Saturday, December 22, 2007

This Time It’s Different


At the height of the late-1990s boom, New Economy advocates insisted, “This time it’s different,” because (they believed) rising productivity (efficiency) ensured continually rising corporate earnings. Soaring profits guaranteed the stock market would never cease climbing. As long as inflation remained at bay, the engine couldn’t stall. (Because – they thought - only rising inflation brought the higher costs that eroded profit margins.) As we now know, profits stopped rising when full employment boosted wage costs without generating inflation (modest capacity-utilization rates and cheap imports restrained prices). Slumping profits stopped the boom and the bubble burst.

Something similar happened at the height of the recent real-estate boom. Lenders and their advocates (such as the Federal Reserve), insisted this boom was different because of inflation’s absence. Therefore interest rates would not rise and snuff out the mortgage lending that powered the boom. Besides, lenders’ new instruments brought the possibility of homeownership to an ever-wider circle of Americans, constantly expanding the market for new homes. The boom would keep rolling along. The boom’s advocates didn’t realize that a bubble could form without inflation’s presence, and that risky lending practices could imperil financing. Now that the air is escaping from the bubble, it’s not clear that the Fed’s expansionary policy can stop the leak.

Ironically this real-estate boom was different in at least one important way, and that impedes the Fed’s attempts to rescue the economy. See the December 19 article by George Anders in The Wall Street Journal, available at (

Mr. Anders observes that shrinking down payments, or their complete absence, have eroded some home owners’ commitment to their homes. In the past substantial down payments buttressed home owners’ commitment to their property. Loan default and abandonment meant forsaking the home owners’ stake in the house. Since buyers had some skin in the game, they were reluctant to walk away from their homes. Today’s buyers are more likely to abandon their properties because they have nothing to lose.

As Mr. Anders put it:

“Because of lax lending standards in the past few years, many homeowners never amassed much equity in their homes. Sizable down payments became a rarity, as many buyers borrowed close to 100% of the purchase price through a blend of first mortgages and home-equity lines of credit. Others kept refinancing their mortgages as property prices climbed, taking on bigger loans and draining the equity value of their homes.
“As a result, there is a new class of homeowners in name only. Because these people never put up much of their own money, they don't act like owners, committed to their property for the long haul. They behave more like renters, ducking out of an onerous lease in the midst of a housing slump.
“In such an environment credit scores don't really provide a definitive gauge of how hard a borrower will work to avoid default, says Mark Zandi, chief economist of Moody's Inc., a West Chester, Pa., economic-research firm. A better test, he says, is how much equity owners have in their home. If they have a lot at stake, default becomes almost unthinkable. Without much equity, the commitment to keep paying the mortgage, no matter painful that may be, begins to dwindle.
“How did banks' lending standards get so far off course? Familiar answers include a race for market share, a herd mentality and the apparent profitability of risky lending in boom times.”

If the real-estate bust does drag the economy down into a slump, there’s another way this time may be different. The Fed’s expansionary policies easily cured past recessions that had been instigated by rising prices and interest rates. As soon as recession halted the inflation, and the Fed’s expansionary policies depressed interest rates, borrowing and spending snapped back. The economy was off and running again. Low interest rates cured the 2001 recession by substituting a real-estate bubble for the bubble.

This time, however, falling interest rates may not work effectively to re-start demand. The residential real-estate market may be too depressed for lower interest rates to work their magic. Why buy an asset with little prospect for appreciation?

That could present a different kind of problem for the American economy. It may begin to resemble Japan’s economy in the 1990s. Japan took more than a decade to recover from its real-estate bust and its economy consequently languished.

As the December 15 Economist ( said:

“Another month, another bank in trouble, another raised estimate of bad assets in the financial system, and another move by the central bank to try and contain the problem: to observers in Japan, America's spreading credit crunch has an eerily familiar ring.
“Though differences between the subprime crisis and the bursting of Japan's own property bubble after 1989 are inevitably great, the similarities are striking.”

This time may really be different if the Fed’s expansionary policy can’t work its magic once more.

© 2007 Michael B. Lehmann

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