Affordable Housing Institute : US

If gloom-and-doom newspaper articles moved markets, house prices would long since have dropped … but they haven’t.  Why not? 

 

“Sorry, the monetary policy was over here.“

 

For that matter, the United States is running major budget deficits and a gargantuan trade deficit, yet our interest rates are likewise very low.  Why not?

 

Perhaps it’s due to the Amazing Mystico:

 

 

Cut to a building site. The camera pans over it.
Voice Over	Even more modern building techniques are being used on an expanding new town site near Peterborough; here the Amazing Mystico and Janet can put up a block of flats by hypnosis in under a minute.
	Mystico removes his cloak, gloves and top hat and hands them to Janet, who curtseys. He then makes several passes. Cut to stock film of flats falling down reversed so that they leap up.

 

 

Cut back to Mystico and Janet. She hands him back his things as they make their way to their car, a little Austin 30.

 

You don’t think so? 

 

You do not believe?

 

 

Building on Fed Chairman Greenspan’s remarks, the Wall Street Journal (subscription required, naturally) has a lengthy, substantive, and very intriguing article (June 9, 2005, “After Bubble, Fed Helped Create New Threats,” by Greg Ip) about the markets’ continuing belief:

 

By many yardsticks, the Federal Reserve’s response to the bursting of the stock and tech-spending bubbles in 2000 has been a remarkable success.  The 2001 recession was mild and economic growth since has been brisk.  Employment is up and inflation remains within the Fed’s hallowed zone of price stability.

But five years after the stock market’s peak, the economy faces other threatening imbalances: a potential housing bubble, rock-bottom personal saving rates and a gargantuan trade deficit. And the Fed’s post-bubble prescription bears some responsibility for all three. Fed officials acknowledge as much but say the alternatives were worse.

How did the Fed pull this off?  In time-honored fashion, when facing a slowdown in demand, cut interest rates, which forces capital out into the marketplace:

 

In the 1990s, Mr. Greenspan chose [that] as long as the prices of goods and services were stable, he would leave the stock market alone. When the stock bubble finally burst, the Fed cut short-term rates aggressively beginning in 2001 and then held them at a 45-year low of 1% through early 2004 until the Fed was sure the threat of deflation had receded.

The Fed thus encouraged Americans to borrow more, gave them little reward for saving and helped ignite a surge in housing prices.

 

“Let’s see, at 80% loan-to-value …”

 

And it has worked!

 

“We have done what no other economy has done before, faced with an asset bubble,” Lawrence Lindsey, a former Fed governor and Bush adviser, said at a recent panel discussion.  Praising both the Fed’s rate cuts and Mr. Bush’s tax cuts, he said, “This is the first time in history the textbook economic policy… was used, and worked.”

 

Indeed, compared to other alternatives, the Fed’s actions are worthy of El Mystico himself:

 

Voice Over	The local Council here have over fifty hypnosis-induced twenty-five story blocks, put up by El Mystico and Janet.  I asked Mr Ken Verybigliar the advantages of hypnosis compared to other building methods.
	Cut to a man in a drab suit.
	SUPERIMPOSED CAPTION: ‘MR K. V. B. LIAR’
Mr Verybigliar	Well there is a considerable financial advantage in using the services of El Mystico. A block, like Mystico Point here (indicating a high-rise block behind him) would normally cost in the region of one-and-a-half million pounds. This was put up for five pounds and thirty bob for Janet.

 

Indeed, the benefits of low interest rates and high home prices are well-nigh irresistible:

 

This is pleasant for Americans as long as it lasts. But Fed officials, international financial watchdogs and private economists say it can’t. At some point, American consumers must spend less, save more and rely less on foreigners’ savings.

How that will happen puts the nation in uncharted territory: After treating a bubble, how does the Fed manage the side effects of its medicine?

 

Lawrence Lindsay again:

 “The problem is, once you finish that chapter of the economic texts, you turn the page and the page is blank — because no one has gone through the process before.”

 

Like a Red Sox fan, you gotta believe!

The Fed is confident these imbalances will be resolved with little pain. As it raises interest rates, consumers will slow their spending and save more. Foreigners’ appetite for U.S. goods will rise. The engine of U.S. growth will shift smoothly from consumers and government to business investment and exports.

So much of the prosperity that is currently sustaining the US economy is attributable to the low interest rates and flat yield curve.

 

 

[After Greenspan's interest rate cuts], the dollar didn’t fall initially, but rose because foreign economies were in even worse shape than the U.S.’s. This meant the economy relied disproportionately on the one channel that did respond: consumers. They bought record numbers of houses and cars, mostly on credit. They also borrowed against their houses’ appreciated values, allowing them to spend more still.

