February 29, 2004

Note: The Sustainability of America's Recovery

The Economist is worried about the sustainability of the U.S. expansion:

Economist.com | The American economy: WHEN The Economist sounded the alarm about America's bubble economy in the late 1990s, what concerned us most was that share prices were no longer just a mirror that reflected the underlying economy, they had become its major driving force: soaring share prices encouraged a borrowing and spending binge. Although the stockmarket is lower today, in some respects the “economic bubble” has still not burst. The value of households' total wealth (in financial assets and homes) is well above its level before share prices started to slide in early 2000—and the American economy is more dependent than ever on asset appreciation.

America's economy has survived the bursting of the bubble better than had been expected largely because policy-makers have pursued what is possibly the biggest fiscal and monetary stimulus in history. This week, even Alan Greenspan, chairman of the Federal Reserve, expressed concern about spiralling deficits. Tax cuts have given consumers more to spend. More importantly, historically low interest rates have inflated the prices of homes (and more recently shares again), encouraging households to pile up more debt.

This has allowed consumers to keep spending even as wages and salaries have stagnated. Strikingly, although GDP has grown by a robust 4.3% over the past year, wage income rose by barely 1% in real terms. According to Kurt Richebächer, an independent economist who publishes a monthly newsletter, wages and salaries have, on average, increased by 9% in real terms in the first two years of previous post-war recoveries, but have been almost flat over the past two years, thanks to the sickly jobs market. Despite this, consumer spending has continued to boom, at an annual rate of 4.7% in the second half of last year. The gap between stagnant wages and rising spending has largely been filled by tax cuts and rising asset prices....

It concludes by arguing that Alan Greenspan should be raising interest rates and pushing asset prices down:

Economist.com | The American economy: In January Mr Greenspan declared himself fully vindicated in his decision not to prick the stockmarket bubble in the late 1990s, but instead to wait for it to burst and then cut rates sharply to cushion the consequences.... The Fed is also determined not to repeat Japan's mistake in the 1990s, by tightening monetary policy too soon. That, however, runs the risk that the Fed is cushioning the impact of the bursting of one bubble by inflating another—in housing. This is hardly a sound basis for a sustainable recovery. So addicted has the economy become to debt, that this will make it harder for the Fed to raise interest rates when it needs to do so....

The current dilemma for the Fed is that inflation is presently too low for comfort, which argues for holding interest rates down. But low interest rates, in turn, risk further fuelling asset-price inflation. Still, a small rise in interest rates would still leave monetary policy very loose, while serving as a warning to investors and homeowners that shares and house prices cannot keep rising for ever. In a recent article in the Wall Street Journal, Otmar Issing, the chief economist at the European Central Bank, argued that central banks cannot afford to ignore asset prices. This, he said, is one reason why they should keep a close eye on excessive growth in money or credit as well as on their inflation target. He also suggested that central bankers should avoid contributing to unsustainable collective euphoria and should perhaps signal concerns about asset values. Mr Greenspan, alas, shows no sign of taking his advice.

But it leaves unanswered the important question: How, exactly, would a U.S. economy with higher interest rates, lower housing prices, lower production, and higher unemployment be better than our current one? It would be nice, I agree, to have an economy with a higher savings rate--with a lower consumption level offset by higher investment. But what does raising interest rates or jawboning down asset prices do to get us there? Posted by DeLong at February 29, 2004 03:31 PM | TrackBack

