Stock, Housing, and Bond Market Bubbles

Greg Ip writes about the housing bubble. In my view, the housing bubble is secondary--it is the bond market conundrum (the continuance of very low long-term interest rates) that is central. Housing prices, after all, are not *that* out of line if current long-term interest rates were likely to continue. I don't think that long-term interest rates at current rates are likely to continue. There will have to be "adjustments" in many markets other than the housing market. How to finesse them is an interesting and unanswered question: a "research topic."

Let me turn the microphone over to Greg Ip:

WSJ.com - In Treating U.S. After Bubble, Fed Helped Create New Threats: 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.

By slashing short-term interest rates to 45-year lows, the Fed encouraged Americans to borrow more, gave them little reward for saving and helped ignite a surge in housing prices.... All that spending contributed to a growing U.S. economy, a steady increase in imports and... a mountain of foreign debt. This is pleasant for Americans as long as it lasts. But Fed officials, international financial watchdogs and private economists say it can't.... After treating a bubble, how does the Fed manage the side effects of its medicine?...

[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.... Accused by some of fostering excess, Fed officials responded that the alternative was worse: a deeper recession and the risk of deflation -- a period of generally falling prices, which can worsen a downturn by making it harder for workers and companies to repay debts....

"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." Almost every economist agrees. The debate is over how, not whether, the global economy rebalances: Will it be smooth, through some combination of declining dollar and accelerating foreign demand? Or will it be chaotic, with a dollar collapse, much higher U.S. interest rates and perhaps a global recession? Mr. Volcker thinks a crisis is likely. Investor confidence could fade "at some point," he said, with "damaging volatility in both exchange markets and interest rates."...

Fed staff research shows that in the past, when a big, rich country has a large current account deficit, it usually narrows without crisis.... That benign scenario has yet to unfold. Business investment is growing but by less than the Fed had expected....

Comments

[Alex]

The main reason to fear that the rebalancing will be chaotic is that noone seems to know what to do about it, and it's exceedingly unlikely that Bush and co. would have the courage to implement a plausible fix if there were one.

[Nicholas weaver]

I disagree. Housing prices ARE way out of line, even WITH the low interest rates.

A condo equivelent to my apartment (SF bay area, Richmond CA), financed with 10% down, 6% interest, 30 years, costs $500/month MORE in interest, property tax, HOA, insurance (nonrecoverable costs), etc, after including the tax deductions. ~$700 if you get AMTed.

If that isn't out of line, I don't know what is.

[Movie Guy]

It's unfortunate that Greg failed to note the rising percentage of interest-only and other variable interest mortgages.

Overlooking that component of market sales and the potential implications vastly underestimates the situation.

[Silent E]

Nicholas,

How does the rent compare to the IO payments on a 5 yr IO ARM? Maybe it's not so absurd...

[Josh Narins]

Sometimes I think that when long-term interest rates are low, people just don't see too many bright spots in the future.

Get it now, or not at all, could be one idea.

Or, the world will have gone to pot by then.

[modus potus]

Silent E, I recently moved out of a house in the South SF Bay area that I rented for $1900/mo. A comparable house just down the block sold for $795,000 last Fall. Both figures are representative for the neighborhood. Show me an IO ARM that would yield a payment even close to as small as the rent.

[jon]

I think it goes beyond stock, housing and bond bubbles. It is a world wide credit(debt) bubble that has been caused by the United States Government and the Federal Reserve. Am not sure we have ever experienced anything like this before. The deflating of this bubble will not be pretty and has already started.