To Mr. Greenspan, who had studied housing and mortgage markets all his life, this came as no surprise. “Households have been able with increasing ease to extract equity from their homes, and this doubtless has helped support consumer spending in recent years, complementing the traditional effects of monetary policy,” he observed in August 2003.

Ordinarily, big budget deficits and trade deficits would kick off fears of inflation, and a steeply positive yield curve.  The housing marketplace, that vast source of liquid wealth, has kept demand going, in part because the yield curve has stayed so flat, and the yield curve will stay flat so long as people believe it will:

 

Voice Over	But the obvious question is, are they safe?
	Cut to an architect’s office. The architect at his desk. Behind him on the wall are framed photos of various collapsed buildings.  He is a well-dressed authoritative person.
	SUPERIMPOSED CAPTION: ‘MR CLEMENT ONAN, ARCHITECT TO THE COUNCIL’
Architect	Of course they’re safe. There’s absolutely no doubt about that. They are as strong, solid and as safe as any other building method in this country — provided, of course, people believe in them.

 

So far, American consumers, American policymakers, and foreign investors have all been content to live in America’s Mystico Towers. 

 

“If I were a biologist I’d call this a perfect example of symbiosis,” former Fed Chairman Paul Volcker mused in a February speech at Stanford University. “Contented American consumers matched against delighted foreign producers. Happy borrowers matched against willing lenders. The difficulty is, the seemingly comfortable pattern can’t go on indefinitely.”

Critically, however, a few economists do not believe in them:

 

But a minority of economists warn of a more damaging scenario. Some say the Fed has simply replaced the stock-market bubble with one in housing, which could burst. That would sap the consumer spending that mortgage refinancing and home-equity loans have fueled. Or foreign investors could stop buying U.S. stocks and bonds, sending the dollar down and inflation up, prompting both the Fed and bond market to jack up interest rates sharply. In either case, the U.S. economy could slow sharply or fall into recession.

	Cut to a council flat. On the wall there is a picture of Mystico.
Tenant	Yes, we received a note from the Council saying that if we ceased to believe in this building it would fall down.
Voice Over	You don’t mind living in a figment of another man’s imagination?
Tenant	No, it’s much better than where we used to live.
Voice Over	Where did you used to live?
Tenant	We had an eighteen-roomed villa overlooking Nice.
Voice Over	Really, that sounds much better.
Tenant	Oh yes – yes you’re right.

 

“The magnitude of these imbalances is increasingly moving into unfamiliar territory,” Mr. Kohn said in April. Since his February 2003 speech, house values have risen 25% and total mortgage debt by 28%, while after-tax incomes have expanded just 13%. The household saving rate, a low 2% in 2000, has fallen to 0.9%. A growing share of mortgages have gone to speculators and people making little or no down payment. House “prices have gone up far enough since then — relative to interest rates, rents and incomes — to raise questions,” Mr. Kohn said in April.

Is Mystico Towers tottering:

 

	Cut to stock shot of block falling down in slow motion. Cut back to tenant and wife inside. Camera shaking and on the tilt.
Tenant	No, no, no, of course not.

 

Fed staff research shows that in the past, when a big, rich country has a large current account deficit, it usually narrows without crisis. Homes may be overvalued but are much harder to trade than stocks and thus unlikely to collapse abruptly. Fed officials expect home prices to stagnate while incomes advance, bringing affordability back to historic ranges.

	Cut to stock film again. The building rights itself. Cut back to interior again. Camera slightly on tilt. They are holding bits of crockery etc.
Tenant	Phew, that was close.

 

Meanwhile, even as the Fed raises short-term interest rates, long-term interest rates, which are set on markets, have actually declined, a development that baffles Mr. Greenspan.

 

Belief in Greenspan is trumping Greenspan’s belief. 

 

“I don’t believe it!”

“That — is why you fail.”

– Yoda, The Empire Strikes Back

 

Since mortgage rates are tied to long-term bond yields, home prices have advanced at one of their fastest rates yet over the spring. Mr. Greenspan has acknowledged “a little froth” in the housing market.

 What should the Fed do? Mr. Volcker, focusing on the current account deficit, thinks the Fed ought to put added weight on keeping inflation under control. “I am worried about a tendency to relax our guard,” he said. It is critical foreigners remain confident that “those trillions of dollars they are piling up are going to be protected against inflation.”

 

Foreign investors will continue to invest so long as they remain confident:

 

Some of today’s Fed leadership shares this view: The Fed can minimize the odds of crisis by keeping inflation down, which means erring on the side of higher interest rates.

Mr. Lindsey, on the other hand, believes the Fed should worry less about inflation and more about keeping the housing market from sinking. “You don’t want to collapse asset prices,” he says. “You want to give people time to adjust in a gradual way.” He thinks the Fed should slowly raise its target for short-term interest rates, now at 3%, to 3.5%, and then stop.

