the main price indicators from the Nationwide and Halifax are showing annual price inflation slowing rapidly. The Halifax reported on Friday that prices were only 2.3% higher than a year ago, a nine-year low.

Fairly soon, probably in October or November, this annual rate could turn negative. There is no reason for it to stop at zero. Then any lingering pretence that bricks and mortar remain a rock-solid investment will have gone.

This could be a key psychological blow to the housing market. Over the past year, you could hear people saying things like, "My house price may have dipped this month but it is still 10% higher than a year ago."

And the knock-on effects on the economy could be grave. Already household spending has slowed sharply, as has mortgage-equity withdrawal, where people add to their mortgage to spend on other things. This has hit the retail sector hard and has slowed the whole economy down faster than the Bank of England had expected. This is why the Bank cut rates last week. Slower growth leads to slower inflation and its remit is not to let inflation slow too far.


To get a broader perspective on the house price bubble, it is worth looking at other countries. Britain's bubble is far from unique. Indeed, it is clear that the wave of interest rate cuts around the world in the wake of the bursting of the dotcom bubble five years ago, which saw shares tumble 50%, created a boom in housing instead.

All across the rich world, with the exception of Germany and Japan, house prices have been booming. The United States, France, Spain and Ireland are just a few of the countries that have seen double-digit property price rises in recent years. The resultant increase in (largely illusory) wealth has been bigger than the dotcom bubble.

And the correction now seems to have started in Britain, Australia and the Netherlands. Prices are still steaming away in France and the US and many other countries, but the warning signs are flashing. Prices in Sydney are down 16% in two years, according to international comparisons done by the Economist. Why shouldn't that happen in London, where prices are already down 3-5% on some measures?

But any way you look at it, it is clear the correction has only just begun.

In Britain the slowdown in consumer spending has occurred with house prices standing still. If and when prices start to fall, there could be trouble for the economy. The Netherlands is stuck in recession after its house price boom turned to bust a few years ago. The Japanese property market has been falling for 14 years since its bubble burst.

The link to consumer spending and therefore GDP growth seems based on more or less (depending on which country) refinancing of mortgages, but also on the "wealth effect", (by which I feel richer because the dotcom I bought six months ago or the house I bought a few years ago have doubled in "value"). (When I say I...) In either case there's debt involved, and the collateral is largely bubble gas...

by afew (afew(a in a circle)eurotrib_dot_com) on Mon Aug 8th, 2005 at 11:55:35 AM EST
Somehow I missed noticing yesterday that that guy with an axe to grind (Paul Krugman) wrote an NYT op-ed in which he explains the US housing bubble is already bursting, though prices change slowly.

...Of course, some people still deny that there's a housing bubble. Let me explain how we know that they're wrong.

One piece of evidence is the sense of frenzy about real estate, which irresistibly brings to mind the stock frenzy of 1999. Even some of the players are the same. The authors of the 1999 best seller "Dow 36,000" are now among the most vocal proponents of the view that there is no housing bubble.

Then there are the numbers. Many bubble deniers point to average prices for the country as a whole, which look worrisome but not totally crazy. When it comes to housing, however, the United States is really two countries, Flatland and the Zoned Zone.

In Flatland, which occupies the middle of the country, it's easy to build houses. When the demand for houses rises, Flatland metropolitan areas, which don't really have traditional downtowns, just sprawl some more. As a result, housing prices are basically determined by the cost of construction. In Flatland, a housing bubble can't even get started.

But in the Zoned Zone, which lies along the coasts, a combination of high population density and land-use restrictions - hence "zoned" - makes it hard to build new houses. So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think that prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. In other words, the Zoned Zone is prone to housing bubbles.

And Zoned Zone housing prices, which have risen much faster than the national average, clearly point to a bubble.

In the nation as a whole, housing prices rose about 50 percent between the first quarter of 2000 and the first quarter of 2005. But that average blends results from Flatland metropolitan areas like Houston and Atlanta, where prices rose 26 and 29 percent respectively, with results from Zoned Zone areas like New York, Miami and San Diego, where prices rose 77, 96 and 118 percent.

Nobody would pay San Diego prices without believing that prices will continue to rise. Rents rose much more slowly than prices: the Bureau of Labor Statistics index of "owners' equivalent rent" rose only 27 percent from late 1999 to late 2004. Business Week reports that by 2004 the cost of renting a house in San Diego was only 40 percent of the cost of owning a similar house - even taking into account low interest rates on mortgages. So it makes sense to buy in San Diego only if you believe that prices will keep rising rapidly, generating big capital gains. That's pretty much the definition of a bubble.

Bubbles end when people stop believing that big capital gains are a sure thing. That's what happened in San Diego at the end of its last housing bubble: after a rapid rise, house prices peaked in 1990. Soon there was a glut of houses on the market, and prices began falling. By 1996, they had declined about 25 percent after adjusting for inflation.

And that's what's happening in San Diego right now, after a rise in house prices that dwarfs the boom of the 1980's. The number of single-family houses and condos on the market has doubled over the past year. "Homes that a year or two ago sold virtually overnight - in many cases triggering bidding wars - are on the market for weeks," reports The Los Angeles Times. The same thing is happening in other formerly hot markets.

Meanwhile, the U.S. economy has become deeply dependent on the housing bubble. The economic recovery since 2001 has been disappointing in many ways, but it wouldn't have happened at all without soaring spending on residential construction, plus a surge in consumer spending largely based on mortgage refinancing. Did I mention that the personal savings rate has fallen to zero?

Now we're starting to hear a hissing sound, as the air begins to leak out of the bubble...

Commenter b on MoA adds this:

He is a bit late - the main indicator some used was the price of lumber futures. They started to break down nearly a year ago. House price deflation is sloooow.

and sends us to look at this (from AGEdwards):

(click for source)

by afew (afew(a in a circle)eurotrib_dot_com) on Tue Aug 9th, 2005 at 07:53:01 AM EST

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