Brad DeLong's Semi-Daily Journal (2004)

When you do this seminar - can you please let me hear it - webcast it or something. This is THE issue in my view in my career (which is managing money in an environment I think irrational).

I am not sure that the Fed shouldn't fire a warning short accross a bubble by raising interest rates early. But I am stuffed if I know what they should do when the bubble is in full swing. Is it true that by the time I can convince myself its a bubble its already too late to act?

Please let me hear your seminar.

Loyal, almost daily reader.

I understand from my relatives that a housing bubble of sorts occurred in Hawaii. During the Heyday of Japan, (1990?) Japanese investors were dropping cash on Hawaiian properties and bid up prices greatly. Since then in the period of Japanese deflation, Hawaii property values have declined to "non-bubble" levels. It is interesting that the decline is matched by very low interest rates in Japan.

I don't know how much serious study this has been given, but does the Japanese bubble experience give some clues to our own economy?

BTW-Are property taxes a way to dampen real estate speculation? Higher taxes on 2nd homes, etc.?

.... perhaps because interest rates are being kept pegged at an artificially low rate for the sake of economic stimulus, in lieue of 'floating' to their natural level.

Interest rates don't seem to be appropriately priced considering America's public and private debt burdens; the risk premium is too low.

Instead of a gradual, painful but controlled, rise we're possibly in for an uncontrolled, sharply upward rise which may well overshoot the optimal interest rate. And the whiplash will hurt.

That's my take anyway.

I gathered that it's a matter of limiting the damage of a real-estate collapse. By feeding and perpetuating this real-estate bubble, we're allowing consumers to eschew savings and build up dangerous debt loads that will ultimately lead to some sort of ugly reckoning. Raising rates now would reduce borrowing and slow consumer spending, but in a controlled manner. It could also scare the markets into re-evaluating the current bubble prices.

Raising interest rates affects current "bubble" prices by reducing demand. Real Estate is affected by the monthly payment. The monthly payment is comprised of two main parts, Principal and Interest. Assuming a fixed monthly payment, as the interest part goes up, the principal part must go down. As the principal goes down the value of the present value of all those payments goes down. So less can be borrowed. Demand will go down. Additional money could be added to the payments to hold the excessive prices up, but income is not growing so there is no source for the additional money to be added to payments. In simple, the bubble cannot be maintained because the sources of principal(less interest and more income) are lacking.

Finally there is the emotional part. As prices drop, the conceit that prices always rise is disproved and there is no more anticipation of price rises. So both from an emotional and a fiscal view point prices drop.

In Japan, interest is not an issue, but deflation of income and the anticipation of further deflation provide the fiscal and emotional bubble popping rational.

I second the first posters request for some way to get your comments on the real estate bubble. I wonder, however, if your insights will come too late for me. Like a lot of middle class people I have rental property and it is a pain in the kister to maintain and keep rented. Love the income stream but not the hassle. Selling it and putting the proceeds into TBills sounds good. Then all I would have to worry about is the bankruptcy of the government. Wait, that to is worrysome as I am also a retired government worker. Ho Hell, dammed if you do and dammed if you don't. Go foreign?
Thanks again Prof Delong and all the great posters on this site.

The point of raising interest rates is due to the issues of economic dynamics. The longer you allow a bubble to continue, the bigger the misallocation of capital, and the fewer the things that are going to work when you all hit reality.

It's really like gravity, or stopping digging the hole you're in.

If somebody launched you into the sky, provided you had time to think about it, you'd want to prevent yourself from going so high that when you inevitably start falling, you won't fall from as great a height.

some people are saying that there is a ledge, and we are trying to reach that ledge and all of a sudden we don't have to worry about gravity. That ledge is productivity.

I doubt productivity is the magic cure all ledge. For all the time we are enjoying such productivity growth, we have seen little job growth, or visible, concrete improvement in the economy. All we've seen from productivity is that things aren't as bad now as before.

One thing about the housing boom. I think that much of this is due to pretty severe misallocation of priorities. We have a serious homelessness problem here because homeowning is so artificially easy that renting can be an unprofitable preposition for consumer...no capital preservation, no tax deductions, or anything. Therefore builders have built apartment buildings according to demand...not enough of it. In kinda short, much of the rise in housing prices is feeding on its own positive feedback where building houses is increasing "demand" by decreaseing supply of overall housing.

"The point of raising interest rates is due to the issues of economic dynamics. The longer you allow a bubble to continue, the bigger the misallocation of capital, and the fewer the things that are going to work when you all hit reality."

Exactly !

The Fed hasn't solved the problem of the Nasdaq bubble. It's just postponed it, and the postponement has made the problem worse. Of course, when the sh* hits the fan, everyone will criticize the Fed - but the alternative would have been more sh* hitting the fan later, i.e. the future paying for the sins of the present (sort of like a budget deficit!).

A real estate bubble and an associated popping has been a recurrent lagging accompanying feature to an financial instrument bubble - stocks, bonds, etc. in the modern era. It's because the money that was in stocks or bonds, flows into real estate which appreciates creating another bubble, and only when that pops does the situation deflate. Think of the Tokyo real estate prices in the 80's, and Hong Kong, and how real estate price collapses were associated with the economic deflation of "asian tiger" economies in the 90's. I wrote a small paper on the subject a while back.

