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Alan Reynolds' housing bubble denial

January 6, 2005

It is always interesting to see to what lengths pro-Bush supply siders will go to in order to deny the existence of problems in the U.S. Economy. Just take Alan Reynolds' latest townhall.com article. In it, he attacks those of us who believe in a housing bubble and more specifically Morgan Stanley economist Stephen Roach.

First he attacks a straw man version of Roach's argument, when he quotes Roach as saying that the bursting of the housing bubble will be worse than the bursting of the equity bubble by saying this would have to mean that housing prices would have to fall 80% like NASDAQ did. Which of course is not what Roach meant. As the housing values are so much greater than the NASDAQ market capitalization ever was, a much smaller decline in % is required to produce the same loss in dollar value.

Next he claims that the rise in housing prices is not something to worry about since housing debt has not increased faster than housing values. But that is only true in comparison to the record high leverage that was reached in 1999 and that reflects the enormous price increases. Relative to disposable income , mortgage debt has increased sharply from the already record high levels in 1999, from 65% to 84% in the third quarter of 2004 (Total household debt has increased from 94% to 115% in the same period).

His next line of argument is that the talk of a national housing bubble is meaningless since prices has increased much sharper in some areas than others. But that prices has increased even sharper than the average in some areas is not something which should make this seem like less of a bubble. To the contrary it probably (though not necessarily as the relative price movements could reflect greater attractiveness of some areas) reflect even greater imbalances. In the end of the article, Reynolds wonders what could burst the bubble.

Well, what is it that bursts bubbles in general? Usually it is a combination of buyers losing faith as prices becomes to unreasonable and require so great amounts of money that they neither can nor want to borrow more and is unable to pay for it with their income as well as a increase in interest rates. Reynolds argue that interest rates will only rise if inflation rises and higher inflation is good for housing prices. But the point he misses is that real interest rates have been at record low levels during the last few years (real short-term interest rates have actually been and still is negative).

When real interest rates move up to normal levels, interest costs will become so high that households will be forced (particularly given the current non-existent savings) to stop their bidding up of housing prices. Indeed, Reynolds earlier in the article actually tries to justify the bubble with the record low interest rates. But if interest rates return to normal then so should housing prices relative to disposable income something which would mean a 25% relative decline from current levels.

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