Mr. Kohn, in his April speech, made it clear the Fed would not let imbalances deter any necessary action to keep inflation down: “We should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly.”

 

Have the markets, in other words, adopted so much confidence in Mr. Greenspan and the Fed that their belief amounts to faith?  How long can we live in Mystico Towers?

 

“All right, I’ll give it a try.”

“No.  Try not.  Do, or do not.  There is no try.”

 

 

Building on Fed Chairman Greenspan’s remarks, the Wall Street Journal (subscription required, naturally) has a lengthy, substantive, and very intriguing article (June 9, 2005, “After Bubble, Fed Helped Create New Threats,” by Greg Ip) about the markets’ continuing belief:

 

By many yardsticks, the Federal Reserve’s response to the bursting of the stock and tech-spending bubbles in 2000 has been a remarkable success.  The 2001 recession was mild and economic growth since has been brisk.  Employment is up and inflation remains within the Fed’s hallowed zone of price stability.

But five years after the stock market’s peak, the economy faces other threatening imbalances: a potential housing bubble, rock-bottom personal saving rates and a gargantuan trade deficit. And the Fed’s post-bubble prescription bears some responsibility for all three. Fed officials acknowledge as much but say the alternatives were worse.

How did the Fed pull this off?  In time-honored fashion, when facing a slowdown in demand, cut interest rates, which forces capital out into the marketplace:

 

In the 1990s, Mr. Greenspan chose [that] as long as the prices of goods and services were stable, he would leave the stock market alone. When the stock bubble finally burst, the Fed cut short-term rates aggressively beginning in 2001 and then held them at a 45-year low of 1% through early 2004 until the Fed was sure the threat of deflation had receded.

The Fed thus encouraged Americans to borrow more, gave them little reward for saving and helped ignite a surge in housing prices.

 

“Let’s see, at 80% loan-to-value …”

 

And it has worked!

 

“We have done what no other economy has done before, faced with an asset bubble,” Lawrence Lindsey, a former Fed governor and Bush adviser, said at a recent panel discussion.  Praising both the Fed’s rate cuts and Mr. Bush’s tax cuts, he said, “This is the first time in history the textbook economic policy… was used, and worked.”

 

Indeed, compared to other alternatives, the Fed’s actions are worthy of El Mystico himself:

 

Voice Over	The local Council here have over fifty hypnosis-induced twenty-five story blocks, put up by El Mystico and Janet.  I asked Mr Ken Verybigliar the advantages of hypnosis compared to other building methods.
	Cut to a man in a drab suit.
	SUPERIMPOSED CAPTION: ‘MR K. V. B. LIAR’
Mr Verybigliar	Well there is a considerable financial advantage in using the services of El Mystico. A block, like Mystico Point here (indicating a high-rise block behind him) would normally cost in the region of one-and-a-half million pounds. This was put up for five pounds and thirty bob for Janet.

 

Indeed, the benefits of low interest rates and high home prices are well-nigh irresistible:

 

This is pleasant for Americans as long as it lasts. But Fed officials, international financial watchdogs and private economists say it can’t. At some point, American consumers must spend less, save more and rely less on foreigners’ savings.

How that will happen puts the nation in uncharted territory: After treating a bubble, how does the Fed manage the side effects of its medicine?

 

Lawrence Lindsay again:

 “The problem is, once you finish that chapter of the economic texts, you turn the page and the page is blank — because no one has gone through the process before.”

 

Like a Red Sox fan, you gotta believe!

The Fed is confident these imbalances will be resolved with little pain. As it raises interest rates, consumers will slow their spending and save more. Foreigners’ appetite for U.S. goods will rise. The engine of U.S. growth will shift smoothly from consumers and government to business investment and exports.

So much of the prosperity that is currently sustaining the US economy is attributable to the low interest rates and flat yield curve.

 

 

[After Greenspan's interest rate cuts], the dollar didn’t fall initially, but rose because foreign economies were in even worse shape than the U.S.’s. This meant the economy relied disproportionately on the one channel that did respond: consumers. They bought record numbers of houses and cars, mostly on credit. They also borrowed against their houses’ appreciated values, allowing them to spend more still.

To Mr. Greenspan, who had studied housing and mortgage markets all his life, this came as no surprise. “Households have been able with increasing ease to extract equity from their homes, and this doubtless has helped support consumer spending in recent years, complementing the traditional effects of monetary policy,” he observed in August 2003.