Comments

A different article in that issue, the one on the (perhaps) decline of paper money, got me thinking the following:
Observing our current situation we have that Asia appears to be creating wealth, while the US is consuming it. This is only sustained by the fact that Asia is buying Treasuries.
So-why are they doing this rather than enjoying conuming what they've created? Some hypotheses:
• (Holds especially for China and India) These nations (or at least their leaders) believe an implicit understanding has been reached with the US, that they are shipping cheap wares and services to the US but in return are being paid off with know-how; and that this trade-off, at least right now, makes sense --- that is, the know-how is worth the cost in foregone consumption. The interesting implications here are is the US population aware that this is the deal that has (implicitly) been struck, and would they agree to the price put on their know-how? And, of course, we all know the stock of useful US know-how is finite --- how many years before China and India believe they're learned all they care to learn?
• (Perhaps applies to Japan) The US provides implicit services for other countries, in return for which it is paid through cheaper wares. These services are things like the US military guarantee, keeping the middle east from going even more insane than it is, world-wide anti-piracy (real pirates on ships) action and so on. Presumably this deal only makes sense as long as the US provides those services, and no-one else can. A Japan with its own nuclear weapons, or a US that is so obsessed with fighting ghosts in Iraq that it can't deal with real problems in the rest of the world, or a US that has run out of cash to pay for its military (ala Soviet Union) is no longer worth propping up.
• (Probably applies anywhere and anytime -- but to what extent?) The real issue is not how well China or India or the US do out of the deals, but how well the individual deal-makers do. To the extent that they control the political process and the important decisions, as long as they continue to get rich, nothing will change.
If this is the case, the recent net reports (well publicized, NOT, in the US media --- go big media!) about the uncannily prescient stock-picking skills of US politicians are not an encouraging sign. Sure we expect that China and India probably operate on this basis, but people also tacitly assume that when enough people hurt and complain about outsourcing in the US something real will occur. If enough money is flowing, not just to political parties, but to individual politicians, this seems unlikely --- we'll see a stream of empty gestures and rhetoric until the process reaches its logical conclusion in such situations --- the election of the Hitler type individual untainted by money, filled with anger, and able to put together enough hate-filled individuals to get his way.

Comments?

Posted by: Maynard Handley on February 29, 2004 04:25 PM

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Well, it would seem to me that if you classify the current housing market as a bubble, the question becomes what happens when that bubble inevitably bursts. One can imagine some pretty nasty consequences. My guess is that what the folks in the article are driving at is that if you find yourself in an asset bubble the first course of action should be to stop inflating it. Somewhat like the first law of holes. The question is how do you stop the inflation of the housing bubble without crashing the consumer based economy.

Posted by: SW on February 29, 2004 04:37 PM

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Maynard Handley wrote, "but in return are being paid off with know-how" asking for comments.

We have turned the idea of patents and copyrights on its head. Originally, the purpose of both was to promote r&d in the United States. One certainly doesn't do such, when you permit r& d from Japan or Germany or S. Korea to be patented here.

Even worse, we spend billions in federal and state tax dollars on R&D each year. At the very least, the American taxpayer is entitled to insistent that products that exploit that R&D be made here.

Any other argument is nothing but the most regressive tax on can imagine.

Posted by: John on February 29, 2004 05:13 PM

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Maynard,
Your hypotheses don't compute. India, China, Japan and others sell to us at the prices they do because that is the price point at which they can maximize their profits. They can't consume all they make because their domesic economies have neither the capacity to afford all those goods or the demand for many of the products they produce. Most of the factories in the third world are built with 1st world capital. Most of the profits return to the western economies that supplied the capital. Treasuries are bought by foreign buyers because they are safe place to put their money with a market rate of return.US

Posted by: Kozinski on February 29, 2004 05:16 PM

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Isn't part of the problem here that the Fed has to watch too many economic variables - inflation, unemployment, value of the dollar, the value of various assets like stocks or houses - with control over only really one policy lever - the fed funds rate?

Does the Fed need some more policy levers?

Posted by: Tom Geraghty on February 29, 2004 05:22 PM

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If this is an investment-led slump - why would anyone wish to discourage investment? Of course, the real question is why investment remains so weak despite low interest rates.

Posted by: Harold McClure on February 29, 2004 05:23 PM

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The issue of the sustainability of the US recovery has been gaining traction overseas for quite some time now.

Niall Ferguson oublished an article in October on this very same subject: "U.S. Power and Fiscal Over reach
National Interest, October 2003
http://econ.bu.edu/kotlikoff/Going%20Critical.pdf.pdf

Note that Ferguson is a conservative, is calling for either tax increases or Social Security cuts or both.

This should be a concern for US citizens who may occasionally forget that we are a debtor nation who's financial obligations are 46% owned by foreign investors and governments. If they ever decide to stop buying US Treasuries, we would be in some real fiscal trouble.

Foreign purchases are what's keeping interest rates so low. If overseas governments stop buying US Treasuries, interest rates would spike up dramatically.

It is a worsening problem . . .

Posted by: Barry Ritholtz on February 29, 2004 05:32 PM

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Harold McClure:

That has something to do with low real employment, lack of wage growth, right?