The news is that the stock market bubble burst is only really over after it suffers a secondary real estate bubble burst. In other words, the bubble didn't really deflate yet. The keynesian policy of the Federal Reserve board has delayed it, and correspondingly has worsened what will come.

With more and more houses being asset stripped by home equity loans, consumer debt rising to unsustainable levels to wage increases, and the policy of the Fed making long-term unhealthy loans viable by keeping the interest rates low and aggregate monetary supply extremely liquid ... the economy is being set up a classic moral hazard real estate crash. Sooner or later, bubbles always burst. Someone starts selling, and then everyone wants out, and the over-leveraged situation forces a mass fire-sale.

The oldman called the asian monetary crisis of the 90's several years in advance, he sold at the top of the market in the late 90's, and he's suggesting that if anyone has a home to expect a probable devaluation in the future and any loans collateralized by home equity to become under-performing as well as this being the time to get the HELL OUT of real estate investments like REITs as fast as you can. No one can ever tell the top of a market, but you can recognize signs of a market topping. You may pull the trigger a little too early, but it's better than getting burned. Is it unavoidable? Nope, it ain't unavoidable, but if the Fed keeps low interest rates up much longer (as it seems to be doing) then it could get pretty bad indeed.

Thanks Oldman. Do you have any real estate I can borrow for a while and sell?

On the other hand, if there is a widespread spectacular crash in real estate values, what are the banks going to do? Foreclose on everybody and sell it back (to us?) at distressed prices? Somehow I think not. We consumers have them right where we want them.

But I'm not so sure this a battle we want to win in this manner.

"I think these two paragraphs translate into the Federal Reserve is making a bad mistake in keeping interest rates so low. But it is not clear to me why Stephen Roach is so sure that keeping interest rates low is a bad mistake".

I didnt read that Stephen Roach wanted higher rates. I have to guess but I think Stephen Roach thinks the Federal Reserve should accept responsibility for bubbles and do something about them. Of course Alan Greenspan won't go there. Nobody knows how to gently prick bubbles while keeping interest rates low. So we keep driving the car towards the cliff at high speed.

Brad, John Hempton and I are hoping that you can solve this puzzle.

I vote for a slow wage bubble (it is the final bubble-reflation by another name) similar to inflation targeting.

If this wage bubble is created gradually, the financial sector's equations stay linear and they don't collapse as they did in the 80's.

A gradually increasing wage/interest rate allows for long-term investors to take their losses over the long term, keeping the properly hedged financial sector sound. This IS Greenspan's main objective after all.

BTW, it also saves the property market...

The two previous posters are right. For the last year that I've been reading Roach, a steady tenet of his arguments has been that artificially low interest rates result in capital misallocation. Witness the word "imbalance" he is so famous for using.

With regard to Brad's fundamental value of real estate comment, why don't we lessen the gap between the bubble and the fundamental value of real estate and drop the Fed rate to 0.75%? Lessen the difference even more and drop the rate to 0.50%.

I don’t understand why the Fed didn’t raise the margin rate to help dampen the equity bubble in the late nineties. Perhaps research says that raising the margin rate wouldn’t have helped. If anyone can enlighten please do.

This is the same Stephen Roach who has been worried for years that the end of the 90s dot com and telecom bubble was going to bring on a deflationary depression. Well, the consumer price inflation rate continues to be really low. So I was expecting Roach to continue to beat the drum for an expansionary monetary policy.

After all, with a budget deficit of $500 billion this year it is hard to argue that the government isn't applying a major fiscal stimulus (unless government deficits are not stimulative). So that makes an expansionary monetary policy as the only other tool that can be used to stimulate the economy in hopes that demand for labor will rise. I would expect Roach to argue for this viewpoint based on his previous arguments. But no.

I'm not an economist and I have serious doubts about the assumptions underlying economic models. It seems to me that the ability of demand to shift toward stocks or houses or consumer non-durables or other categories really makes it hard to run a monetary policy with the goal of providing some degree of price stability. We can have declining prices in some consumer goods categories and rising unemployment even while having rising housing prices. Under such conditions what should the government and the Fed do?

Heck, to back up even earlier: What should the Fed do during a stock market bubble? Should the Fed have raised interest rates starting in 1995 and kept raising them until equity prices ceased to be crazy? If a central bank doesn't know what to do about a bubble when it is happening why assume that it can figure out what to do about one afterward?

bakho wrote, "BTW-Are property taxes a way to dampen real estate speculation?"

Google on "Henry George," who realized that Ricardian rents on land should be fully taxed away.

In the 90s in britain, the BOE raised rates very high. Unemployment increased, people could not meet their mortgage payments, houses came on the market, prices dropped until the selling price was less than the mortgage,still owed. People just walked away from the properties, moved into cheap rental, or if out of work, moved in with family or friends, and let the banks take over the house.

'Here we are, just a few years after America's most devastating post-bubble carnage'

if the post-bubble carnage he is referring to is the one you're coming out of, I think he's gone seriously hyperbolic to refer to it as the most devastating.

April 15th is the perennial commitment mechanism that ruins my springs.

I didn't understand the post about low interest rates exacerbating a housing shortage. From what I have seen locally, builders rushed to put up everything they could at the new low interest rates. This has led to a housing surplus with landlords offering deals to students, etc. As I understand it, the lower interest rates means that a lower occupancy rate can still be profitable and expectations are for the population to grow into available space. I suspect that once interest rates do rise, new housing starts will plummet because of the lower profit in an overcapacity market.

It seems to me that we are stuck with low interest rates and the consequences for the housing market until we get a decent jobs package that allows interest rates to rise. Raising interest rates slightly would slow the building industry, keeping upward pressure on prices. Raising them a lot would price out potential buyers and put downward pressure on prices. At some point the stimulation of building by low interest rates should put downward pressure on housing prices. When Volcker had the interest rates jacked up to 15% houses were cheap. Once the rates dropped below 10%, housing prices in Boston doubled.

Currently, building is a strong employment sector. I don't think the Fed would want to raise interest rates and eliminate many of those jobs at this time.

Here in the Midwest, the response to low interest rates has been an incredible building boom. We see many new subdivisions going up all the time. Is the experience in California, where there are restrictions on building (space, water, etc) different?

I think it should be. In the Midwest, supply increases to meet demand. In some markets, supply cannot increase so demand is inflationary. I suspect that housing inflation differs depending on location.

I work in commercial real estate and I honestly don't see a bubble. People complain about high prices not reflecting rental market weakness, but the truth is that properties that provided going in yields of 9-10% a few years ago (fully-leased at high rents) are now providing 7-9% yields (with some vacancy that will allow for revenue growth if/when demand growth returns). Compared with stocks and bonds, I think the returns look good. And since most private buyers are locking in mortgage rates for 10 years, I only see them getting hurt if we return to a recession soon. That's not a bubble, but the hard reality of most investments. Lastly, most bubbles are characterized by frenetic activity. Unlike single family residential homes, sales activity is way down for the commecial investment market.

Raising interest rates affects the "fundamental" value just a little. That value should already have discounted expected future interest rate hikes. Having those hikes just a little earlier or just a little larger than expected won't be quantitatively significant. What they might do to any bubble is, or course, harder to say.

Also, a close look would reveal that most refi revenues went to household balance sheet repair, not consumption.

As a business economists that has put a lot of time and study trying to understand the bubble and the aftermath I suggest you put a great deal of time in preparing your presentation to the role of uncertainty in policy making.

It is easy now as a monday morning quarterback to blame the Fed for causing the bubble. but I have doubts that that is a good way to go. In the 1966-98 period when the bubble started the fed raised rates slighlty and rates were above where the Taylor rule suggested they should be. The Fed was under significant critism from both congress and wall street for being too tight. Based on historical analysis another tighting by the Fed in that period was not a realistic possibility.
the Fed is independent "in " the government, not independent "of" the govt.

From 1996 when Greenspan made his irrational excuberence speech until the stock market peaked the S&P 500 PE on operating earnings rose about 800 basis points. If the relationship between fed funds and the s&p 500 is roughly one to one
-- a basic PE equation is pe=21.5 - 0.9* funds --
-- this is based on 1960 to 1995 regression model-
the Fed is absolutely right that they could not have popped the bubble without raising rates high enough to significantly harm the economy.

Greenspan was certainly guilty of being a cheerleader for the new economy. But I am not sure he is guilty of much more. Actually, using a Taylor rule as a guide to fed policy in the 1990s implies that there was no significant difference between actual fed policy and what a mechanical application of a Taylor rule guideline would have achieved.

I believe the primary driving force behind the stock market boom of the 1990s was a sharp drop in the stock market risk premium. In turn that was due largely to the very success of the Fed in achieving exactly what we desired -- a record business cycle expansion with low inflation.
see my article in the april edition of "Business Economics".

The Fed is dealing with a major problem of uncertainty. Their study of the history of the Japanese bubble led to the conclusion that letting the bubble run and dealing with the aftermath with extremely aggressive monetary policy is what they are doing and it seems to be working. much of the conflict behind questions of current fed policy revolve around this.
My question is can you realistically offer a better policy prescription.

I wonder whether the costs in the residential 'rent vs. buy' choice are being subsidized by low interest rates. So, for example, how much of the money from the mortgage refinancing boom has been going to unanticipated capital costs (e.g., replacing that leaky 15-year old water heater in the basement... ) rather than to, say, buying a 40 inch TV. Any data on this?

I think that a lot of people seem to think that real estate cannot lose value.

I would remind them of a joke from circa 1991:

Which of these don't belong?
* AIDS
* Herpes
* Gonorrhea
* A Condo in Massachusetts

Answer: Gonorrhea, you can get rid of it.

There is another dimension to real asset prices that has not be mentioned that may compound a dramatic (and painful) correction. A sustained decline in the value of the dollar raises/lowers returns in the traded/non-traded goods sector, which, of course, will lead to upward/downward price pressures across the two sectors--in other words, this will hasten any collapse in the real asset bubble..

Signalling. It's all about signalling. By definition, a bubble is sustained by people's beliefs that it will continue. Those beliefs change at some point, and the bubble ends.

I think that Roach believes (and I would probably agree with him) that an increase in interest rates would be a triggering event to end the bubble, by suddenly making people think that we're near the end of the appreciation. Put another way, in this case the sunspot will be an interest rate hike.

Why do I think that? Because if you read a lot of the popular press about house prices, the thing that is repeated over and over by a myriad of different people is that as long as interest rates stay low, prices are perfectly sustainable. People are looking at interest rates as their cue.

Why would Roach want to prick the bubble? Because given that it's going to pop at some point, better sooner rather than later.

What I do not understand is why propose using such a blunt instrument to solve a specific problem. Raising interest rates will affect the price of everything. If you think real estate prices are too high, why not use the FHA to raise its down payment requirements and require Freddy and Fannny to similarly increase their down payment requirements. (In addition there are good budgetary reasons why we might want FHA and others to raise their down payment requirements.)I thought generally we wanted more narrow tools.

In the late 1990s raising the margin requirements on stock might have reduced that asset bubble without imposing the added costs of high interest rates on the economy as a whole.

Seems to me that fewer and fewer people are benefitting from the residential housing market. Not just that the room for refi is erroding but that the developers are building for a smaller and smaller crowd. ( ie in the End, it will be Gates building for Buffet). Even if interest rates don't rise, this sector of the economy has a finite and, it seems to me, calcuable life span.
We should be able to predict this without resorting to the Japaneese experience of the '90s. So I'm glad that Brad is building a model to tell us when that 850 sq foot new dog house next door will have a price tag that won't make us sputter in disbelief.

I too hope Brad makes his presentation available.

"Currently, building is a strong employment sector. I don't think the Fed would want to raise interest rates and eliminate many of those jobs at this time."

I think the case can be made a little stronger. Residential construction is a huge employer of skilled and unskilled labor. Manufacturing jobs aren't available to accept this additional labor. The people who currently have jobs will be under increased competetive pressure to work work 110 hours per week for the 40 hr wage, up from the current 55-60 hours/wk. Look to see people mowing lawns at a dollar above the price of gas.
That may be a little hyperbolic, but I really can't see our economy absorbing additional losses of this magnitude. In a different industry, Newt Gingrich has put out a plan to modernize health care through available technologies, and much of it makes sense. But, if you look at the entailing job losses through modernization, it just dumps more skilled and unskilled labor on the market. Every job loss is one less home buyer, and potentially a vacant home on the market, so it can become self feeding.

On the other hand, I think a high level of economic chaos is to be expected, and the pain somewhat inevitable. Why would the Information Revolution be less (should be more) chaotic and disruptive the previous revolutions? For many reasons (including the lack of sustainability), our economy will change dramatically, and society along w/ it.

Given today's economic growth numbers of 4% I don't see a rate hike on the horizon. The Economist is out of touch.

Considering the dollar's fall of 20% in the past 6th month, an interest rate change may very well be driven by a need to stabilize the dollar rather than by inflation or an overheated economy.

Higher US interest rates makes the dollar more attractive and keeps it stronger.

BTW, I know that I keep harping on this, but this is where I see the bubble bursting.

"the key problem is the gap between the current 'bubble' and the fundamental value of real estate"

Why isn't the key problem the gap between the fundamental value based on interest rates today, and the fundamental value based on expected interest rates two years from now (or two years ago)? At least, if you expect a stronger economy and interest rates to move significantly.

The Fed watches inflation, and sets monetary expansion on that parameter.

So, the solution would be to weight the inflation index to more accurately reflect money allocation by individuals. If housing takes some percent X in year 1, then in year 2, housing takes a percent x + x/2; then the inflation basket should be re weighted.

I would expand the inflation index to include a much bigger basket of purchases, incuding large capital goods, equities, real estate, commodities. Then publish the forumla that re-weights this inflation basket as public allocations change. Apply the taylor rule, and replace Greenspan with a computer.

What's wrong with this approach?

Phooey. Stephen Roach is bright and writes well and has been wrong about investment in American assets for so long I can not remember a time when SR was right. SR believes that we must suffer suffer suffer for the sins of buying assets at prices that are not to his liking. But, how does he know what proper asset prices are especially since his calls on proper asset prices have been so wrong according to the "markets" for so long?

The Fed began to raise rates in 1999 and continued to May 2000, when it raised the funds rate 50 basis points despite no sign of inflation, a faltering stock market, and slowing economy. By January 2001, the Fed was quite worried about the more rapidly slowing economy and more quickly falling stock prices and began to lower the federal funds rates sharply.

Would SR have preferred a really fierce recession? After all, he is safe at Morgan Stanley so why worry about whether I am safe.

The no pain no gain argument of SR has been going on since 1964, and I say "phooey."

Mankiw + Friedman ?

I will definitely be looking forward to late spring, and any interim output in any form, for two reasons: One is that I remembered when I was taking Econ 101 some 30 years ago, what fascinated more than any thing else was interactions between markets and I loved doing the exersizes involving that subject -- not too many of them, unfortunately.

Second, as I expect the post-capitalist/post-industrial society to come to being through building unto market economy and free enterprise the institutions of collective ownership of capital and direct democracy, with enhanced and expanded programs of social safety net and higher education up to the point of 100 percent coverage, and as I expect all that to come to being through transition/evolution and not -- probably not - through 1789 or 1917 style revolution, having now read (quickly) through Brad's posting -- as contrary to that I usually "read" comments before I read Brad's posting -- it all of a sudden occurred to me that a deep and thorough understanding of interactions between key markets would be extremely crucial, in fact essential, in managing and steering all that change and transition.

Incidentally, it is not a matter of choosing whether or not to initate a transition. It is rather a matter of carefully and safely managing and steering transition and change as they are made inevitable by ever increasing productivity.

I wonder if Brad aspires to a Nobel Prize? (I don't know how else I can motivate this feller!? "I do need to find a way to wrap my brain around these issues", says he! Wait! I recall somebody (NorthernLights?) posting something about "his piscean ways". And that "I do need to find a way to wrap my brain around these issues" does read like a goddam lazy pisces just like I am. If that's the case, he won't really give a hoot about any Nobel Prizes. What he would need for motivation is (a) he and his family is OK, (b) he is not pissed off and (c)he remains intellectually interested in the matter.

And this blog should be of some help with part (c).

http://www.cbpp.org/1-29-04ui.htm

Unmet Need Hits Record Level For the Unemployed -1/29/04

Due to the end of the temporary federal unemployment benefits program, the estimated number of unemployed running out of regular unemployment benefits and qualifying for no further aid will be higher in January than in any other month on record, and is also expected to hit a record level for the first half of the year.

http://www.cbpp.org/1-29-04ui.htm

An estimated 375,000 unemployed individuals are exhausting their regular unemployment benefits in January without qualifying for any further assistance — and are receiving neither a paycheck nor unemployment benefits.

In no other month on record have so many unemployed workers exhausted their regular unemployment benefits without being able to receive additional aid. This finding holds even if the number of exhaustees in previous years is adjusted upward to reflect the growth in the labor force since then....

http://www.epinet.org/content.cfm/webfeatures_econindicators_gdppict

Fourth quarter output growth generated only 207,000 jobs. This 0.6% growth rate for jobs remains less than half the 1.3% growth rate (about 450,000 jobs per quarter) necessary to keep up with the working-age population. When analyzing these issues, commentators often note the "lag" from the end of a recession to the start of job growth. But what the analysts often fail to mention is how extraordinarily long the lag was this time. In fact, jobs started to return within three months after all prior recessions on record but took 21 months to reverse course after this latest recession.

The weak job market is also reflected in today's data on national income. The final quarter in 2003 saw real labor compensation grow at an annualized rate of only 1.6%, too slow to generate a healthy self-sustaining recovery. Since the last recession ended two years earlier, labor compensation has crept up by only 1.7%.

"I think these two paragraphs translate into the Federal Reserve is making a bad mistake in keeping interest rates so low. But it is not clear to me why Stephen Roach is so sure that keeping interest rates low is a bad mistake."

This is a great blog and the comments seem to be well-considered.

Here is my theory, and forgive me if I've fallen into some simple traps. If the fed keeps interest rates low, that should help to keep corporate debt service low, right? At the same time, it helps to generate consumption through a lower rate of debt service for consumers.

Isn't the real estate bubble partly a result of investors getting out of stock temporarily and storing value in homes? As people lose jobs and the ability to keep up with their payments, they will have to sell. Maybe this doesn't happen right away because they try to ride it out and only bail when there is no choice. They spend savings or refinance at first.

Meanwhile the rebound of stock values goes well beyond earnings growth. Low interest rates and tax cuts for the rich put too much money in the hands of people with high propensity to save - which they choose to put into stocks or real estate because the sight of 1.5% in their money markets makes them sick to their stomachs.

Could it be time for what Greenspan calls a "blunt instrument"? Get money to the spenders and out of the hands of investors. Starve the capital markets and maybe they will perform better.

How do we know there is a bubble in real estate? I know nothing of the sort. Where is there a bubble? In Chicago? Where in Chicago? In Baltimore? Where?

Just because the "Economist" and Stephen Roach are annoyed about selective rises in home values, is no evidence of a bubble. Suppose my house is bubbling, what is the Federal Reserve to do? Should the Federal Reserve slow the economy and worsen the labor problems because my house bubbles?

http://www.epinet.org/content.cfm/webfeatures_snapshots

Economic growth not reaching middle- and lower wage earners

The persistently weak labor market is taking a toll on the living standards of middle- and lower wage workers. The weekly earnings of these workers were lower at the end of 2003 than one year earlier (adjusted for inflation).

The trend reveals two notable facts: first, those in the middle of the earnings scale and below (at or below the 50th percentile) are losing ground—their weekly earnings were lower, after adjusting for inflation, at the end of 2003 than one year earlier. Second, the pattern of earnings changes is highly skewed: the losses are greatest for the lowest earners, while the weekly earnings of those at the top of the scale (the 90th percentile) grew by 1.1%. This pattern of earnings growth suggests that while the economy is expanding, the benefits of growth are flowing to those at the top of the wage scale.

I see two well founded questions here. Anne asks "How...we know there is a bubble in real estate?". BW, asks the same thing by adding that he "don't see a bubble." from his real estate business perspective. And I do think this subject has been discussed more widely - how should e.g. the Fed know that there's a bubble when the much of the market doesn't?

