Houses in the Air

Over the past six months, attention and worry have shifted from America’s enormous trade deficit to its surging property markets and real-estate bubble. At least two of the reasons for high – and rising – home prices in the United States are well understood. What remains highly uncertain, however, is whether an obviously overheating market can be cooled without sending America, and its main trading partners around the world, into an economic tailspin.

The US housing boom is due, first, to low interest rates, which mean that large amounts of money can be borrowed for mortgages with moderate monthly payments. Low interest rates strengthen the ability to pay, and thus boost demand. And, with demand high and housing supply fixed – at least in the short run – prices go up.

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Second, the 70-year period that began with the widespread diffusion of the automobile –during which one could get nearly anywhere in a typical metropolitan area in half an hour or less – is over. Before there was widespread automobile ownership, land prices depended on location, and proximity to the central city or to the local railroad station carried a premium.

Now, with serious congestion slowing traffic in major cities to a crawl, the land gradient in housing prices is steep once again. Perhaps this steepening of the location gradient could be delayed for a decade if we were willing to shift to denser residential patterns. We could, for example, tear down San Francisco’s row houses and replace them with buildings more like those of New York’s Upper West Side. But we aren’t willing to do that.

These two factors – low mortgage rates, and the fact that the country has filled up so much that our cars no longer marginalize location costs – go a long way toward explaining the surge in housing prices over the past decade or so. But they don’t go all the way.

On top of these two powerful fundamental factors sits a bubble. The bubble is filled by people with money who are buying extra houses because they think home prices will continue to rise, and by people without money who are buying $400,000 houses in less-fashionable neighborhoods with zero percent down and floating interest rates.

Both groups’ demand is inherently ephemeral. When the first group discovers that housing prices don’t always go up, they will try to dump their properties. And when the second group discovers that interest rates don’t always stay low, many of them will be unable to meet their higher mortgage payments and will likewise try to dump their properties.

The end of the American housing bubble might not turn out badly. But if it does, it will probably be due to a sharp rise in interest rates. This could happen for two reasons. First, investors, recognizing that the dollar is overvalued and that they are likely to suffer large losses when it returns to its fundamental value, could start selling their Treasury bonds, corporate bonds, and mortgage-backed securities. As the prices of these assets fall, their yields will rise. At some point, the yields on bonds and mortgages will be high enough that investors’ appetite for yield will balance their fear of exchange-rate depreciation.

In the corridors around my office, all the economists agree that this factor should have pushed US interest rates up three years ago. But so far it has not. Does this mean that a hurricane could hit world financial markets at any moment? Yes. Or it could also mean that economists’ baseline model of the international economy – especially the assumption of “uncovered interest parity,” which holds that foreign interest income expressed in the domestic currency should equal the domestic interest rate – is simply wrong.

The second factor that could push US interest rates sharply upward is not fear of a decline in the future value of the dollar, but the fact of a past decline in its value. The US imports the equivalent of 16% of its GDP. A 40% fall in the value of the dollar – of which half passes through to increased dollar prices of imports – thus implies a 3.2% rise in the overall price level. A Federal Reserve committed to effective price stability will likely raise interest rates rather than allow any year’s inflation rate to jump from 3% to 6%.

If there is a sharp spike in interest rates – caused either by capital flight in anticipation of a dollar decline or by tight monetary policy in reaction to a dollar decline comes to pass – we will see how good the Federal Reserve really is. If interest rates rise too far, then the collapse in housing values will lead to large-scale foreclosures and a collapse in consumption spending as well.

This would mean a depression not just for the US, but for Asia and probably Europe as well, for the US can remain the world’s importer of last resort and guarantor of effective demand only as long as its domestic consumption is strong. But if interest rates don’t rise far enough, the value of the dollar will spiral downward and US inflation will spiral upward like in the 1970’s, setting the stage for the type of extremely painful measures imposed by then Federal Reserve Chairman Paul Volcker.

In these circumstances, straight is the gait and narrow is the path that the Federal Reserve will have to walk – hardly an enviable position. And yet journalists – not very experienced reporters, to be sure – ask me who is likely to get the “plum job” of Fed Chair next year.