Posted by: john c. halasz on February 29, 2004 06:23 PM

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Kozinski, naive believer in the free market, claims
"Maynard,
Your hypotheses don't compute. India, China, Japan and others sell to us at the prices they do because that is the price point at which they can maximize their profits. " and " Treasuries are bought by foreign buyers because they are safe place to put their money with a market rate of return.US "

But the reason those prices are cheap is, among others, because the govts hold down the values of their currencies, among other ways by buying treasuries! That's my whole point --- who is benefitting by their buying treasuries? And it is the central banks of those countries that are major buyers of treasuries -- hence issue of political stability that might apply to individuals are irrelevant.

Posted by: Maynard Handley on February 29, 2004 06:36 PM

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Brad asks
"But what does raising interest rates or jawboning down asset prices do to get us there?"
-Stephen Roach in his open letter to AG asks for the same ( 3% prime).
-AG is actually on the soap box selling ARMs as if the folks at Fannie and Freddie needed help persuading those suckers ( ok conservatives) with the 30 yr mortgages.
So AG can't really persuade the flock to feed at the 6mo trough and then surprise them with a 2-3% increase. Ergo the prime rate is not following SR . Atleast not now.
How precarious is the mortgage picture? According to AG the consumer debt picture is "reasonable". That forclosure rates are not alarming. That credit card debt is not all that bad and personal bankruptcies are tolerable.
So cheer up.
Be Happy.
But then he goes and squanders this whole position/posture by touting the ARMs as bargains not to be missed.
It's like the Pope handing out condoms.
Big Al is making me quite nervous.
I feel that the housing market would take a real hit with even a small increase in the prime rate. I do not have numbers here but I expect that even without an increase, those who have depended on refinancing to make ends meet will be looking at selling for smaller/cheaper or forclosure.
Or going to those ARMs if they are not already in place. If the day of rising median house prices is not past, it must certainly be drawing close. It seems to me that the other side of this cresting is not a gentle sloping correction.
So "jawboning down the asset prices" is not like taking say, a 10% discount on your favourite chunk of real estate. For many, if the interest rate doesn't sink them, the resultant drop in the values of their houses will.

Posted by: calmo on February 29, 2004 09:10 PM

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Interesting thread. Being as I am a California resident not owning property, this issue is particularly relevant to my situation at this time. Certainly real estate in cali, NY, Wash DC and mebbe a few other places around the US are very much in a bubble. LA County saw 26% in house price increase last year, and about the same every year for the last 6 or so, which has put prices into the stratosphere. It is absolutely absurd now, and one would have to imagine that at some point the madness has to stop. But there are no signs of it at all, with the median home price pushing the $400,000 range and still rising fast. And this is not just Beverly Hills and Malibu, this is Inglewood and Crenshaw and Van Nuys for crying out loud!

I think the Economist estimated a few months ago that Cali real estate was already overvalued about 50% more than the historical wage/housing ratio. Either we are going to evolve into feudalism for the hereditary propertied class vs. sharecropper serfs who can never own their own land, or there will have to be a future "readjustment". Just when it might occur is anyone's guess... Anyone willing to hazard an estimate of when the bubble will pop?

Posted by: non economist on February 29, 2004 10:01 PM

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"How, exactly, would a U.S. economy with higher interest rates, lower housing prices, lower production, and higher unemployment be better than our current one?"

It won't. But the point is that it'd be better than where we'd be *after* the bubble bursts.

Posted by: fling93 on February 29, 2004 10:07 PM

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Same way as Japan would have been better off for "restructuring" and creating a "market-friendly economy" for the last ten years of not listening to the economist, ie it wouldn't.

Posted by: dsquared on February 29, 2004 11:36 PM

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"How, exactly, would a U.S. economy with higher interest rates, lower housing prices, lower production, and higher unemployment be better than our current one?"

Because the "balance sheet" of US households would look much better. It now resembles the balance sheet of a highly leveraged hedge fund that is bound to fail.

Posted by: Nescio on March 1, 2004 04:37 AM

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After a decade of watching the BOJ try to hit the bull's-eye and miss below every time, and then having the same experience himself, Greenspan is right to aim so that one goes sailing over the top.

I think this article is basically asking AG to return to aiming at the center and telling him to this time hit it exactly, which is easy for an observer to say. The claim that the Fed needs to slightly raise rates now in order to convince everyone of its price stability goal is just silly. What is possibly the reason to believe that AG will not sharply reverse direction once price pressures occur?

Posted by: snsterling on March 1, 2004 05:09 AM

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Brad DeLong: How, exactly, would a U.S. economy with higher interest rates, lower housing prices, lower production, and higher unemployment be better than our current one?

It would not, of course, especially given the way you put the question. But isn’t it more a question of how much pain now vs pain later, and a guess excercise at their relative quantification? Your question reminds me of the question a bull could have asked a bear in March 2000: “How, exactly, would a lower stock market be better than our current one”? Too which an easy answer, (ex post of course), is: Doesn’t gravity, sooner or later, apply to the creation of wealth out of thin air? And isn’t there a square, somewhere, in that kinetic energy term?

Calmo: Big Al is making me quite nervous

You are not the only one ... It looks like he himself is getting nervous. Once confident of his straight out of Keynes policy, he is puzzled at the weakness of unemployment numbers, and is persisting in his bet that it is only a question of time: He got it right on GDP, which sure recouped. But why of why is income stagnating and unemployment still high? He always made it clear in his speeches (as well as Bernanke et al.) that higher rates would “be ok”, cause they’ll come up when and only when the economy is warming up, which he thought was just waiting at the corner, and coupled with higher income, so consumers would be able to manage them.

House prices high? Barely, says Greenspan, and besides that market is slow and he does not see rampant speculation. (But he should really read and/or mention Shiller on housing bubbles, along with at least Leamer and Baker). And why worry when debt service and debt to wealth ratios are reasonable, just “a bit” higher? I’ve always had a hard time with this argument: the American consumer is not overly in debt because debt service ratios are reasonable (yes, thanks to low interest rates) and debt to wealth ratios are reasonable (yes, thanks to higher prices thanks to low interest rates). Circular reasoning at its best! You’d better be dead sure income and employment goes up when rates do, and in the right proportion to boot.

Greenspan’s recent comments on GSEs and the deficit, along with blaming high productivity (after tauting it as the greatest achievement of the 90’s, he is now *hoping* for lower prodictivity) now betray an unsual hint of pessimism. It seems he knows time is working against him, and I’d guess he is now seriously worrying at the ever increasing amounts of chips he has to come up with at his poker game, as every month passes without higher employment and income.

Harol McClure: Of course, the real question is why investment remains so weak despite low interest rates.

Indeed. A guess, admitedly not very original: Over-investment and capacity still has not been washed out It takes a long time to get back from a state where too many workers were hired, too much capacity was planned, too much “this time it is different” sentences were driving just about any business venture.
So now high productivity and cautiousness is the number one priority. Getting back to those earnings, with *less*, and being careful, is the order of the day.
But isn’t that deflating bubbles are all about? Takes a loooong time to get back to some kind of sustainable equilibrium, especially if one can inflate somewhere else (credit, housing) and foreign mercantilism (Japan, China et al.) is all too happy to finance.

If I remember corrrecly, the Economist first rang the bell on the asset bubble in mid 1998. It took another 2 years for the market to begin crashing.. But then again, some permebears (possibly like the one quoted by the economist) were lamenting debt and predicting a decade long bear market in ... 1990 ...

If the Economist bearish call is correct this time too, it could be quite a while (or tomorow, of course) before something gives. Or never happen, or don’t worry be happy, as Mr. Greenspan now tries to persuade himself... And so, for this poster, the question lingers on. “Fed hubris” per Steve Roach? “Irrational optimism”, (Dimson, 2003) in the case of markets? Or will it be one more time the triumpth of the optimists? I guess he’ll just have to stay tuned ...

Posted by: ojb on March 1, 2004 05:37 AM

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Surely the wealth effect created by the stock market resurgence is helping sustain the recovery.
I don't see either what a Dow 8000 is going to do for us. Think of the effect of that on pension plans, 401ks.

I would like to see the Democratic economists come up with some specific proposals to stem job loss, sustain recovery. But the press would rather ask questions about "likeability", "Elvis factor", "Will God always side with us?", etc.

Posted by: Bob H on March 1, 2004 06:04 AM

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From the Economist article...
. . In January Mr Greenspan declared himself fully vindicated in his decision not to prick
. . the stockmarket bubble in the late 1990s, but instead to wait for it to burst and then cut
. . rates sharply to cushion the consequences....

Did Greenspan actually say this? IIRC, Greenspan started raising interest rates at the end of the last decade in order to curb the "irrational exuberance" being exhibited by the stock market.

Then, after Bush declared right after his selection in December 2000 that the economy was headed for a recession (a prediction that NO ONE else was making at the time---but that wound up being self-fulfilling) and the prediction came true, Greenspan panicked, driving interest rates to historic lows that were completely unjustifiable given the relatively mild nature of the recession (not to mention the fact that the recession was driven by high inventories and excess capacity--which meant that low interest rates would not have any substantial impact until inventories were reduced and demand started catching up with capacity again.)

The real problem I have with Greenspan is that his current insistence upon maintaining ridiculously low interest rates leaves the American economy with virtually no options should "something happen" that sent us back into a recession. We can't (realistically) increase the federal deficit to stimulate the economy, and interest rates can't go much lower.

And given that this recovery is based largely on shifting sands of low mortgage and short term interest rates, and a resultant over-valuing of assets, it might not take much of a "something" to "happen" to send this economy into a freefall.

Posted by: p. lukasiak on March 1, 2004 06:22 AM

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Bob H. asked...
. . I would like to see the Democratic economists come up with some specific proposals
. . to stem job loss, sustain recovery. But the press would rather ask questions
. . about "likeability", "Elvis factor", "Will God always side with us?", etc.

Higher communication (telephone, internet) taxes would be one means of stemming job losses. Right now, it costs so little to communicate over great distances that the American "service economy" is beginning to disappear just like our manufacturing base did during the last half century. If a way could be found to tax commercial communication based on the distance between those who are communicating, we wouldn't be hemmoraging "call center" jobs to places like India right now.

Posted by: p. lukasiak on March 1, 2004 06:31 AM

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The very last thing the Federal Reserve should be doing is adjusting short-term interest rates based on over-heated housing markets such as in coastal California. Balancing the usual conflicts between inflation and unemployment is quite enough. For Greenspan to add in an assets valuation factor to the calculus would be too cute by half.

Besides, it might be GOOD for all those people willing to be "house-poor" to get right with the world. We have the "greater fool theory" in the stock market. Apparently it is operative in over-heated housing markets too.

Posted by: Lawrence on March 1, 2004 06:33 AM

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The boom and bust was driven by overinvesting in
tech and a concurrent overemployment in tech.
We had the bust and with massive fiscal and monetary stimulous got the weakest recovery on record. Moreover, it is starting to look like much of the recovery in cap spending -info tech--
was a product of firms shifting cap spending forward to 2003 from 2004. Cap goods orders are clearly peaking.

Greenspans policy of letting the bubble run and trying to inflate us out at the bottom can be
moneday morning quarterbacked, but it probably was the only politically fesible policy.

but now it looks like growth is peaking and the econ is slipping back into stagnation and we have no fiscal or monetary bullets to use to restimulate the economy.

the admin is trying to use a weak dollar but that is almost certain to only generate inflation, not stronger real growth.

I see little hope that we can avoid an extended period of stagnation as japan did even though the US bubble was not as severe as the japanese bubble
and was not financed by the banks as it was in japan. At least in the US the banks can finance a stronger econ, and that was not the case in japan.

Now we see Greenspan very worried about the future -- why else would he bring up social security that can only be a negative for the Bush reelection campaign. the dem only need to take his testimony and lay it out that people have a choice -- they can have tax cuts for the rich
or social secutity. why the dems are not jumping on this I do not understand.

Meanwhile the NASDAQ is starting to slip as investors realize that we are going back to the 1990s rates of growth in tech and we still have too much tech capacity. Tech is not starting a
cycle of sustainable growth, rather it is starting a cycle of consolidation and capacity contraction.

Posted by: spencer on March 1, 2004 06:51 AM

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Spencer: they can have tax cuts for the rich
or social secutity. why the dems are not jumping on this I do not understand

Beyond just tax cuts for the rich, it seems you can argue that the cuts are a reallocation from bottom to top; the regressive payroll tax helping to add padding to social security for the 'boomers, then blowing resources on regressive cuts and suggesting trimming the benefits most direly needed by those hit hardest by the payroll tax in the first place.

Class warfare?

I suppose that line of reasoning is too wordy for sound-bite media campaign coverage.

Posted by: Ethan on March 1, 2004 08:15 AM

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How, exactly, would a U.S. economy with higher interest rates, lower housing prices, lower production, and higher unemployment be better than our current one?

