Waiting for the Housing Bubble to Burst Jude Wanniski June 15, 2005

When it looks like the "housing bubble" will burst, you can be sure we will let you know so you can adjust your asset portfolio accordingly. Meanwhile, our advice is to ignore all the research reports, news articles and television interviews you come across that warn a bursting is just around the corner. In all of economic history, the only time "bubbles" appear is when economists are not around who understand why the broad market suddenly decides a downward adjustment in asset prices is necessary. So those available announce "a bubble" as the reason for the sell off. This means the marketplace is irrational and steps must be taken to control it through new laws and regulations.

To this day, the Economic Establishment insists the 1929 Wall Street Crash was simply a bubble bursting, the puncturing of an "irrational exuberance" among crazed speculators. In 1977, I discovered it was the effective enactment of the Smoot-Hawley Tariff Act that caused the Crash, but to this day no economic textbook includes even the possibility that I am right. The professionals prefer John Kenneth Galbraith's "bubble" hypothesis.

In 1987, Wall Street crashed again, and although I spent an hour and a half the week before warning Treasury Secretary James Baker III the market would break unless he did everything he could to prevent the slide of the dollar, including the sale of gold to mop up surplus liquidity, and instead he got into a fight with the Bundesbank over the weekend and the market went south on Monday. Another bubble.

In 2000, I warned my clients in March that there would be a sell-off on April 14, a Friday, and the last day taxpayers could sell shares to raise the funds to meet their swollen capital-gains liabilities. Except for the New York Post, which credited me with the forecast and its reason, the major media decided it was just another bubble.

This background is of course partly to blow our horn, but more pointedly to underscore our conviction that the boom in the U.S. housing market is entirely rational, as is the related global boom in real property. I`d put off writing this, but something snapped on Sunday when I read the "Mr. Bubble" editorial in the New York Times, which opined that low mortgage rates are "symptomatic of an economy that is not doing as well as Mr. Greenspan suggests," and "depressed bond yields are generally the market`s way of saying that the economic outlook is worrisome."  This nonsense was followed by ABC`s "This Week" with George Stephanopolous devoting an hour to the housing bubble – with Rep. Barney Frank [D MA] saying society would benefit if the bubble would burst, so low-income people could afford to buy housing! Then came Gary North, the Austrian economist, writing yesterday that America is impoverishing itself by building too many houses; Americans not saving enough of their incomes. I almost have to pinch myself to see if I`m dreaming all this.

The real reason for the housing boom is that American families are getting wealthier, which means they can afford to buy bigger and better housing, while the monthly cost of financing those upscale homes out of current income has dropped significantly with the lower mortgage rates. This isn`t something that has happened in the last few years. It began with the Reagan Revolution. In 1980, according to Census figures, there were 80 million housing units. By 2002 there were roughly 120 million, with the 40 million increase a net of new units minus abandoned or destroyed units. In 1990 the housing industry was adding 1.5 million units per year and now it is adding 2.1 million per year. Almost all of the labor and material that goes into housing is domestic, so housing`s contribution to domestic GDP is very high in the global exchange economy. No outsourcing.

The NYTimes notion that low interest rates are bad news ignores the fact that there are two components to an interest rate, one reflecting the real demand for credit and the other reflecting inflation expectations. Interest rates were rock bottom in the Great Depression because real opportunities for productive enterprise were smothered by ridiculously high tax and tariff rates. Interest rates are low now because the monetary deflation of 1997-2003 wiped out the inflation component of interest rates, which is why the Fed sees long-term rates falling even as it raises short rates. There is no serious inflation threat here as long as gold behaves itself, which means long-term interest rates and mortgage rates will remain low as long as gold doesn`t shoot up. And that will not happen as long as the GOP government is following supply-side fiscal policies that keep demand for liquidity high.

