|Adventures in BubbleLand
||[Sep. 8th, 2005|02:49 pm]
Octopus Grigori **West**
It's become passé to observe that the current U.S. housing price boom is a bubble that is just about to pop. Still, it appears that the current situation is extremely tenuous.|
U.S. consumer spending has continued even as job growth has been relatively sluggish largely due to skyrocketing housing prices, which leave homeowners feeling flush with disposable income.
A crucial factor that has allowed housing prices to continue to rise are low interest rates; so long these rates remain relatively low, consumers are much more willing to enter into mortgages and purchase homes.
However, interest rates probably would not be as low as they are if China and other countries were not purchasing U.S. Treasury bonds at a voracious clip. The U.S. has been running a massive trade deficit (or current account deficit (“CAD”)) for a while now. On top of this, the Bush administration, by coupling massive tax cuts with huge expenditures on Iraq (and not New Orleans), has run up a tremendous federal budget deficit. Both CAD and federal budget deficits generally produce higher interest rates, as the government has to compete with private sector to borrow money. However, the U.S. has not had to raise rates on its bonds, as China and others have been more than willing to snap up bonds, regardless of the interest rate offered.
[T]he fast accumulation of home equity wealth is powerfully stimulating consumer spending and the economy. Full article at, er, The Wash. Times.
American's burgeoning trade deficits with China and oil-producing countries, which have fed the record $668 billion current account deficit, have indirectly enabled the housing bubble, because foreigners have re-invested large portions of their trade earnings in U.S. Treasury bonds.
That has driven bond yields and interest rates -- which determine the rates on mortgages -- to their lowest levels in decades.
The ready availability of low-cost credit and financing options has enabled consumers and investors to turn their housing wealth into cash like never before, leading to an unprecedented build-up of mortgage debt as well as wealth, according to Fed surveys.
The Chinese (and others) are not, of course, snapping up T-bonds out of altruism. The foreign investors are doing this to prop up the dollar a bit (China must purchase U.S. dollars to buy U.S. bonds, thereby supporting the dollar, which would otherwise be falling against other currencies as U.S. consumers spend dollars to purchase foreign commodities), and to help keep interest rates low in the U.S, which will allow U.S. growth to continue, and thus, U.S. consumers to continue purchasing Chinese goods. (In the absence of such foreign purchases of T-bonds, a CAD would generally produce a weakening dollar, as U.S. consumers spent dollars to purchase goods from other countries. A weakening dollar would help - in theory - as an automatic correcting measure to the CAD: purchases of imports would decrease, as the purchasing power of the dollar declined, and U.S. exports would increase as U.S goods became cheaper (because of the greater relative strength of foreign currencies) for the Japanese, Europeans, Chinese, et al.) (Isn't amateur economics fun?)
Many predict that the current state of affairs cannot hold (if you believe in some of the ideas of economics, you likely have faith in the inevitable paths back to sweet, fleeting equilibria). Eventually, China and others will have to change their policy of snatching up U.S. bonds. The Economist has argued that it is possible that China's recent delinking of the yuan to the dollar may speed China's move to kick its U.S. T-bond habit:
[T]he switch from a dollar peg to a currency basket may cause China to diversify its reserves away from dollars. It is unlikely to dump its dollars, but it could well reduce its new purchases of Treasury bonds in favour of other currencies [such as, e.g., the euro]. And, if China really has broken the yuan's link with the dollar, then this could be the trigger for another general slide in the greenback against the euro, the yen and other currencies, prompting investors to demand higher yields [and thus higher interest rates]. The fate of American house prices could thus be determined by unelected bureaucrats in Beijing rather than the unelected central bankers of the West.If or when these events come to pass, the U.S. interest rates will begin to skyrocket; and as a result, consumers will be much less willing to purchase homes. Continuing to follow this cascade, the prices of homes will drop, and, the main engine of recent economic growth in the U.S. will stall out. The dollar, no longer propped up by foreign investments in T-bonds, will plummet. As the dollar drops, U.S. consumers will cut back sharply on purchases of Chinese, Japanese, and European goods. This cut- back will slow the economies of our main trading partners, on whom we would normally rely to purchase our exports to help lift our economy. like Hello, recession.
Add to this mix the recent dramatic increases in the price of oil, which will likely increase costs for manufacturers and shippers, and raise food prices (due to transportation costs). This may (1) cause employers to cut back on other costs, such as labor, and (2) trigger an inflationary spiral that may lead to higher interest rates
If the Federal Reserve smells inflation [in the wake of Hurricane Katrina] . . . it could raise interest rates more aggressively. That would put a more severe damper on economic growth, particularly in the nation's real estate market where the average rate for a fixed-rate 30-year mortgage remains near historic lows at 5.71 percent.Full article at Sac. Bee.
"It'll kill the housing sector," said economist Edward Leamer of UCLA.
Another potential complication: The hurricane, whose price tag is estimated at $150 billion, will surely add to the federal budget deficit, putting more pressure on foreign investors to finance the deficit by purchasing U.S. Treasury bonds. If they don't, interest rates could go up sharply. [Also killing the housing sector, and thus, again, wiping out the primary engine of recent U.S. economic health.]
What can be done? The federal government should attempt to reduce the federal budget deficit (hopefully by reducing our massive expenditures in Iraq and by repealing much of Bush's gigantic tax cuts to the wealthiest Americans). Outside of that, I'm not sure. Anyone have any ideas?
Of course, I probably have no idea what I'm talking about. I'm just a hobbyist.
P.S. - I am confident that I have made numerous fundamental mistakes in the above analysis. Please feel free to offer corrections or stern reprimands. Cheers.