Monday, June 30, 2008

Root Cause


On June 25 The San Francisco Chronicle carried an op-ed article on the root causes of the housing crisis: Here’s a slightly longer version that includes a chart that did not appear in the online piece.

On June 25 the Census Bureau reported 512,000 new-home sales in May. Update the chart below with that data, and two observations strike you. First, there’s the enormity of the unfolding 2007 - 2008 real-estate debacle. Second, there’s the unprecedented nature of the 2000 – 2005 real-estate build-up. Home sales rose 50 percent beyond their earlier record. This was no ordinary cyclical upturn. This was the economic equivalent of a 100-year flood.

New Home Sales

(Click on chart to enlarge)

Recessions shaded

Here’s what happened.

Recall the expansion of the late 1990s. Business capital expenditures soared. Then the 2000 - 2001 crash hit. Orders for new plant and equipment plunged and the Federal Reserve came to the rescue by cutting interest rates.

The Fed did what every textbook recommends. As aggregate demand slumped, the Fed spurred lending and spending by reducing interest rates. This would revive the economy.

But the boom had been a technological phenomenon, not a response to reduced interest rates. Since falling rates had not instigated the boom, falling rates could not rekindle it.

Instead the Fed’s medicine stimulated a sector that was in no need of help. The chart shows that real estate was already strong when it received the Fed’s easy-money blessing in 2001.

For decades (1960 - 1990) new-home sales had fluctuated in a range of 400,000 to 800,000 annually. They attained new records in the late 1990s and barely suffered during the 2001 recession. When the Fed depressed interest rates in 2000 - 2002 and held them there, real estate exploded. New-home sales grew for an extraordinary 15 years as the 2000 - 2005 increase stood on the shoulders of the 1990 - 2000 real-estate expansion.

Rising inflation and rising interest rates had choked off demand in earlier housing expansions. Those upturns began at depressed levels and grew for a few years to strong but not excessive levels. The 2000 - 2005 upswing, by way of contrast, began after a decade of sales growth. By starting at such a high level of activity, the recent boom was able to go where no others had gone. It generated an asset inflation, excess supply and a glut of homes on the market.

Since the recent real-estate boom, like the boom before it, created an asset inflation that was not adequately reflected in the conventional (i.e. CPI) statistics, few cared. Enjoying a boom without CPI inflation was like draining the punchbowl without a hangover. Unfortunately asset inflations behave differently from ordinary price inflations. Asset inflations encourage demand rather than discourage it. Speculation carried housing prices and the size of the housing stock (supply) beyond any reasonable relationship to the earnings potential (rental value) of the underlying assets.

It is true that evolving lending practices contributed to the debacle. Mortgage securitization, the erosion of lending standards and lax regulatory oversight compounded the damage done by the Fed’s easy-money policy. Home buyers already had the speculative incentive to purchase homes because their prices were rising rapidly. Lax lending provided the means. Supply grew until it became a glut and toppled under its own weight.

Now the hangover has arrived and a great asset deflation is upon us. And just as asset inflations perversely stimulate demand, asset deflations perversely discourage demand. Buyers will hang back, waiting for prices to fall further. Receding interest rates sparked recovery from earlier real-estate declines because rising rates had choked-off demand and initiated the preceding slump. Today’s overbuilding is very different from earlier circumstances: Falling rates will be less effective in dealing with over-supply and asset deflation. Time must elapse for the market to absorb the glut.

Unfortunately, many lives and livelihoods will face ruin on the way. Too bad, because Federal Reserve policy lies at the heart of the crisis. In response to a high-tech bust that falling interest rates could not alleviate, the Fed employed falling interest rates to stimulate a housing sector that already enjoyed boom conditions. That mismatch of diagnosis and treatment built the foundation of all that followed, including the Fed’s current difficulty in resuscitating residential real estate.

Of course, this critique has the wisdom attributable to all hindsight. The Fed did meet most people’s expectations in 2000 - 2002, and the chairman wasn’t called “Maestro” because he disappointed. It is monetary policy itself that requires re-examination. Perhaps the textbook remedies are not applicable in every circumstance. Demand management worked in the past. This time it didn’t.

(The chart was taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of Economic Indicators.)

© 2008 Michael B. Lehmann

No comments: