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Sunday, December 22, 2002

Housing. Bubble, What Bubble?

The United Kingdom is a country which has often been blessed in terms of its human resources. The most recent example is that of Mervyn King who has recently been appointed to the post of Governor at the Bank of England. A comparison with the work of a roughly equivalent intellect – Otmar Issing say – at the ECB would show that there was, as the Spanish say, ‘ni color’. Meanwhile the Washington Post today makes a comparison with the Fed’s own Alan Greenspan, a comparison from which our dear Mervyn emerges almost smelling of roses.The issue in question is whether to treat the current escalation in house prices as a bubble, and whether, if the former proposition is well founded, it should be well-and-truly pricked. King’s observations come from a recent speech delivered at the LSE (and which can be found here).

Among the more interesting of the points which King makes about the current UK bubble (in the US the question may be more debateable, but in the UK there is a bubble!), relates to the relative expected evolution of capital values and the debt repayment schedule. In his speech King identifies two regimes: a high-interest, high-inflation regime, and a low-interest, low inflation one. These two regimes have very different underlying structural properties in terms of capital values and debt repayments. In the case of the high interest regime, the initial cost is high, but the burden progressively reduces as inflation eats into the capital value and nominal salaries are adjusted upwards. In the second regime however the entry cost may seem relatively low while the burden of repaying the debt changes little (or even rises in the case of deflation).

Now behavioural economics has been in the news recently with the Kahneman (alias Tversky) Nobel. One of the strong arguments in favour of this way of analysing economic decision taking is its emphasis on the use of ready-made rule-of-thumb criteria for decision taking (this has come into popular parlance through the notion of common sense). This notion of the rule-of-thumb is derived essentially from the work of evolutionary psychologists like Cosmides and Tooby (as popularised by MIT’s Stephen Pinker in books like ‘How the Brain Works’ and ‘Blank Slate’) The point about these rules is that they normally work (and this is why we have a positive appreciation of common sense) since they have been positively selected through an evolutionary process. Now logically normally doesn’t mean always. There are cases where such rules may break down, and I have a feeling King has just identified one such case.

The simple rule of thumb for the future is that this year is going to look something like last year, or, the next five years should look like the last five years (actually stochastically speaking the first statement seems sounder, while from the rule of thumb perspective the second SEEMS sounder) and this is where the mismatch may arise. Central bankers tend to see it differently. They tend to assume that the next twenty years will not resemble the last twenty in the area of inflation because they will be applying a policy of inflation targeting or something like it. Good economists may also have well founded intuitions that the next twenty will be different from the last. But the young person trying to decide on a flat or house may not have recourse to such ideas. This is where the rule of thumb sends things badly awry. For what is more reasonable than to think that with interest rates coming down, and the same monthly payment getting apparently more capital action, to target constant monthly payments rather than square metres. Of course this doesn’t get the extra capital action sought after since the housing stock cannot be expanded rapidly in the way the flow of mortgage funds can (‘sticky’ I think is the word here), and the value of the existing stock adjusts upwards accordingly.

The real problem arises since initial repayments under the inflationary regime tend to consume a rather large part of the current income stream, but this is accepted since with time the proportion of current income consumed reduces. However, as has been observed above, in a disinflationary or outright deflationary environment this doesn’t happen and the proportion remains relatively constant (or even grows if in a given moment interest rates have to rise). This has knock-on effects for other areas of consumption as the money to fund it does not become available. Bottom line: a complete mess. Solution, the normal one as advocated by Keynes, stoke-up a bit of inflation to sweat off some of the debt. But the world of Keynes was then, and this is now. In front of Keynes were years of young generations progressively entering the labour market. The problem was how to create enough employment for an ever expanding working population, our problem is how to persuade more working age women to go to work and to persuade men of 58 not to retire early. We are facing generations to come in declining numbers.

The political dynamics of this are rather complicated. The much longed for inflation would, as we know, devalue both debt and savings. But with ageing populations the losers can outnumber the winners. One further lag should now become of interest to economists, that between immigrant arriving and immigrant voting. Roughly ten years is my back-of-the-envelope guess. This is relevant since immigrants tend to have neither debts nor assets, live on a stream of income basis, and are likely to be inflation/deflation neutral. Without the immigrant vote the ageing savers can dominate the electoral process. I still cannot really claim to understand the subtleties which like behind the dynamics of the Japanese political system, but could the age structure of their population just possibly have something to do with their reluctance to adopt inflation boosting strategies to fight deflation?

A New Bubble
Even as the debate over the stock market bubble continues, another is just beginning, this one over house prices. Nationally, house prices were growing at the annual rate of about 8 percent through much of 2001, while in some metropolitan areas, such as Washington, the average annual percentage increases were as high as the mid-teens. Such increases were two and three times those in household income, leading some analysts to argue that investors who had once poured their savings into the stock market had now decided they could get better, or at least more secure, returns by investing in new and bigger homes. Lending support to that notion were the Fed's own figures on household wealth, which show an acceleration in the growth of mortgage debt beginning in 2001. By the end of 2001, mortgage debt burden as a percentage of disposable household income had reached its highest level in more than 20 years.

A number of critics, including Ed Yardeni, an economist and chief investment strategist at Prudential Securities, blame the Fed for helping to create and fuel what they characterize as a housing bubble. Keeping interest rates at their lowest level in decades, they argue, had the effect of pushing house prices even higher while encouraging households to allow their debt to grow faster than their incomes or their wealth. But Fed officials have repeatedly declared that there is no housing bubble worthy of the name. "We've looked at the bubble question and concluded it's most unlikely," Greenspan testified at a congressional hearing in July, noting that the housing market by that time had already begun to cool. "We see no evidence of it." Indeed, rather than expressing concern about the increase in mortgage debt levels, Greenspan and his colleagues have applauded the boom in mortgage refinancings that allowed millions of homeowners to "cash out" on some of the equity value of their homes. Consumers have used much of that money to continue spending on new cars, furniture and other goods right through the recession, Fed officials argue, helping to smooth out the business cycle and make it one of the mildest in memory.

By contrast, Mervyn King, the new governor of the Bank of England, used a speech last month to warn that the British economy had become overly reliant on consumer spending propped up by increases in housing values that reached nearly 30 percent in the past year. "Even the optimistic Mr. Micawber would realize that this cannot continue indefinitely," King said, referring to Charles Dickens's character in "David Copperfield." But King went on to acknowledge that he wasn't sure whether the central bank should try to prick the bubble before it burst, or give it a chance to deflate on its own.
Source: Washington Post

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