This is good for the global housing industry because the other key currencies are either tied to the dollar (China and Hong Kong), or are guided by the dollar (The EU and Japan). With stable currencies, that serious part of financing housing ownership is reduced and so more housing is built and the better housing in better locations is bid up in price. The U.S. housing market also continues to benefit from the 1997 Tax Act, which exempts the first $500,000 of a primary home`s increase in value from capital gains tax, a measure that instantly added $4- to $5 trillion to the value of the nation`s housing stock. That gigantic number was then available as equity, against which families could borrow to move to bigger and better housing at those low interest rates.

Gary North, an excellent Austrian economist at the micro level, does not do as well at macroeconomics, and in this case fails to see that a home is both a consumer good and a capital good. So is a new suit of clothes, if it is required for business. The economics profession after WWII decided that economics would no longer be a behavioral science, but would become a mathematical science. This meant all economic "goods" had to be pigeonholed into the "consumer" box or the "capital" box. To extend North`s logic, which is also rampant among the neo-Keynesians, Americans should not only buy fewer homes, but also eat less and buy fewer clothes, putting their savings into "productive enterprise," such as the auto industry, the restaurant industry and the textile industry.

As for Barney Frank, who I have a number of times identified as one of the brightest lights on the House Financial Affairs Committee, we have to write off his display of ignorance to partisanship, as he hates to admit that Republican economic policies can produce general prosperity. Even before I met Art Laffer and Bob Mundell in the 1970s, I knew that the people at the bottom of the ladder could only afford to buy the homes being vacated by those who were buying homes of people vacating them on the next rung of the ladder, moving onwards and upwards. A bursting of the bubble now would not help low-income people, who would only find themselves being pushed off the ladder by folks crashing down from above, unable to make their mortgage payments. The housing industry – all those construction workers and suppliers of building materials and folks working on the financing – would have to downsize dramatically until the entire surplus inventory was absorbed.

Several years ago, I spent serious time on the telephone and in person with Barney Frank trying to get him to grasp the importance of fixing the dollar/gold price a la Bretton Woods. He was at least willing to engage in the exercise, but finally told me it was just too hard for him to understand, which only meant a failure on my part to get through to him. Because it can only be grasped completely in a behavioral model, not a mathematical model, there are only a handful of people in Washington who might be able to do so without complete retraining. Fed Chairman Alan Greenspan might, as he was predisposed to gold as a follower of Ayn Rand, but he shut down on the topic in 1997 when his six hikes in the funds rate had no effect on the gold price. He did not want to hear Poly`s arguments that the gold price could only be brought down by the central bank if it put interest rates aside and sold bonds to drain surplus liquidity. Once again, the problem is that Greenspan must operate in the mathematical model employed by the Fed, putting aside the behavioral aspects of changing one variable or another.

My effort lately has been to try to persuade other members of the Fed to at least consider the costs of the floating dollar since Nixon unhinged it in 1971. One open-minded FOMC member responded to my request that he look at the track record of the last half-century when the dollar was tied to gold and when it floated, in terms of household net worth. A Fed technician responded, sending us the tables from 1952 to 2004 from flow-of-funds data. I asked Paul Hoffmeister to make sense of them if he could and he soon reported:

Between 1952 and 1971, household net worth rose 3.2 times, while gold held steady. Meaning, real household net worth (based on gold, i.e., using gold as the inflation measure) grew 6.3% annually over this period.

Between 1971 and 2004, household net worth rose 12.9 times, while gold rose roughly 12.1 times. Meaning, real household net worth grew about 0.18% annually over this period.

This should be expected. Under Bretton Woods, real GDP (again, based on gold) grew 4-5% annually. During the post-BW era, real GDP grew roughly 0.25-0.50% annually.

These are knock-your-socks-off numbers, I think you must agree. Even if one doesn`t understand the theory on why a floating dollar is inefficient, a politician of Barney Frank`s intellectual heft should be able to also correlate the decline in American living standards over the past 34 years. Plus: Two breadwinners per family instead of one; two million Americans living in prisons; gigantic unfunded liabilities in the pension systems public and private; astronomical projected costs in national health care. 

The good news is that there is no bubble in the housing market, and there will not be one that threatens to burst, as long as the Fed nails down the dollar and prevents a new inflation.