"Bubble, bubble, toil and trouble," is not what Macbeth's witches said. It is, rather, the phrase that has entered the language. And now, after one bubble has caused rather a lot of trouble, another is bubbling up. "Double, double toil and trouble," was what the witches said. And that is what the U.S. economic cauldron is cooking: Double trouble as a second asset price bubble is allowed to boil.
What are we talking about? It is a question, we fear, our readers often ask. But take this August economic commentary from the Mortgage Bankers Association of America and our meaning may soon become clear. It is about asset price bubble No. 1, now an ex-bubble: "Stock prices were hammered sharply lower over the past month, widening the losses of consumer wealth, raising the cost of equity capital to businesses, and taking a substantial toll on business and consumer confidence."
In 1995-1999, but especially in 1998-99, the U.S. stock market bubbled. The world applauded it at the time. Indeed not to applaud it was considered wrong-headed and perverse. The cauldron was bubbling healthily with high growth, low inflation, high productivity, capital inflows, strong dollar, new paradigm and miracle economy as ingredients and never an "Adder's fork" or "blind-worm's sting," nor an eye of Enron, nor a wool of WorldCom, nor "a hell-broth boil and bubble" in sight. Yet, in August 2002, more than two years since the cauldron suddenly started to cool, its poison is still running through the veins of the U.S. economy.
Bubbles can be fun, but there are problems with them. When the prices of assets inflate rapidly, the economy becomes distorted in all sorts of ways. Why? Add $1 million to your bank account and -- assuming you are unaccustomed to having $1 million in it -- your behavior is likely to change. You could, after all, always use a second car, or a third one. Your computer is a little old, and on the new ones you can make your own videos. Speaking of which, a video camera would be nice. And a bit more room. Perhaps a house extension would be good? Or even, a new home -- which we will come to.
Put a million dollars into pockets is just what the stock market did in its late 1990s bull run -- and if not a million, half a million, or a hundred thousand, or ten thousand. Not all Americans shared in this bonanza. Only about half the population has direct ownership of shares. And this money, it is true, did not go direct into bank accounts but mostly into saving schemes intended to provide pensions. But some of the extraordinary stock market gains were converted directly into house purchases or new cars or new computers, and a sense of growing affluence persuaded many Americans and, on average, all of them to save much less of their income and spend more of it.
But what if the source of that spending, that additional magic million, suddenly disappears, as the stock market drops back to where it was before it began to boil? Then a great deal of consumption and investment has been encouraged by funny money. The adjustment may be difficult. More income may need to be saved to provide for the future or to service debts taken on in the champagne days. Americans are just beginning this process. It explains why, in our view, the prospects for consumer demand and growth in the U.S. economy are poor next year. Double-dip recession is a very real prospect. But one sector at least is strong, a defense, a bastion. What is it? Housing.
Economy struggling? You would not think it from some figures. The Commerce Department reported Monday that new home sales rose to 1,017,000 in July: the first time sales of new homes had ever exceeded 1 million units in a month. The sales figures in four of the last five months are the highest the market has ever recorded.
The National Association of Realtors celebrated Monday other bullish data on the housing market, for sales of existing homes in July, which "rose 4.5 percent to a seasonally adjusted annual rate of 5.33 million units in July from an upwardly revised pace of 5.10 million units in June," the NAR reports.
Housing sales are at an all-time high -- even as the economy, emerging from its 2001 recession, struggles to obtain the momentum to avoid renewed slowdown. This is a mismatch that is easily explainable yet nonetheless a cause for alarm.
It is not difficult to understand why the market is booming. David Lereah, NAR's chief economist, said "Mortgage interest rates were ... the lowest since Freddie Mac started tracking them in 1971, and looking at other sources we have to go back to 1967 to see interest rates as low as they are today. Combined with other strong market fundamentals, this is keeping the housing market on track for another record year."
The NAR forecast record sales of new and existing homes in 2002. In other comments, Lereah said, "the fundamentals show us there is no risk of a national housing bubble."
Indeed so, how could anything be wrong? This, after all, is the fourth year in which the housing market has boomed, showing that boom is sustainable for all time, just like the 1995-99 stock market one.
But consider some figures. In the first half of the 1990s the annual level of existing home sales was almost invariably below 4 million units per year. Since the beginning of 1999, sales have been consistently above 6 million units per year. Is this super-high level of activity sustainable?
In fact, in the NAR's own data, there are signs that the boom is beginning to ease. In the Northeast where the financial centers of Boston and New York dominate, existing home sales were down by 3 percent in July compared to July 2001. And in the West, too, where tech used to be king, sales were down, by 2.9 percent. It is no coincidence that these are areas in which the late 1990s economic bubble bubbled hottest and where the post-bubble pain is being felt first. Here, even with interest rates still lower, the first signs of cooling can be seen.
The housing bubble cannot inflate much further. If there is a solid economic recovery, interest rates will rise and demand for housing will fall. And when demand falls, house prices, too, are likely to drop from their current high level. Those who have indebted themselves to buy at a high level are likely to find their mortgages worth more than their homes. That is unfortunate and will act as a drag on the economy for some years to come.
But another outcome is perhaps more likely. It is only housing that is responding wholeheartedly to the current record low interest rates. The danger for the United States is that because of the damage done by the first asset price bubble, still lower interest rates do not stimulate much of a recovery. Yet whether this is a better outturn for the housing market is in question. Rates may fall but, with unemployment rising and incomes stagnant, house prices may drift -- and still have to face the impact of higher interest rates when the U.S. economy finally does strengthen. After its record run, the housing market's slump could also be long-lived. That is worrying.
The U.S. economy was poisoned, we said, by that first steaming cauldron in which equity prices bubbled. The second bubble, in housing, risks doing further harm and perhaps greater harm. The wealth effect from housing, the International Monetary Fund argued in a report this year, is greater than that from stocks. More people own houses than stocks. The housing boom that most economists applaud may be more distorting and leave more of a negative legacy than the boom in stocks.
U.S. economic policy got it wrong in the 1990s when it allowed stock prices to soar out of control. The lesson has not been learned. Now house prices are emulating the stock bubble -- and most people, including Federal Reserve Chairman Alan Greenspan -- say this is good. Double, double toil and trouble. It is all a charm of powerful trouble.
With apologies to Shakespeare. Comments to [email protected].