Ordinarily, big budget deficits and trade deficits would kick off fears of inflation, and a steeply positive yield curve.  The housing marketplace, that vast source of liquid wealth, has kept demand going, in part because the yield curve has stayed so flat, and the yield curve will stay flat so long as people believe it will:

 

Voice Over	But the obvious question is, are they safe?
	Cut to an architect’s office. The architect at his desk. Behind him on the wall are framed photos of various collapsed buildings.  He is a well-dressed authoritative person.
	SUPERIMPOSED CAPTION: ‘MR CLEMENT ONAN, ARCHITECT TO THE COUNCIL’
Architect	Of course they’re safe. There’s absolutely no doubt about that. They are as strong, solid and as safe as any other building method in this country — provided, of course, people believe in them.

 

So far, American consumers, American policymakers, and foreign investors have all been content to live in America’s Mystico Towers. 

 

“If I were a biologist I’d call this a perfect example of symbiosis,” former Fed Chairman Paul Volcker mused in a February speech at Stanford University. “Contented American consumers matched against delighted foreign producers. Happy borrowers matched against willing lenders. The difficulty is, the seemingly comfortable pattern can’t go on indefinitely.”

Critically, however, a few economists do not believe in them:

 

But a minority of economists warn of a more damaging scenario. Some say the Fed has simply replaced the stock-market bubble with one in housing, which could burst. That would sap the consumer spending that mortgage refinancing and home-equity loans have fueled. Or foreign investors could stop buying U.S. stocks and bonds, sending the dollar down and inflation up, prompting both the Fed and bond market to jack up interest rates sharply. In either case, the U.S. economy could slow sharply or fall into recession.

	Cut to a council flat. On the wall there is a picture of Mystico.
Tenant	Yes, we received a note from the Council saying that if we ceased to believe in this building it would fall down.
Voice Over	You don’t mind living in a figment of another man’s imagination?
Tenant	No, it’s much better than where we used to live.
Voice Over	Where did you used to live?
Tenant	We had an eighteen-roomed villa overlooking Nice.
Voice Over	Really, that sounds much better.
Tenant	Oh yes – yes you’re right.

 

“The magnitude of these imbalances is increasingly moving into unfamiliar territory,” Mr. Kohn said in April. Since his February 2003 speech, house values have risen 25% and total mortgage debt by 28%, while after-tax incomes have expanded just 13%. The household saving rate, a low 2% in 2000, has fallen to 0.9%. A growing share of mortgages have gone to speculators and people making little or no down payment. House “prices have gone up far enough since then — relative to interest rates, rents and incomes — to raise questions,” Mr. Kohn said in April.

Is Mystico Towers tottering:

 

	Cut to stock shot of block falling down in slow motion. Cut back to tenant and wife inside. Camera shaking and on the tilt.
Tenant	No, no, no, of course not.

 

Fed staff research shows that in the past, when a big, rich country has a large current account deficit, it usually narrows without crisis. Homes may be overvalued but are much harder to trade than stocks and thus unlikely to collapse abruptly. Fed officials expect home prices to stagnate while incomes advance, bringing affordability back to historic ranges.

	Cut to stock film again. The building rights itself. Cut back to interior again. Camera slightly on tilt. They are holding bits of crockery etc.
Tenant	Phew, that was close.

 

Meanwhile, even as the Fed raises short-term interest rates, long-term interest rates, which are set on markets, have actually declined, a development that baffles Mr. Greenspan.

 

Belief in Greenspan is trumping Greenspan’s belief. 

 

“I don’t believe it!”

“That — is why you fail.”

– Yoda, The Empire Strikes Back

 

Since mortgage rates are tied to long-term bond yields, home prices have advanced at one of their fastest rates yet over the spring. Mr. Greenspan has acknowledged “a little froth” in the housing market.

 What should the Fed do? Mr. Volcker, focusing on the current account deficit, thinks the Fed ought to put added weight on keeping inflation under control. “I am worried about a tendency to relax our guard,” he said. It is critical foreigners remain confident that “those trillions of dollars they are piling up are going to be protected against inflation.”

 

Foreign investors will continue to invest so long as they remain confident:

 

Some of today’s Fed leadership shares this view: The Fed can minimize the odds of crisis by keeping inflation down, which means erring on the side of higher interest rates.

Mr. Lindsey, on the other hand, believes the Fed should worry less about inflation and more about keeping the housing market from sinking. “You don’t want to collapse asset prices,” he says. “You want to give people time to adjust in a gradual way.” He thinks the Fed should slowly raise its target for short-term interest rates, now at 3%, to 3.5%, and then stop.

Mr. Kohn, in his April speech, made it clear the Fed would not let imbalances deter any necessary action to keep inflation down: “We should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly.”

 

Have the markets, in other words, adopted so much confidence in Mr. Greenspan and the Fed that their belief amounts to faith?  How long can we live in Mystico Towers?

 

“All right, I’ll give it a try.”

“No.  Try not.  Do, or do not.  There is no try.”

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