Detecting and Controlling Housing Bubbles

By Charles Kirchofer, Feb. 20^th, 2009

I had originally intended to devote this post to an idea of how to control housing booms and target specifically asset prices that are rising in an economy as an alternative to the blunt (and at times ineffective) tool of interest rate increases. However, upon researching the matter further, I discovered the mere detection of a housing bubble is more difficult than I'd originally thought. Everyone knows that bubbles very often remain unidentified until after they burst. There are always some people shouting warnings, but they are often the ones who had said it would happen every year - when it didn't. All too often, the investment and regulatory communities stop listening to the investor who cried "bubble!"

But then I thought, "geez, I knew it was a bubble... I think." Indeed, Alan Greenspan had even suggested that we might be looking at a bubble. The amount this concerned him was, we know now, not enough to mobilize him to avert a crisis. It's clear that he did not see the true nature of what was coming. Of course, the housing bubble was not the only cause of our current woes, but it was a main contributor to the intermediate causes, or so it would seem (to read more about other intermediate causes, as well as the deep cause, check out our other posts (some of them coming later as Mr. Mohr joins and moves his posts to this blog from my old geocities website). So why didn't regulators step in? Surely a bubble bursting with kind of pow must have been foreseeable?

So I started doing some research. This is what I found:

Sale Price of New US Homes		House price	Boom gain/			Ratio Houses
Year (Dec)	Median Price	inflation	Bust loss	CPI inflation	Boom CPI	to CPI boom
1980	$67,000.00	8.9%		13.52%
1981	$68,400.00	2.1%		10.38%
1982	$71,700.00	4.8%		6.13%
1983	$75,900.00	5.9%		3.21%
1984	$78,300.00	3.2%		4.32%
1985	$87,900.00	12.3%		3.56%
1986	$95,000.00	8.1%		1.86%
1987	$111,800.00	17.7%		3.65%
1988	$121,000.00	8.2%		4.14%
1989	$125,200.00	3.5%		4.82%
1990	$127,000.00	1.4%	189.6%	5.40%	4.72%	4 to 1
1991	$122,000.00	-3.9%		4.21%
1992	$126,000.00	3.3%		3.01%
1993	$125,000.00	-0.8%		2.99%
1994	$135,000.00	8.0%		2.56%
1995	$138,600.00	2.7%		2.83%
1996	$144,900.00	4.5%		2.95%
1997	$145,900.00	0.7%		2.29%
1998	$152,500.00	4.5%		1.56%
1999	$164,800.00	8.1%		2.21%
2000	$162,000.00	-1.7%		3.36%
2001	$180,200.00	11.2%		2.85%
2002	$197,600.00	9.7%	58.1%	1.58%	2.46%	2.6 to 1
2003	$196,000.00	-0.8%		2.28%
2004	$229,600.00	17.1%		2.66%
2005	$238,600.00	3.9%		3.39%
2006	$244,700.00	2.6%	24.8%	3.23%	3.09%	2.7 to 1
2007	$227,700.00	-6.9%		2.85%
2008	$206,500.00	-9.3%	-15.6%	3.84%
Sources:	http://www.census.gov/const/uspricemon.pdf
	http://www.measuringworth.com/calculators/inflation

OK, I know it's a lot of information, so I'll break it down now. Notice the column boom gain/bust loss. The inflation of house prices is staggering, especially when compared to consumer price inflation in the next column. What's even more noticeable is the growth during the boom of the 80s. During the 80s house prices rose by over 189% compared to a rise of just 47.2% in consumer prices in the same period. That's a ratio of more than 4 to 1! This of course ended in the Saving and Loan Crisis of the late 80s and early 90s. As a result, house prices remained stagnant in the early 90s, during which the U.S. also found itself in a recession. By 1993, however, things had recovered. Soon the recession was forgotten. There were small dips in house prices due to the 2000 dotcom crash and the 2002 recession in the wake of the September 11th attacks on the World Trade Center in New York. Otherwise, things were all up hill. Please note that I count the overall rise in house prices only during the boom years. The early 90s, therefore, have been left out. During the 2000 boom years, house prices grew, on average, around 2.6 times as fast as consumer prices. That's quick, but nothing like the rates seen in the '80s. After the brief dip in house prices after the 2002 recession, house prices began to rise yet again. We can see from the ratio, however, that they rose little faster than they did in the 1990s.

Looking at it this way, it is not surprising that many did not realize there was a housing bubble. What you may also notice, however, is that there are very few real "busts." I would hardly call one year where house prices fell only mildly a bust. You'll notice that from 1980 to 2006, house prices never fell for more than one year, and their largest fall in one year (December to December anyway) was 3.9%. It may therefore be more accurate to look at the whole situation from the late 1970s until 2006 as one long, nearly continuous housing boom interrupted by a few short breathers, most notably in the early '90s.

Also of note is the steady fall in household saving rates (not in the table). These peaked in 1981 at somewhere around 12% and fell steadily through 2005, when they even became negative. For comparison, the rate in the 50s and 60s was around 7.5%.

So what's to make of all this? I have already alluded to my opinion (which isn't really anything new): We've witnessed one long, credit-fueled housing boom from the late 1970s until 2006. So what does this mean for regulatory policy?

It means the Federal Reserve and other regulators may have to start reacting to things other than inflation. Looking at the data, however, it's easy to see why they didn't realize this. The "end" of the 80s housing boom resulted in a couple years of housing market stagnation and relatively mild recession. The U.S. economy got through it with little difficulty. The same is even more true of the dotcom crash and the 2002 recession. After all, if the U.S. economy could snap right back into growth again after terrorist attacks on one of its largest financial centers and keep growing right through a war with rising oil prices, they must be doing something right.

So what should regulators react to and how? They should react to a whole myriad of things the Fed has been tracking all along (but not necessarily regulating) in addition to consumer price inflation; like house price inflation, household saving rates, and mortgage down payment requirements. I think the Fed might want to use interest rates to influence saving rates in the future. Saving rates as high as those in the early 80s, when combined with low inflation (unlike the early 80s), may be too high. Conversely, saving rates below 5%, even when inflation is low, might signal problems on the horizon. Much was said in this direction during the '90s and 2000s, but no one reacted because of uncertainty about just what the figures meant. I think now it would be reasonable for the Fed to raise interest rates during times of low inflation (and even fairly slow economic growth) to increase household saving rates if necessary to stop a credit-fueled rise in house prices or even stocks or other investments not counted in the consumer price index (a common measure of inflation). This goes along with my article on global imbalances in saving and borrowing, half of which begins at home (the borrowing part).

The other thing the regulators ought to look at is house price inflation. We've seen that house prices can inflate for decades without causing problems (at least right away). I postulate that house price inflation, despite relatively low consumer price inflation, coupled with declining household savings (certainly becoming critical when they drop below 3 to 5%) is a toxic mix to be steered against. For this (and for other types pf asset price inflation), I would recommend a more precise attack, possibly in addition to higher interest rates, to spur household saving. One possibility would be increased down payment requirements. Down payments averaged over 31% of the price of a home in 1982. From there they dropped steadily until reaching a low of 19.2% in 1994, a level that was again approached in 2007.

But it is perhaps not the average rate that is of greatest concern. So far house prices have not fallen so far that they've caused negative equity on the average. In spite of that, negative equity is occurring with alarming frequency, even if not to the "average" mortgage. Mortgages with no money down are a bad idea, particularly when the toxic mixture I mention above is present. In times when the conditions above are present, I would recommend setting down payment requirements up to as much as 20-30% for all mortgages, not just the average mortgage (and no exceptions or loopholes, which was the main problem recently, not that banks suddenly thought mortgages with no money down were necessarily good). This would serve to slow the inflation of the bubble, as houses become somewhat more difficult to buy. This reduces the incentive for speculation with real estate as well, another cause of many of the headaches. Finally, it would cushion the bursting of any bubble that managed to form by ensuring that any mortgages made are placed on a sound footing and that negative equity is avoided, thereby not providing an incentive for homeowners to just walk away. Of course, as I've mentioned in previous articles, teaser rates and the like should be outlawed (see Mr. Mohr's article on teaser rates for more information (move from old site pending)).