If you are person who derives most of your income from returns on capital investments, low prices for hosuing with high interest rates are probably a good thing. Your notionally risk-free investment has better return, meaning you can probably mix investments for any desired expected return with overall lower risk, and you can afford a bigger mansion -- plus, higher unemployment counteracts the effects of lower production on consumer goods, so your basic needs won't be more expensive, either. For the ultra-rich capitalist, its a winning scenario.

Pretty much sucks for everyone who has to rely on work to pay the bills, and who has more costs from debt than return from investments.

Posted by: cmdicely on March 1, 2004 09:51 AM

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Economists will jabber and debate even as the mobs appear to drag them to the Bastille. [I would happily plead with the rabble for your salvation, however!] The fact is that for anyone not living high on the hog on borrowed cash, this is one unfortunately very cruel economy. Close down the home equity money machine and millions more will lie awake at night and tremble in their beds.

My Blue Cross premiums have more than doubled in three years and I have dropped the insurance. Anyone sensitive to karma, divine retribution, or the state of the planet will be digging out worn copies of the Whole Earth Catalog and learning to save seeds.

Prayer wouldn't hurt, either, though I remain stubbornly optimistic at my core and somehow think I'll pull through no matter what.

Posted by: John H. Farr on March 1, 2004 10:04 AM

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I do not claim to have the level of expertise that many of your commentors do - but there is a little common horsesense I wish to apply to this conversation, specifically refering to the housing "bubble".

The potential housing buyer spends little time evaluating the true cost of his or her house - ie: borrow $400K @ 5-6%, and rather than look at the final figure of 1M for the house after 30yrs, look instead at the "monthly payments" and the susposed value gain in the housing market (the sales pitch). The banks only motive is to get them to sign on the dotted line. After that, they take their money and run. Even if the bank goes under from overextention of loans, those who have the most to gain have protected themselves (their hugh bonuses from sales), and the consumer is left holding the bag.

The way out - simply do not buy at their asking price. If potential so. cal. buyers were smart, they would set up an buying co-op and play wal-mart with the market. But so long as you play it alone, you will lose.

Food for thought.

Posted by: Bb on March 1, 2004 10:05 AM

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Ahhh. The Economist knows what is best for us all. Squoosh the economy, squoosh the stock and bond and housing markets, and we will all be the better for the squooshing. Yuch!

Posted by: anne on March 1, 2004 10:22 AM

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"Ahhh. The Economist knows what is best for us all. Squoosh the economy, squoosh the stock and bond and housing markets, and we will all be the better for the squooshing. Yuch!"

A house on my street in SF sold for $550k last November.

A similar house (save maybe $20k in remodeling) four doors down will close at $715k next week. We need squooshing of the housing market. Now.

Posted by: Tom on March 1, 2004 11:47 AM

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It's not just going to be a popping housing bubble, but a popping stock market, and a destabilization of the dollar hegemony regime and a freefall in the dollar ... plus a yield curve correction on Treasury issued debt forcing up interest rates. There will likely also be a contagion in foreign debt destabilization as well as currencies fluctuated wildly and effect the long term export forecast for developing economies. That's where the convergence of events is leading.

The only way to avoid this is to lead the yeild curve now and strengthen the dollar. We wait until the market corrects it's going to be brutal, all the more so since monetary policy will be limited by the need to act as buyer of last resort for Treasuries.

That's how the economy is better off if we have higher interest rates. What we are looking at is a convergence of a correction in multiple tied together systems - domestic and foreign securities, housing, currency, debt, export/import trade balances, etc. Unless we start easing the pressure built into the system now, it's all going to blow later. The characteristic of bubbles is that they go on and on until one thinks it will never end, and then sometime in that free floating mental space of thinking you can never come down - then you do - and hard.

Greenspan is highly worried all right. He's in trouble and he knows it. The lack of job growth is partly reflected in the inefficiency of capital particularly in the inability of foreign capital inflows to build real business expansion since foreign purchases of US treasury debt have failed to become equivalent to US export purchases in creating capital investment in real revenue growth. The money is just sloshing around in financial instruments without ever really becoming invested in actual commercial growth. Hence a dollar invested in a Treasury is not the same as a dollar used to buy a US good or service.

