Economy

The Logic of Bubbles

By Ryan McGreal
Published September 07, 2005

The "recovery" in the United States the past three years has been largely due to Federal Reserve Chairman Alan Greenspan's rock-bottom interest rates (one percent in 2002 - effectively zero when inflation is taken into account) spurring a housing boom that The Economist calls "the biggest bubble in history".

Over five percent of America's GDP is directly tied to housing; 40 percent is indirectly tied to housing. Two-fifths of all new jobs created in the past four years have been directly housing-related. Nearly all the growth in GDP since the 2001 recession has been related to houses and consumer spending to fill those houses.

Meanwhile, the houses themselves are purchased on ever-shakier financial foundations: no money down, interest-only or 'negative amortization', adjustable rate mortgages are fast becoming the norm, not the exception. Investors are buying second homes and renting them at a loss in the expectation that house prices will continue to rise.

The whole shaky edifice will stand only as long as interest rates remain low and the number of homeowners continues to grow. There are plenty of reasons to doubt that those two criteria will endure for long.

Just about everyone who can remotely afford a house (and many who clearly cannot afford it) has already bought one. At the same time, the massive run-up in house prices over the past five years has reached the point where it is now pricing new buyers out of the market.

At the same time, inflation is returning to the American economy, driven by high oil prices. The Fed has already begun ratcheting up the overnight lending rate, partly in response to inflationary pressures. Each quarter point increase pushes everextended home buyers on adjustable rate mortgages closer to bankruptcy.

At the same time, the central banks of other countries have begun reducing their reserves of US dollars in response to America's poor economic fundamentals ($500 billion federal deficit, $700 billion trade deficit, $7.9 trillion federal debt, zero savings rate) in an attempt to insulate themselves from the risk of a dollar slide against other currencies, particularly the euro (it's already lost a third of its value since 2001).

The long run-up in oil prices over the past two years has been a boon for the dollar, forcing oil importers to mop up all the dollars America is hemmoraging overseas so they can buy more expensive oil. However, a number of OPEC countries are publicly musing about selling oil for euros rather than dollars. Iran plans to establish a euro-based oil bourse in early 2006.

If that happens, many central banks will begin diversifying their oil currency reserves, and the dollar will continue to slide. The Fed will have no choice but to jack up American interest rates to continue attracting foreign investment, and that will push even more American homeowners over the edge.

The Fed is currently tweaking interest rates in the hopes of a "soft landing", in which home prices simply level off and the mania subsides without slowing overall growth. In Greenspan's customary understatement,

the housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home price increases will slow and prices could even decrease. As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures. The estimates of how much differ widely.

However, the logic of the bubble more or less precludes any outcomes on the optimistic side of the scale:

All these signs point to a significant recession when the bubble stops expanding.

The housing market may already be on a peak. As of this summer, new home sales are still increasing, but resales are down slightly, and average prices for both are down slightly as well. Houses are also taking longer to sell. These are all signs that the mania is starting to lose steam.

One more thing: even as homebuilding executives continue to boast the the market is doing great, they've started selling their own shares in droves, and stocks in housing companies are falling. The prudent observer's response is to ignore what these people say (after all, it's in their interest to convince the public to keep buying) and pay attention to what they do.

As Globe and Mail columnist Derek DeCloet warns, "There are many reasons to sell a stock, and believing it's about to go up usually isn't one of them."

Ryan McGreal, the editor of Raise the Hammer, lives in Hamilton with his family and works as a programmer, writer and consultant. Ryan volunteers with Hamilton Light Rail, a citizen group dedicated to bringing light rail transit to Hamilton. Ryan writes a city affairs column in Hamilton Magazine, and several of his articles have been published in the Hamilton Spectator. He also maintains a personal website and has been known to post passing thoughts on Twitter @RyanMcGreal. Recently, he took the plunge and finally joined Facebook.

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