Then, for the sake stringency, aren't real property values inversely related to some risk free long term interest rate level rather than to the short (repo) rate? If so, isn't the link between short rate changes, via expectations on their further long term changes, related to property-prices in a way much more complicated than Brad's "highly normal, expected, and predictable fashion"?

Did I add to many "?"s relative to "."s there? Maybe its OK anyway?

jon asks if people took money out of stocks and into real estate. the answer, generally, is "no"; equity ownership continued to broaden and deepen, but housing starts increased mainly in response to lower rates; the Fed was quite active in getting the entire yield curve down. But the "blunt instrument" he proposes, a bad recession to cure the ills, is not a good policy choice, if it can be avoided.
anne asks where there are bubbles. mainly in the NE and SW of the country, around big cities.

As several posters have pointed out, the question is really to cure imbalances sooner rather than later. Low rates and tax breaks over-stimulate housing and consumption, decreases savings, which causes the US Current Account deficit. Gov't dissaving adds to the problem if it is pro-cyclical. These imbalances can cause confidence shocks and crises, and bad recessions; the tough challenge for the Fed is to try to engineer soft landings.
Greenspan's major problem is that the economy is changing rapidly (productivity, globalization of blue and white collar jobs) so inflation is low even as bubbles form and the economy looks both healthy and sick. For now, he has decided to let the bubbles form, and clean up the mess as best he can after.
The question is: are the Feds now out of stimulus measures, should the next recession hit before deficits are cut and Fed funds rise?

I didn't read Roach as wanting an interest rate hike--I read him as being amazed that adults could pretend that this cycle:

US buys Asian goods.
Asian CBs finance US CA deficit.
Excess liquidity from this leads to US asset bubbles.
US consumers skim wealth off asset bubbles to finance
purchase of more Asian goods.

Is any kind of a sane way to run an economy.

Marku,

No, that's not the right way to run a global economy. But you got the sequence wrong. It starts with China and other Asian nations refusing to spend their wealth on themselves and choosing instead to work for the benefit of Americans and invest the proceeds in the US without regard to return on investment. Americans are just taking advantage of this silly behavior. If the US was taking on debt from foreigners at high rates in order to consume then I would make the list in the order you did, but that is not the case.

Still, I think there is no bubble. Why should New York City housing prices not compare with those in London or Paris? Of course, I worry about the issue of who can afford housing as prices rise but I find no reason to believe there is a New York City housing bubble. And, I see no reason for the Federal Reserve to raise interest rates.

On the 'how do we know it's a bubble' topic, Dean Baker has some thoughts. He's become more insistent since that this is, indeed, a bubble. Worth reading, no matter what your final take.

Another colleague, Randall Dodd, disagrees with Dean, i'll look for his take and send it on.

josh bivens

http://www.cepr.net/Housing_Bubble.htm

anne wrote, "How do we know there is a bubble in real estate?"

As josh bivens points out, Dean Baker discusses this a lot.

The claim that there's a bubble in real estate goes like this: an earnings can be imputed to a dwelling unit, even if it's owner-occupied. Notionally, it's what someone would be willing to pay to rent the domicile for a year. Of course, coming up with such numbers isn't easy in practice, because the rental and owner-occupied markets have different characteristics (building types, locations; demographics of tenants versus homeowners, etc).

Anyway, the people who *have* done this computation claim the numbers show that in much of the US, the resulting "P/E" for housing has gone up quite a bit. Put another way, housing prices have gone up faster (perhaps much faster) than rents.

Even the advocates of the bubble hypothesis would agree that it's not uniform across the US...

Josh and Liberal

Dean Baker's article is nicely done, but a healthy San Francisco or Boston is going to be an attractive are to live for quite a while. They really are not making much more land in either city, though there is building, why should there not be growth in home values over an extended time. There will be rapid growth in prices and slow growth and even periods of decline, but surely San Francisco homes are a reasonable value over a decade and more. Why should there be policy to limit the rise in Boston home prices, when that rise is helping to keep the economy as healthy as possible given the fiscal policy we have?

Anne:

I think you're being harsh on Mr. Roach, but perhaps you're being facetious? To my recollection he called the top of the market in 2000 when the large majority of economists were busy preparing articles on the new economy for one of the kazillions of economics journals, and he called the 2001 recession fairly well to boot. Even Professor DeLong has cited him as being one of the better economists out there in commenting on the business cycle. In fact, don't you yourself often post his links to the Morgan Stanley website? The no pain, no gain argument that an economy must suffer a recession because it has structural issues like too much debt, a large budget deficit, etc., doesn't necessarily follow as P. Krugman has noted numerous times(monetary policy is the lever). I don't think that that is what Mr. Roach is promoting in this piece.

But, I'm sure you're being facetious?

monte

PS I am not the official apologist of Mr. Roach.

monte,

I believe Roach was also warning investors of inflation sometime around 1995. Instead he got disinflation and a market boom. So I don't know if it is accurate that he called the top in 2000 or if he called the top every year. It seemed to me that he was also bearish at the market bottom when he was writing about impending deflation and a collapse in demand with the fed being powerless to stop it. Apparently Roach was betting on a disaster and didn't get it, so I'm not surprised that he's changed his tune from 'the economy needs more stimulus than the Fed can provide' to 'the recovery is a mirage built on a second bubble'. I think that's how most liquidationists get started, they place an incorrectly pessimistic bet and then refuse to admit defeat.

