The first bubble was in stocks. Their excessive rise in the second half of the 1990s distorted the U.S. landscape and that of the global economy. Demand for goods and services was stretched by magic money: money that bubbled up from an effervescent stock market.
But since the first quarter of 2000 the fizz has been waning. This is why the U.S. economy suddenly lost buoyancy even though interest rates began to be cut by the Federal Reserve at speed. Fed Chairman Alan Greenspan has been pumping -- to little avail. Who, two years ago, would have predicted that in 2002 the Fed funds rate, the main short-term interest rate would be at just 1.75 percent and yet the NASDAQ and the Dow would be well down on their levels in 1999?
So that was bubble one, the stock market bubble that encouraged Americans to spend, spend, spend, not worry about saving, and believe that that they were living in the best of all possible economies. Those were euphoric times. No longer.
But when the bubble deflates, what, as a policy-maker, do you do? Greenspan has had to ask himself that question and the answer he has found -- let us admit -- may not be the worst one. The policy problem he is dealing with is difficult and has few precedents. His answer has been, as we put it above, to keep pumping: to do all possible to stop the U.S. economy crumbling. And so far he has enjoyed some success. Growth rebounded strongly in the first quarter of this year from contraction in the third quarter of last year. Greenspan, it might be thought, is winning or, at least, was winning until stocks headed down again in recent weeks amid signs that the recovery may be waning. Now he may be tempted to cut rates still further in coming months to try to ensure that growth ensues.
That would be welcomed by Wall Street, business and most Americans, yet we feel it would be a mistake. The reason is that economic policy making in the United States has already created a second bubble, a bubble that is substituting to some degree for the first, and that will create problems of its own.
Housing, we hear constantly, is buoying up the U.S. economy. People in the industry are euphoric. Listen to them: "So far this year we've already recorded the four highest monthly sales rates on record for existing-home sales," said David Lereah, the National Association of Realtors' chief economist.
"American consumers are flocking to purchase homes or refinance existing mortgages thanks, in large part, to some of the lowest interest rates we have seen in over 30 years," said Doug Duncan, the Mortgage Bankers Association senior vice president and chief economist. "Without a doubt, the housing market is very strong and is helping to push the U.S. economy toward recovery. Consumers and mortgage markets are receiving a boost as the bond market benefits from the present investor uncertainty in the stock market."
"It's good to see that the housing market is back up to its first-quarter pace after some slippage in March and April" said Gary Garczynski, a builder/developer from Woodbridge, Va., and president of the National Association of Home Builders. "Housing is still doing its part to keep the economic recovery going forward."
"Given the strong marketplace demand, we're confident of setting records for both existing- and new-home sales this year," said the president of the National Association of Realtors, Martin Edwards Jr.
Heard enough? Housing is in a boom. That's good, isn't it? Just as good as the stock boom, perhaps?
"Boom" is good to most people but it makes this economist, a particularly dismal one, of course, nervous.
Why is there a boom? The cheering men of the industry have the answer. Come on, Duncan, let's have it: "We have felt that to ignite another boom, rates would have to break through the magic 6.5 percent barrier which they did the past week. If rates stay there for a time or fall more we will have another major wave of refinancing."
OK, Duncan, and what are people doing with the money?
"The average size of a mortgage loan has also been increasing recently as jumbo ARM (adjustable rate mortgage) holders refinance, home prices continue to appreciate, and borrowers tap equity through refinancing. Last week's average loan size was $206,500, the largest on record."
So there we have it. Consumers are tapping the equity in their homes and taking out bigger loans than ever before. Splendid. What will that lead to? Ask Duncan. (A good Scottish name, I might add, though he seems less affected than your correspondent by Scottish caution.)
"Because of various demographic factors, including household age distribution and immigration, we expect that the housing market will stay strong over at least the next decade."
So a decade of buoyancy awaits. But is not the economy struggling to grow despite ultra-low interest rates? Is there not perhaps some danger in the fact that homeowners are using the wealth in their homes to fund expenditure when house prices have risen substantially in recent years? What if house prices were to fall?
Even some people in the industry admit that this boom cannot go on and on. Take the NAR's Lereah. He predicts some moderation: "The pace can't stay at unprecedented levels indefinitely ... Going forward, the trend should be a gradual decline in home sales activity but they'll stay above last year's record."
How important is what is happening in housing for the economy? Earlier this year the International Monetary Fund reported in its World Economic Outlook the "wealth effect" associated with rising house prices. It found that this wealth effect -- the incentive giving to consumption by increased wealth -- was stronger for house price rises than for rises in stock prices. It's true: the housing boom has propelled the U.S. economy. It has helped to keep consumers spending, using the wealth generated by rising house prices and spending it on -- well, why not have a new car? They are nice, you know, and the deals on them are better than ever.
But there are threats to this boom, just as there were threats, now being realized, to the stock one. What if interest rates were to rise? New buyers would not be so keen to borrow and would be likely to want to pay less for new homes. Prices would have to fall. Tricky if you used your equity to fund consumption.
Of course, it might be said that with the economy slack neither inflation nor interest rates will rise, and that may be true, even with the dollar falling -- and therefore import prices rising. But if the economy remains slack, then unemployment will rise and earnings and bonuses will be weak, and stocks will fall further or remain depressed. Money is not going to be as abundant as it once was and people may be less able to pay high prices for homes.
A lesson that should be learned from the shrunken NASDAQ and the weakness for more than two years of U.S. stocks is that bubbles do not go on. They burst. And when they burst someone suffers.
The worst time to buy, of course, is when the bubble is almost fully inflated and ripe to burst. That is the case for housing now. If Greenspan cuts rates, the bubble will extend a little further. And the damage in years to come will be all the greater. Americans may find that they can sell their homes only at a loss, and that they perhaps need to borrow to pay off the mortgages taken out in a period of euphoria.
Beware euphoria. Beware over-priced houses. Beware cheap money. They may all end badly.
At some point the United States must accept the consequences of its irrationally exuberate boom. Greenspan may have been right to try to prevent a steep, self-reinforcing decline in U.S. demand. But at some point consumption has to fall. Building another bubble in housing is not the way forward.
Global View is a weekly column in which our economics correspondent reflects on issues of importance for the global economy. Comments to email@example.com.
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