The past forex exchange destabilization and capital flight meltdowns of the last decade have shown that no matter how large the hard currency reserves, central banks can only delay corrections once speculators realize that the difference between actual and market prices have become large enough to become profitable for arbitrage. The only way to stop such a contagion mid-seizure is to institute capital controls, like Malaysia did. Otherwise attempting to maintain pegs like in the Mexican peso devaluation scenario, the Banks only make worse the crisis when it hits. Market fundamentals always catch up sooner or later, and the more you delay such corrections by intervenionist monetary policy the more interest you pay on your debt later ... literally and figuratively.

We're on the verge of something big here ... potentially what could happen to America would make what happened to the Asian countries in the 90's and to Long Term Capital a walk in the park ... a true firesale stopped only by massive buyer of last resort action ... and a stagflation scenario. If dollar hegemony destabilizes we could see a flood of inflationary dollars come home to roost suddenly at the same time interest rates were rising. Ack.

Too much to contemplate, but this is the grim scenario we are facing.

Posted by: Oldman on March 1, 2004 12:33 PM

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"But what does raising interest rates or jawboning down asset prices do to get us there?"

Us? Who said anything about us being the beneficiaries of a more sustainable economic structure. Just be cause life will go on, doesn't mean your life will go on.

Since there is a finite amount of energy flow at any time, there is, likewise a finite amount of affluence - which is a function of the amount of energy. Dividing this affluence up among the available people interested means that, naturally, those most able to do more while taking less will have affluence flow to them, and away from those who charge more. Which is to say, it is natural for those people in low affluence countries to go up, while those in high affluence countries to go down until there is equalibrium again.

If that outcome isn't appealling, then the only solution is to find ways of expanding the amount of affluence available based on those inputs which are scarce, and get busy on it quickly.

How large tax cuts for rich people achieve this has been a mystery to me all along, and how higher interest rates will help is even more of a mystery. We should, as a matter of pure macroeconomic fact, have higher interest rates, because the US is no longer producing enough new wealth for people to buy given the current supply of dollars. Hence, the supply of dollars should be lowered. This doesn't have much to do with helping the US, as basic supply and demand.

Posted by: Stirling Newberry on March 1, 2004 12:39 PM

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"India, China, Japan and others sell to us at the prices they do because that is the price point at which they can maximize their profits."

This one earned a true "LOL." Applying right-wing free-market ideology to Chinese Communists! Are you thinking that they're looking for their quarterly stock bonuses and not their long-term strategic national (and Party) advantage?

Let's just hope that the Bushies have one or two people with sense and not just an ideological echo chamber, because this is exactly how some very serious foreign-policy "miscalculations" can occur.

Posted by: Dave Johnson on March 1, 2004 12:51 PM

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Regarding popping the housing bubble at this point -- what happens if a bubble of this magnitude does pop? Fairly moderate houses here in California are selling for prices in the 6's and 7's and still rising, even though the rental market has softened. And commercial prices are not dropping in spite of 2-3 years of 20-30% vacancy rates. This in an area with high long-term unemployment that is still losing jobs.

Many people here have refinanced, taking out cash, to keep things going or just for consumption. So with the leveraging people have done, what happens here if prices drop even a little? And what if prices fell to some reasonable multiple of national, like down to only 3 times national averages?

Posted by: Dave Johnson on March 1, 2004 01:13 PM

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It is tiring to hear The Economist claim to have been "right" about the equity bubble and the appropriate moentary remedy during the late 1990s. Consider the following:

1) Their main worry at the time was inflation, not the deflationary aftermath of the equity bubble. But inflation failed to rise -- and then it fell a lot.

2) Total returns to equities have crushed returns to cash since The Economist first turned sour on equities. Bonds have done even better, despite The Economist's inflation concerns.

3) Macroeconomic performance during the past 8 years has been excellent, in historical terms and relative to any counterfactual that The Economist might dream up.

The Fed's failure to deliver perfection is mostly evidence that we live on planet earth. It is not evidence of a systematic failure of moentary policy. And it is certainly not vindication of The Economist's strange view of the world.

Posted by: Gerard MacDonell on March 1, 2004 06:14 PM

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Maynard,
Kozinski is a naive believer in free markets. I'm also a firm believer in Ocam's razor. Japan and China are the two largest foreign holders of US treasuries, the reason they buy US treasuries is twofold, one to find a safe productive place to park their excess dollars, and two (as you said) to beef up the dollar and keep their own currencies down. Why? So they can keep selling to us at cheap prices and continue to attract investment.