Some of the points Roach makes are correct, but only when considered over a very long period. When China decides to consume, and retirees in the US and Japan are interested in consuming what they are now saving, I'm sure we will come to high rates, low growth, and low asset prices. But that might be another 10 years or even 20 before it fully plays out.

And yes, Anne has posted links to Roach before. But before, Roach seemed to be on the side of economic stimulus to prevent deflation. Roach here really does seem to be promoting Fed tightening as far as I can tell by my reading of it. The one bubble to the next argument and the moral hazard argument are quite typical of liquidationist thought. So Roach seems to have switched sides, and so then Anne has changed her opinion of him.

"But the "blunt instrument" he proposes, a bad recession to cure the ills, is not a good policy choice, if it can be avoided.
anne asks where there are bubbles. mainly in the NE and SW of the country, around big cities"

Sorry Uber, but it appears the allusion is too obscure. The blunt instrument is fiscal policy, for example, a good old-fashioned jobs program. Now if we just had the part of the budget going to subsidize pharmaceutical companies in the new prescription drug benefit.

To Marku:

"Is any kind of a sane way to run an economy"?

Education + innovation + criticism + humility + G(t0)=I(t0)-C(t0+1) < 0 and then Y->0

With GDP growth at 4% I don't see how the Fed can possibly raise rates. The way to attack a housing bubble is to build more units, especially in an economy that has unemployed workers looking for jobs. Raising interest rates would kill the building and exacerbate the bubble if it did not entirely force buyers out of the market. To kill the bubble with interest hikes would require interest rates that would price significant numbers of buyers out of the market. I don't think they can even get close to that.

A couple of basis points is not enough to force buyers out. It would take a half dozen or more.

There's a nice short paper on this by John Krainer of the Fed Reserve Bank, San Francisco at
http://www.frbsf.org/publications/economics/letter/2003/el2003-06.html

He demonstrates that housing prices are indeed high relative to rents, but that it would not take a great deal for them to move back towards the long-term relationship.

bakho "the dozen or more" ( basis points)

The enormous amount of refinancing that occurred last year enabled consummers to continue spending. And in some cases, enabled homeowners to continue making mortgage payments that, due to job losses or changes, they might not have been able to. This is well-documented and I apolgize for covering such stale ground.

Consummers also used these funds to pay down credit card debt. The percent of consummers that are not paying off their entire monthly credit card bill is frightening. It is not because they enjoy paying 18.5% interest.
Again everybody has seen this debt-ridden hat.
About mid-summer this cash-out (or equity extraction) fell off markedly as mortgage rates increased. The ( OK, some) ~sub 6% 30 Yr mortgages were then cashed in for the lower rate ARMs as there is a 2-3% difference. (These folks aren't really interested in owning 'the home' after all. They are business people. They own several Properties. I mean they are paying mortgages on several, so why not go for the cheapest? 'Someone far more stupid can pay the remaining 28 years' is how they think about it.)
So how much money does the consummer have left from his last refi? ( This is knowable: we should be able to measure how much is in the consummer's pocket. ) And where is his next fix coming from? ( GWB has a tax cut for you? The tax cuts of course will postpone some from forclosing.) What is that consummer going to do to get his hands on $ to pay his bills? (Ideally we would like to make something in exchange for the off-shore widgets rather than sell them T-bills.)
So much for the grim back ground as I see it.

The job losses mentioned above are continuing despite the spins countering that claim. So we have less, not more, able mortgagers. This may (should?) be putting downward pressure on house prices ( which Are inflated --no matter what Anne says). We also have higher house prices and therefore again less qualified buyers.
According to some there Is a little more room to refinance as the rates dipped and approached last June's lows. We are talking about those (few?) who refinanced 8-12 months ago but not 5-7 months ago. We have only a few more months then of easy refi money.
But later ( May? June?) this year interest rates will have to drop in order to sustain this funding source. Not just for the housing market but for the widgets. ( The medium sized dry good, the new car, the groceries...)
And that drop is going to need to be more than the dozen or so basis points. For starters the cost of a refi transaction is ~$3000 ( according to Roach if my memory serves my correctly). ( A gem if there ever was one, of a counter-example of productivity.)
Now, will they drop?--there is 1% left. (This is sort of like getting big Al all the way to his undies on his way to a full Monty.) I believe he'll keep his pants on.
Or, will they rise? Why would big Al ever want to do that?
Because BOJ might decide that they need a better ROI. Or China might switch to buying Euros for the hell of it. Or they could insist on barrels of oil instead. (I would if I were in their shoes.)
And if they rise very far, it seems to me not only marginal mortgagers will be in trouble but Fannie and Freddie will be excercising that "government backed" clause.

Dear Bobby P,

I too cannot imagine a Depression-like mass foreclosing of properties. In all likelihood what would happen in the event of a real estate bubble crash is that the Federal government would step in, create a bail-out fund, the Fed would increase liquidity to Banks (lender of last resort and all that jazz). The problem is that if we have a weak dollar and poor fiscal discipline when that happens doing that could either result in higher taxes and/or seriously damage American economic competitiveness. We're looking at a possible 80's style S&L bailout only on a more massive scale and with a more massive consequence. Interest rates could rise considerably in the aftermath, to near 80's levels such as 5% for savings accounts, etc.

