Bubble babble

Alan Reynolds
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Posted: Jul 28, 2005 12:00 AM

In economics, bad metaphors often lead to bad policies. As I explained years ago in The American Spectator: "Inflation is never a thermal condition described by 'overheating,' nor a budgetary consequence of 'guns and butter.' Monetary policy is never in the position of 'pushing on a string,' and government borrowing never 'primes the pump' or 'kick starts' entrepreneurial spirits. Booms need not lead to busts (Hong Kong boomed continuously from 1975 to 1997), and busts need not be preceded by booms (witness the United States in 1937). Most important, large increases in asset prices are never inexplicable 'bubbles' that collapse for no reason, or that need to be burst by a central bank assault. These crude metaphors are just journalistic tricks for concealing ignorance, but they regularly foster poisonous remedies for imagined ills."

 Since 2002, when the metaphor of a "housing bubble" began to stick to reporters like Bubblicious gum on their shoes, they have continued quoting the same Chicken Littles warning about an imminent and supposedly disastrous collapse of housing prices. People who are most worried that house prices have been rising too fast appear even more worried that houses prices might stop rising.

 In this journalistic rivalry to blow the bubbliest bubbles, some seized on a comment in Alan Greenspan's testimony about "potential for individual disaster" for overleveraged homebuyers. Yet the key word was not "disaster," but "individual." Greenspan said if home prices did decline in localized markets, "the macroeconomic implications need not be substantial. ... Moreover, a decline in the national housing price level would need to be substantial to trigger a significant rise in foreclosures, because the vast majority of homeowners have built up substantial equity in their homes."

 Why is even the slightest rollback of asking prices on homes supposed to be such an ominous threat? The most revealing answer came from New York Times writer Anna Bernasek in "Hear a Pop? Watch Out." She began with a hypothetical wealth effect. "Economists use this rule of thumb: A $1 change in household wealth leads to a roughly 5-cent change in consumer spending. By that measure, a 10 percent decline in real estate prices would knock about half a percent off the gross domestic product."

 This wealth effect results from single-entry bookkeeping -- looking only at sellers and ignoring buyers. The wealth of young couples mainly consists of their future earnings, or "human capital." High house prices reduce that wealth for first-time homebuyers by as much as they raise financial wealth for sellers.

 Those trading one home for another are both buyers and sellers, so the net effect on their wealth depends on whether home prices are most inflated in the place where they are buying or selling. For those changing homes in the same area, a lower price on the house being sold would be largely offset by a lower price on the one being purchased, with little net wealth effect. If home prices softened sufficiently to make selling less attractive, then fewer people would put their homes on the market and the resulting scarcity would limit any price decline.

  Bernasek went on to fret that "a fall in values ... would probably lead to tightened credit standards, less lending and higher interest rates." Yet her sources believe "the most attractive way for policy makers to cool the housing market would be to put pressure on lenders to tighten their credit standards" and for the Fed to "nudge the long end of the market toward higher rates." Their proposed solution is identical to the assumed problem.

  Bernasek warned of "a new wild card for the economy. In 2004, adjustable-rate mortgages made up a third of new mortgage originations. No one knows what the effect of the widespread use of ARMs would be in a down market." But ARMs only amounted to 17 percent of outstanding mortgages in 2004, though they have often made up a third of new mortgages. ARMs made up 36 percent of new mortgages in 1995, according to the Office of Federal Housing Enterprise Oversight (OFHEO). And 1995 was in the middle of a "down market," according to an April 2003 IMF study she cites.

  "Reviewing the experience in the United States and 13 other industrialized countries," she notes, "the IMF found that a real estate bust is far more dangerous to the economy than a stock market bust." But the United States never experienced a housing bust, according to the IMF, because "to qualify as a bust a housing price contraction had to exceed 14 percent."

 Those "more dangerous" cases the IMF was talking about were in places like Australia 1974-78, Norway 1976-83 and Denmark 1989-93.

 It is unsurprising that the IMF discovered house prices were "associated with" recessions, because recessions result in lost jobs and reduced incomes. Turning cause and effect backward, housing bust theorists suggest housing prices just spontaneously collapse for no reason and therefore cause recessions.

 The IMF finds economic busts and housing busts share one common explanation. "Housing price busts were (more) associated with tighter monetary policy than equity price busts, reflecting the fact that most housing price busts occurred during either the late 1970s and early 1980s or the late 1980s, when reducing inflation was an important policy objective." That lesson is notably irrelevant to this country at this time. Aside from energy, U.S. consumer inflation was 11.1 percent in 1980 and 5.2 percent in 1990, but is only 2.2 percent today.

 According to the IMF, U.S. housing suffered two mini-busts between the first quarter of 1994 and the third quarter of 1996. OFHEO indexes of house prices by state, however, show that particular decline was dominated by California. From the third quarter of 1990 to the third quarter of 1996, average prices of existing homes in California fell 13 percent. Why? The unemployment rate in California jumped from 5.1 percent in January 1990 to 6.8 percent that December, then to 8.3 percent a year later and to 9.9 percent a year after that.

 California unemployment remained consistently well above the national average and did not dip below 9 percent until March 1994. This June, by contrast, California unemployment was down to 5.4 percent, and below 4 percent in San Diego, so it is not entirely surprising that long-depressed California housing prices have since rebounded by 164 percent from the IMF's 1996 trough.

 If unemployment in California once again rose above 9 percent, housing prices would surely fall again, as in 1990-96. But a weak state economy rather than the resulting glut of homes for sale would then be the fundamental problem.

 Those now predicting a nationwide drop in home prices that is even remotely comparable to what happened in California in the early '90s must at least explain what chain of events they imagine might make interest rates and/or unemployment soar. Otherwise, all this overinflated rhetoric is no more than a bunch of bubble babble.