Dave Johnson thinks that the Chinese have got factories full of their most productive workers turning out consumer goods for us at dirt cheap prices out of some sinister plot to take over the world. The Chinese have one hell of an underemployment problem, they are scrambling to keep a high enough of a percentage of their people employed to keep social unrest from breaking out. They've got a tiger by the tail and they know it. The Chinese have got to sell to us a lot more than we need to by from them. Get real Dave, the Chinese have totalitarian government, but capitalism is alive and well in China. Singapore is a long term example of a less than fully democratic country with thriving capitalism.

Neither Maynard or Dave even brings up our most lopsided trade deficit of all. The US has an enormous trade deficit in the most important comodity of all, human capital. We've got the best and the brightest streaming in to the US from every other country on the planet, and it costs us almost nothing for them. The lousy 80b (2002) of Chinese held US treasuries is nothing compared to the tens of thousands of briliant Chinese emigrants that we've gotten in just the past few years, and we can get as many as we want for free.

Posted by: Kozinski on March 1, 2004 08:43 PM

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You may be right about the inflow of legal and illegal Chinese immigrants but you are wrong about the general inflow of intellect. Historically (recent history) the US has seen a huge inflow of intelligence through its universities--when students from other nations came here to attend college or grad school, post docs, research and often stayed for years. 2003 saw a sharp decrease in foreign student enrollment. Not really a surprise. Sure large corporations still want those tech visas to bring people in (who they can pay less), but that's as much to keep salaries and wages low as to continue to bring in intelligent people with skills.
A previous comment seemed to indicate that debt, bankruptcies, and foreclosures are at ok levels. That would depend on your point of view--in 2003 saw the highest level ever of filings for personal bankruptcy, foreclosure rates are up as are defaults on credit card debt. Not astoundingly so, but definitely and noticeably up. And that's happening even though the Bushies are saying the US is doing just great and all those new jobs are waiting just around the corner--sure to come by November 2004 or immediately afterwards.

Posted by: sh on March 1, 2004 09:06 PM

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sh: "Sure large corporations still want those tech visas to bring people in (who they can pay less), but that's as much to keep salaries and wages low as to continue to bring in intelligent people with skills."

While the statement overall has some merit, it's not that simple. I work in a division where most of the engineers and management are from India (and generally very competent and nice people, BTW). They hold engineers educated in the IIT's (India Institute of Technology) in very high regard, including people who studied together with them.

We have relatively few Chinese, but I speculate it is similar (there are other business units which consist to a large extent of Chinese). These guys have strong networks (perhaps applicable to many foreigners in all kinds of places; after all, people tend to have acquaintances and friends of their own nationality or region of origin). The reason that many people from Asia are hired in the US is partially related to that. It also applies to other, less prominent, nationalities.

Finally, during .com times there was a genuine _perceived_ or real (I'm not going to be the judge here and now) shortage in SW engineering labor (the NCG with 10 years of experience in SW technologies that were less than 5 years on the market), and many of the people brought in from Asia, Europe, and elsewhere during that time are still here, contributing to the effects cited above. And the same effects worked then -- people having come here told their friends back at home, etc.

Posted by: cm on March 1, 2004 11:03 PM

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sh: "A previous comment seemed to indicate that debt, bankruptcies, and foreclosures are at ok levels."

Anecdotal evidence, based on a coworker who has recently been in the house market, suggests that foreclosures here in the SF Bay Area are up quite a bit. He was looking at foreclosed houses among other things and reported how the inventory coming up per week in that category was rising.

Posted by: cm on March 1, 2004 11:07 PM

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"A house on my street in SF sold for $550k last November. A similar house (save maybe $20k in remodeling) four doors down will close at $715k next week. We need squooshing of the housing market."

As Tonto is reputed to have said to the Lone Ranger... "What you mean, 'we', paleface?"

That California in general and San Francisco in particular has a housing-price bubble, I am prepared to stipulate. That the collapse of your bubble will drag down the entire economy of the United States, and impact MY savings in Texas real estate and the NYSE, is an proposition I would be fascinated to hear elucidated. How, exactly, would such collapse be any worse than the S&L "crisis" of Whitewater and similar ilk in the 1980s?

Posted by: Pouncer on March 2, 2004 10:05 AM

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Let's not forget The Economist's cover that projected $5 oil.

Posted by: monte carlo on March 3, 2004 06:44 PM

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