For the poster who thinks that real estate in San Francisco and Boston will rise simply becuase they are out of land, let's remember what happened in Japan WRT real estate. They have even greater constraints on land, higher densities, and their real estate values dropped considerably if I recall correctly. OK, maybe we won't see something of that degree, but the "we're out of land" argument really is a bit played out.

And for those of you who think that there is no real estate bubble, please enter the CEPR Contest: "Why Is the Run-up in Housing Prices Not a Bubble?"
(http://www.cepr.net/cepr_fact_check_lotto.htm).

Should be really to take the $1000 prize if you think you can do it.

Just Me

I have thought a little further about this... and suspect that the basic point you make Brad is BS.

The assets in which there is a bubble are invariably long term assets. (Its pretty hard to get a rip roaring bubble in short term assets because they self liquidate fast enough to see that the return is real or not real.)

If the assets are LONG TERM ASSETS - then the appropriate interest rate for determining their FUNDAMENTAL VALUE is a LONG TERM INTEREST RATE.

Unless there is a strong link between SHORT TERM RATES and LONG TERM RATES whereby when SHORT TERM RATES RISE SO DO LONG TERM RATES (a link I have never found much empiricism for) then changing short term rates does not change the fundamental value of LONG TERM ASSETS and hence does not increase the size of the bubble.

Moreover - low short term rates are associated with liquidity which finds its way into investments productive and otherwise. I suspect raising short term rates reduces the price of the asset in which there is a bubble WITHOUT much changing its fundamental value (which is dependent on long term rates).

So your very quick dismissal of Roach's argument is plain wrong. (Sorry).

Now the more pertinent question - is it appropriate or effective for the Fed to determine what is an irrational and destructive asset price bubble? Given your short term repost is not right the question still needs to be asked.

John H

Monte

Right you are. I always read Stephen Roach, but always argue with him. A fine economist to argue with. Right now, I feel a special need for all of us to argue since fiscal policy strikes me as so awful but we have to cope.

Anne

Snsterling

What I object to consistently with SR is the no pain no gain argument for economic policy. We do not need to stifle the economy to correct asset price distortions.

Anne

The “recession” was the result of a capital investment crash and a crash in “reported” corporate profits – both as measured against ridiculous over-investment and ridiculously inflated earnings. Each came not as a result of a “stock market bubble” but as the result of a broad moral breakdown which showed up in slippery when not fraudulent accounting practices. [Examples: Lucent vendor financing a Turkish internet startup with no money, no earnings, and no prospects; Enron’s self dealing; AOL’s predictable earnings crash, etc.]

Self-dealing and phony sales generated a lot of activity, and a lot of activity requires an increase in workers employed. When the music stopped, the unnecessary workers were let go; in an honest corporate culture they’d never have been hired in the first place. Who if not Wall Street investment bankers and stock brokers were responsible for turning a blind eye to when not actively encouraging the fraudulent accounting practices?

Mr. Roach, though, has chosen to locate the cause of the recession in the bursting of the “stock market bubble” – the drying up of investment capital due to low equity prices. By doing so, he can shift the blame for causing the bubble whose bursting he claims to be the cause of everything bad from his employer to the FRB. As J.K. Galbraith argued long ago, with the exception of tiny startups, mature firms internally generate or borrow funds for capital investment. The stock market exists for the purpose of allowing upper management to convert their corporate control into equity which can be sold to the public. Only secondarily does it exist to provide Mr. Roach with employment.

Stephen Roach’s arguments are self-serving balderdash.

Ellen
"self-dealing and self-serving"
So the reasons, (slippery when not fraudulent accounting practices), you cite for 'the recession' are still here? Or are we, in your view, still in the recession? The published view (aka 'the consensus' in Greenspeek) is that we have put that behind us now.
Aren't we making any headway with all thoses fines? LOL... or cry.
I think you are overlooking or under-rating the role of Bernie's Printing Press in that ( and this) stock market bubble.
Roach may be wrong occasionally but he is as influential as big Al ,IMO and smarter.
The "balderdash" from SR is atleast more transparent than the well-rehearsed chorus from the 19 member FED.

Not a single comment in all of this about the impact of the cheap dollar? I recently had dinner with an investor who has successfully converted several Florida apartments to condos. Right now, he is bidding on a $150M + central Florida development, but all of his competition is backed by Euros. He is carrying a 20% penalty because he is using dollars.

The stuff at the top of the Real Estate bubble (waterfront, cityscape, etc.) is getting a lot of support from folks spending Euros and other currencies.

Why? Interest rates are low, but we need rivers of money from outside the US to finance our debt. So, we let the dollar slide to make our financial instruments and equities (and real estate) attractive despite low returns. As interest rates rise, so will the dollar. (thereby rewarding those Euro investors) Those combined raises will quickly take the air out of the real estate bubble.

Some folks praise the low dollar because it helps exports. They don't mention real estate, but helping exports AND real estate is an unintended beneficial consequence of the real game. What's important is supporting our debt instruments today and overnight. Export markets and real estate will take a bath as interest rates rise, but that move also will be a side effect, not the main game. The main game is about supporting credit markets and everything else is secondary.