Sunday, February 01, 2004

Real Estate Bubble II: or why don't we have a home mommy?

Just the other day the oldman wrote a posting on Fed intervention creating a Real Estate Bubble and pointing out that REIT's (Real Estate Investment Trusts) would probably be the vehicle for speculation driving an asset inflation bubble. Well no sooner than the oldman made this prediction than the NYT reports that REIT returns are suspiciously high.

" REAL estate investment trusts surged while stocks fell during the bear market. Over the last year or so, stocks have been rising - but real estate investments have done even better.

That has some real estate mutual fund managers scratching their heads. Many managers warn investors not to count on such favorable results...

Over the last five years, the average real estate mutual fund has generated a total return of 15 percent, annualized, compared with 3 percent for domestic stock mutual funds.

Real estate mutual funds generally invest in real estate investment trusts, or REIT's, which are publicly traded companies that hold portfolios of real estate and are required to pay out most of their income each year in the form of dividends. Over the last 12 months, the Morgan Stanley REIT index has gained 49 percent, compared with 34 percent for the Standard & Poor's 500-stock index.
" [emphasis added]

One could argue that most of this activity is "fundamental value" or increased aggregate demand in the economy spurred by historically low interest rates set by the Federal Reserve driving mortgage costs down. However, if we look at the micro-economics of the modern two-income family (WaPo) we can see that families are falling behind rather than getting ahead on the housing boom. That seems counter intuitive doesn't it? But as the WaPo article notes:

• In the past 25 years, the number of families in bankruptcy has increased 400 percent, and housing foreclosures are up 350 percent.

• The average middle-class family can no longer buy a house without putting both husband and wife to work.

• Parents with young children are more than twice as likely to go bankrupt than any other segment of the population.

• More than 90 percent of those in bankruptcy would qualify as middle-class.

The WaPo article continues with:
" If these trends continue, the authors contend, more than 5 million families with children will file for bankruptcy by the end of this decade.

" That would mean that across the country nearly one of every seven families with children would have declared itself flat broke, losers in the great American economic game," Warren and Tyagi write.

These are all clear signs pointing toward a market being driven by high-end asset pricing as more and more expensive homes get built to feed an insatiable demand of speculation buying up homes just to see their prices rise. This kind of "tulip-bulb mania" occurs when asset inflation bubbles are created by government intervention or an exogenous shock. Contrary to the beliefs of the 'Free Market' economists and the Austrian School of economists, not all bubbles or "investment rushes" are created by unsustainable growth perpetuated by government intervention.

Exogenous demand shocks can create sharp non-linear supply "corrections" as some form of technological, cultural, or political event suddenly creates a radically different future market expectation. The markets react to this by shifting investments, which being irrational and inefficient as Keynesians predict, generally leads to an overshoot and a second market correction coming from a sudden supply surplus that restores "equilibrium" to market conditions. An example of such an exogenous shock would be Columbus's discovery of the New World in 1492 C.E. or the California Gold Rush. Preventing such exogenous shocks and their corresponding financial market adjustments is neither possible or desirable.

However as 'Free Market' economists note, Keynesian intervention to cushion the secondary correction prevents true market equilibrium from being reached and sets off a delayed but worse correction later on. The only way to avoid this is to use the intervening period of time to enact market reforms and structural economic modernization that puts a "bottom" in aggregate demand so that the sharp supply surplus "shock"/"overshoot" of over-investment doesn't cause a complete collapse in prices and a deflationary spiral. Read more about it at the oldman's posting on Keynesian economics and the business cycle also mentioned above.

The reason why Keynesian intervention is desirable despite its inability to prevent the market correction of a supply over-investment as the result of an initial exogenous demand shock is four-fold: 1) To protect the infrastructure of the economy against liquidation arising from artificial financial speculation (making sure Main Street doesn't get taken to the cleaners by Wall Street); 2) By tempering financial market surges of speculation or cushioning delationary spirals as "lenders of last resort" to prevent financial contagion from spreading; 3) To promote full employment ("laizze faire" 'free market' supply and demand do not necessarily ensure full economic utilization) and 4) market corrections are often too swift for government response - a Keynesian intervention in monetary policy and interest rates can buy time for a government to institute regulatory and structural economic reforms to put a "bottom" in aggregate demand so that prices do not collapse to nothing. Otherwise except for these compelling reasons, the principal role of a central bank would be to keep interest rates and monetary policy closely tied to "true market conditions" that would prevent unsustainable growth fueled by speculation. Exogenous shocks of technological, cultural, and political events can and will continue to happen. Keynesian intervention for all its flaws remains the only way to stabilize the economy in the aftermath of a speculative bubble and price collapse long enough to take corrective action.

Right now the United States has two choices. It can suffer a tertiary market correction of the loose monetary policy and unsustainable stimulation of the financial markets by excessively low interest rates, or it can choose to use this time to enact market reforms and structural economic changes that would shore up and put a supporting "bottom" of increased aggregate demand underneath the market. That way when prices fall, it won't set off a mass asset depreciation as every one has a firesale and dumps it all on the market at once. What this means in practical terms is making it more financially possible for the average (or better yet the median) American family to buy a house without taking on excessive Consumer Debt (WaPo).

One step would involve creating better lending standards such as only allowing refinancing windfalls to be reinvested in paying down principal and interest. This would directly reduce debt and increase asset accumulation (savings) by consumers. Other than the regulatory approach, one could build more accessible starter homes for (profitable) sale into the marketplace. If it's already profitable to build such homes, why aren't they being built now? It's because given scarce or limited capital, capital always seeks the highest ROI (Return on Investment) or more simply the best bang for its buck. On any given lot, it's more profitable to build a high end home than a low-end or average cost home as long as someone is willing to buy it.

Since high-end homes also appreciate the most rapidly (have their prices jump quickly after purchase) they are the prime targets for speculative buying (buying not to live in a home but to cash in on the price jumps). This artificial demand feeds back into the home-building industry and we have the ironic circumstances that the average family must struggle to own a home while many expensive homes are bought and sold freely. Since the Federal government is a nonprofit organization it could make capital available through the Department of Housing and Urban Development (HUD) specifically for the purpose of building low to middle price range homes. The profits from sales could be reinvested back into the program to make more affordable housing available.

Some combination of these actions must be taken soon, or else it will be too late and massive wealth destruction will ensue so that we all will be poorer for it.


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At March 8, 2010 at 11:48 PM, Anonymous Anonymous said...

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