The Free Market 23, no. 8 (August 2003)
There is always a bubble someplace. In a world of fiat currency and fractional-reserve banking, where money is effortlessly multiplied and pyramided, the sequence of boom and bust become inevitable, like the sequence of the seasons. In this system, the government cannot prevent the expected corrections anymore than it can prevent the onset of winter. The strong housing market has all the makings of being the next bubble—in particular high leverage and unsustainable price increases.
While the larger economy seems to sputter along, the housing market continues to run a hot race. Low interest rates have propelled refinancing, freeing up $100 billion last year alone, according to the Wall Street Journal. Not surprisingly, the low interest rates have increased buying power and supported housing prices. As the Journal reports, housing prices are up 38 percent in five years and housing starts hit a 16-year high last year. Moreover, sales of both new and existing homes remained strong through April, topping March levels. It was the fifth-strongest monthly sales pace ever, according to the National Association of Realtors.
To most, the strong housing market has "saved" the economy by providing consumers with fresh purchasing power and housing gains have helped cushion many from the withering blows of the stock market’s decline.
But the housing boom is not an unmitigated good. "Economic stimulus that is so dependent on housing carries some risks," the Journal opines. "One is the possibility that a housing ‘bubble’ has developed that could abruptly lose air, although Greenspan doubts that is much of a danger."
No one can foretell the future, including Fed chairmen. Greenspan didn’t warn investors about the dangerous heights the stock market achieved and folks should not expect Greenspan to be any more prescient about housing. The possibility of a calamity beyond their powers is not something that political figures like to dwell on.
Nonetheless, the question must be asked: could the housing market be the next bubble? If so, the consequences would be much greater than the dissipation of stock market portfolios, especially since more people own homes than own stocks, and their homes are worth more than their portfolios. The Journal reports that "In 2001, 68 percent of families owned homes, which had a $122,000 median value; 52 percent had stock portfolios, with a median value [of ] $34,000."
Moreover, the average American consumer is not exactly in the best of financial health. Household debt as a percentage of disposable income hit a new all-time high of 106 percent in the fourth quarter of last year and unemployment is the highest it has been in a decade, according to the Wall Street Journal. Not surprisingly, personal bankruptcies also reached an all-time high of 1.5 million in 2002.
The fact is that housing bubbles can and do happen, though equity bubbles may be more widely known. Certain dates stick out like 1929 or 1987 as well-known periods of stock market meltdowns. No one mentions 1973–1975 or 1989–1993, even though housing prices took a beating over these periods. Many may find it hard to believe that one’s home could take a 25-percent hit in value. Maybe it’s because housing prices are not quoted everyday in the newspaper or updated every second on the Internet. Or maybe it’s because this trend of increasing housing prices has gone on for so long that people just continue to extrapolate the past into the future, just as the long bull market in stocks suspended belief in bear markets and business cycles.
The IMF produced a recent research paper titled "When Bubbles Burst" by Thomas Helbling and Marco Terrones. In that paper, the authors provide some interesting information about past housing busts.
They looked at quarterly real price declines (as opposed to nominal), from peak to trough, of at least 14 percent occurring since 1970 in 14 industrial nations. In total, they found 20 housing busts. In the United States, for example, five such busts were identified using their methodology. For example, they identified a housing bust as occurring between the peak in the fourth quarter of 1973 and the trough in the fourth quarter of 1974. The average decline was 30 percent (after adjusting for inflation) and the average length of these busts was four years.
As Helbling and Terrones note, "housing price busts were associated with more severe macroeconomic developments than equity price busts." This should not be a surprising finding given that housing represents the most valued asset of most consumers. It is also generally the most leveraged. According to National Mortgage News, the average mortgage is now north of $200,000—the highest in history, topping last year’s $190,000 average mortgage. This information was as of the first quarter of 2003 and with even lower rates since and continued strong home sales, this figure will be topped again soon.
Higher leverage means increased vulnerability should things go in the other direction. If you purchase a house with 20 percent down, a 10 percent decline in housing prices will result in a loss of 50 percent of your equity. So, you can imagine what a decline of 30 percent in housing prices will do to the balance sheet of the average family. The losses would be every bit as harrowing as the stock market collapse, more so given the relative financial weakness of the average consumer.
The central problem with the housing boom is that housing is an artificially stimulated sector of the economy. Surely, the housing market would look vastly different if not for the massive liquidity and support provided by the GSEs such as Fannie Mae. Fannie Mae enjoys the implicit guarantee of the federal government, which lowers the cost of its debt and extends the limits of leverage that it may undertake in its efforts to grow mortgages. Home loans, as the Journal opines, "freed from the vagaries of local economic and banking conditions, became cheaper and more readily available."
Long-standing public policy has always been to support home ownership. Mortgage interest, for example, is tax-deductible and housing gains can be shielded from capital gains taxes much more easily than, say, stock gains.
There are problems with this sort of government prodding. It creates a boom that is not sustainable. As Mises observed, "the artificial boom is not prosperity, but the deceptive appearance of good business." More investment has flocked to housing than otherwise would have without the government’s efforts. It is, in that sense, artificial. The housing boom has drawn off capital from other ventures and uses. In the US, the housing market is the overindulged sector of the economy that has gotten more than its share of investment capital. The true cost of the indulgence can only be guessed at. We have no way of knowing what else such capital might have contributed to human welfare.
Real enduring prosperity is achieved only when public savings have reached a level that can support the boom. As Mises warned, "If the public does not provide the means, they cannot be conjured up by the magic of banking tricks." Flooding the economy with money and credit is a banking trick, creating the illusion of wealth.
The world is highly complex; cause and effect are not easily discerned where a confluence of forces operates simultaneously. What first seems like a gain can later prove to be only a fleeting illusion as economic reality forces itself back into the picture. The vast majority of people have not taken the time to study human action in any detail and the effects of continually intervening in the economy can take years to become apparent. Even then, when the bubble bursts, many will not properly see that the root of the problem lies in the monetary order of the nation and in its interventionist political culture.
Christopher Mayer is a commercial lender for Provident Bank near Washington, DC (cwmayer@provbank. com).