This outline is vague. I also am well aware that over-regulating the market could strangle it, preventing American families that otherwise might be able to buy a home from having one. That would certainly be unfortunate. As I'm not an expert on public economic policy details, I leave this to the experts to hopefully find the right balance. One thing is clear, however, the current balance isn't right.

The Conundrum of Global Saving/Spending Imbalances: Why It's so Hard to Stop the Flood

By Charles Kirchofer, Jan. 29^th, 2009

In the realm of international relations, analysts often look at events on three levels: deep causes, intermediate causes, and precipitating causes. The deep causes are often systemic effects, like the structure of the international system (i.e. anarchic, with x number of great powers... it doesn't matter though, just keep reading). The intermediate causes are often related to policies of countries and alliances they form. The precipitating cause is generally just one event. I'd like to spend a little time today talking about the deep causes of the current financial and economic crisis. First, let me just mention what some of the individual causes were.

The precipitating cause was, of course, the bursting of the housing bubble. The intermediate causes were many and varied. They mostly relate to policy and regulatory decisions. Mr. Mohr and I have spent most of our time talking about those, so if you'd like to know more, just check out nearly the all the articles we've written on the subject of the financial crisis on the economics page (www.therealissues.net). The cause I'm going to talk about today is the deep one. It is particularly problematic because it is global and very hard to control. I'm talking, as the title suggests, about global imbalances in spending and saving (i.e. global differences in current account surpluses and deficits, which can also roughly be related to global trade surpluses and deficits).

Everyone knows the United States is the world's largest debtor. This is partly because of its size, however. To put things into perspective, household debt in the U.K. is actually higher than in the U.S., and the U.S. is by far not the most indebted country in terms of debt in proportion to GDP. (It makes sense to look at debt as a proportion of GDP because $100,000 of debt a lot for a person earning $20,000 a year, but chicken feed for a millionaire. The United States, luckily, fits into the latter category). Nonetheless, the fact that American households' saving rate has been negative (the average household has been borrowing more than saving in the past couple years) is obviously problematic.

The usual solution to too little saving is to raise interest rates. Higher interest rates mean it costs more to borrow money and you get a higher return when you save, thus encouraging saving and discouraging borrowing. But household saving rates are not the primary interest of central banks. In the past, households spending more than they were earning translated into inflation. Central banks are charged with price stability (controlling inflation), and the U.S. Fed is also charged with promoting growth. This time around all that borrowing didn't result in inflation (at least of the kind the Fed was concerned about, namely asset inflation (like stocks and housing), it was probably a mistake not be concerned with these features). This left central bankers scratching their heads wondering what to do, and if they needed to do anything at all.

The answer, as we now know, was: yes, you probably needed to do something. But this wasn't completely clear.

Would raising interest rates have helped? It probably would have at least mitigated the effects of some of the intermediate causes. Higher interest rates earlier may have slowed the inflation of the housing bubble and made its bursting much less dramatic. In addition, higher interest rates mean a higher return on money saved in bank accounts or government bonds, and lower returns for investments in stocks, commodities, and real estate. There are certainly indications that this would have been a good thing. As I've explained in past articles, however, the Federal Reserve tended not to bother with asset price inflation, concentrating only on inflation of other consumer goods. As I've also said before, I think this was a mistake (as it also is to leave real estate prices out of the core inflation rate).

Of course it's not that simple. Low interest rates meant people were encouraged to spend money rather than save it. Most of the money that was coming in was coming from outside the United States, since people inside were saving less than borrowing. The problem with raising interest rates is that it could even make that particular problem worse. Getting a higher return on savings in the United States might have encouraged more capital inflows from abroad. In addition, it could have further strengthened the dollar, encouraging America to import even more, and hurting American exports further. This could actually exacerbate the current account problem, making the deficit larger. One way it might work in reverse is with energy. A stronger dollar means imported oil would get cheaper. Cheaper oil would make a smaller contribution to the trade deficit. Normally, however, a central bank might seek to weaken a currency if it wanted to reduce imports. But the way to weaken a currency is by cutting interest rates, which would potentially have been even more disastrous. Left with this conundrum, it was difficult to say what direction the rate setters should take.

