August 23, 2005,
In a recent Wall Street Journal editorial, American Enterprise Institute visiting scholar John Makin wrote that, “America’s economy is heavily dependent on a housing boom.” To Makin’s way of thinking, the “existence of a bubble in major metropolitan areas is not in doubt,” so it’s up to the Fed “to engineer a carefully modulated tightening to avoid the same fate for the U.S.”
Makin cites his own experience while living in Japan in the late ’80s, along with the recent property situations of England, Australia, and New Zealand, to support his belief that the U.S. faces a “leveling of housing prices” in the coming year. If the leveling occurs absent a fall in energy prices, Makin says U.S. economic growth “could easily drop to 2.5 percent or lower.” Though Makin’s story is a potentially chilling one, it’s fortunately not the whole story.
To begin, Makin said the “U.S. real estate bubble is a crucial ingredient in sustaining global demand growth;” the demand growth presently sustained by an “innovative mortgage sector [that] arranges for the easy withdrawal of rising equity in homes.” What Makin seems to miss is that whether we’re talking international or domestic savings, there is someone on the other side of each mortgage origination forgoing the very consumption he claimed is presently driving economic growth. At best the wealth effect he spoke of is a wash.
Moving to interest rates, Makin argued that steady Fed rate increases “will at least slow, and perhaps reverse, the sharp rise in housing.” Japan, England, Australia, and New Zealand were his examples, and in truth Japan’s prime lending rate did rise from 5.7 percent in 1989 to 7.8 percent in 1991 as real estate began its long slide. What wasn’t mentioned is that 7.8 was a high sustained only until February of that year. Since then the prime lending rate has plummeted below 2 percent with no property recovery in sight.
The U.S. real estate experience over the last thirty years offers additional evidence that Makin’s interest-rate/property-price correlations are overrated. For one, each of the three property bear markets during that time (1974-75, 1980-82, 1990-92) occurred amidst falling rates, while the last “frothy” U.S. real estate market (1976-1980) occurred as the prime rate raced into the double digits.
Makin said a steady rise in the present federal funds rate will eventually slow the real estate boom, but from January of 1976 to January of 1980 the fed funds rate rose from 4.87 to 13.82 percent. If Fed rate hikes are so powerful, why has the 250 basis point rise this year been met with ever-rising property prices? Makin’s answer is that “long-term interest rates are actually lower than they were a year ago.” This would seem a logical answer except that the U.S. 10-Year Treasury rose from 7.8 percent in 1976 to 12.4 percent in 1980.
Affordability? Makin argued that it is “becoming an increasing problem at the margin.” Rising prices might make this seem so. But the National Association of Realtors announced last week that existing home sales “soared to new heights in the second quarter of 2005.” This occurred as volume hit a record, and as prices rose 13.6 percent.
Citing England, Australia, and New Zealand, Makin noted that rate hikes from 2003-04 have “quelled the housing boom” in each of the three countries. Are any in the midst of a slowdown? Not according to their equity markets. Since 2004 stocks are up 17 percent in England, 28 percent in Australia, and 38 percent in New Zealand.
Makin urged the Fed to move cautiously with the fed funds rate, and that’s precisely the point: Interest rate hikes are often positive for normalizing the natural interest rate, and in the process strengthening the currency. Since economies and stocks loathe inflation, proper rate hikes can lead to orderly exits from real asset classes such as property and commodities to intangible asset classes such as stocks. That’s apparently what happened in England, Australia, and New Zealand, and judging by recent strength in U.S. equities, that’s what is happening here. If a recession were on the way, would stocks be rallying?
Returning to Makin’s discussion of nominal rates, examples here indicate that they’re somewhat of a sideshow, and that the real challenge is keeping currencies on a stable value path. The Japanese experience (irrespective of rates) shows the dangers of deflation, while our own history shows how a falling dollar (also irrespective of rates) often pulls capital from the metaphysical economy to the physical.
Importantly, the Fed should in the future strive to be neutral about where capital flows. Makin said President Bush should be very interested in how Alan Greenspan’s replacement will maneuver us out of what he deemed an economy-boosting real estate bubble. Here’s hoping Bush keeps it far simpler, and instead asks how the next Fed chairman will maintain a stable dollar. If the latter can be achieved, conversations about stock and real estate “bubbles” will rapidly become a thing of the past.
John Tamny is a writer in Washington, D.C. He can be contacted at firstname.lastname@example.org.