In addition, there's evidence that suggests that the Fed no longer has complete control over interest rates in America. As the Fed raised rates in 2004, Alan Greenspan noticed that long term rates actually fell. This may be because investors from China continue to want to offload money into the United States and continue to offer cheap loans, regardless of what the Fed does (and how low the return on the investment becomes).

Why would China want to send so much money to the United States even though interest rates were so low? This held the Chinese currency, the yuan, lower and boosted Chinese exports. In addition, it made China stable. Investors are less afraid to give someone money if the person (or in this case, country) has a lot of money. The likelihood of the Chinese Yuan collapsing was extremely slim, making China much safer than other comparable developing countries.

For a while, however, it looked like rebalancing might be beginning. The dollar was sliding and the yuan revaluing. U.S. exports were booming and holding the U.S. economy above water. Then came the financial storm of October. After Lehman Brothers collapsed, capital from all over the world fled from the smaller currencies to the world's reserve currency, even though the crisis was most acute in America and America was the world's biggest debtor. The unexpected result: the dollar took off and nearly all other currencies lost value against the dollar. That was it for rebalancing and for the U.S. export boom (as an expensive dollar once again made American exports too expensive and imports cheaper). The yuan has also lost value against the dollar, even though it, too, has gained considerably against most other world currencies. The latter part is something congressional leaders should keep in mind when considering any trade tariffs or other protectionist measures.

As I've illustrated, the Fed is faced with an absolute conundrum. Raise interest rates, and the trade deficit and inflows of capital increase, likely increasing America's current account deficit. The incoming money then seeks investments, quite possibly creating bubbles. Lower them, and Americans save less and foreign investments from abroad must seek higher returns (not in bank accounts or bonds), possibly also leading to yet another bubble. What's a Fed Head to do? I hate to say it, but probably much as he has done, hopefully having learned from the mistakes of the past eight years. The Fed should continue to respond to domestic conditions. Right now that means keeping interest rates low and fighting deflation and recession. Soon thereafter, it could mean raising interest rates in response to inflationary fears, but possibly also in response to asset price inflation or too-low household saving rates. The Fed cannot control the U.S.'s current account balance, so it must concentrate on sound policies for the areas it can influence.

And what about the imbalances? Sorry, there's no easy solution. With higher interest rates the inflows might land in bank accounts and bonds, a less dangerous place than stocks and other markets. I suspect that as things right themselves in the financial markets, money will begin moving to smaller currencies again, meaning the dollar will begin to lose value again. A devaluing of the dollar while the Fed raises interest rates to fight all-around inflation would be the perfect scenario, but it is not alone within the Fed's power. Most of the time, such a development would be nearly impossible. It relies on net creditors around the world seeing diminishing returns in America and slowly investing their money somewhere else. Higher interest rates in China with a smaller foreign currency reserve would allow the yuan to revalue. This would make Chinese exports more expensive and increase Chinese imports. This would do a lot to fix global imbalances and increase global stability. China might have to accept lower growth rates, but in return it would gain a larger domestic market and a more balanced (and therefore more stable, in the long run) domestic economy.

It's important to note, of course, that this should all happen gradually. As I illustrated in my article on a dollar rout, a rapid shift of investments away from the U.S. would present a catastrophe of unbelievable proportions for the U.S. and the world.

So it all comes down to the Chinese? Well, to them, the Americans, the Saudis, and all others with massive current account imbalances. As much as everyone else likes to blame the Americans (and let's face it, the intermediate and precipitating causes are to be found in America), the entire world helped make the mess, and the entire world must clean it up. I just hope that this will occur naturally and gradually over time, without political fights and big policy mistakes. The second part is definitely a big stretch, the first part is hopeable.