From Bubble to Bubble

It seems like yesterday. But it's only been a little over five years since we were going through the same drill that is playing out today -- bemoaning the excesses of an asset bubble and hunkering down for the inevitable post-bubble shakeout. Five years ago, it was the equity bubble. Today, it's the property bubble. These are not isolated events. As night follows day, one bubble has spawned the next. And we have the Federal Reserve to thank for this grand continuum and the cumulative toll it is taking on the US economy. Sadly, as America lurches from bubble to bubble, the endgame is looking all the more treacherous.

The debate has an eerie sense of dj vu. Today, there are those who dispute the very existence of a US property bubble. Similarly, five years ago, there were many who argued that US equities were not over-valued -- that, in fact, they were fairly valued on the basis of the powerful earnings potential of a high-productivity growth New Economy. Today, we hear tales of a "fundamentally-driven" housing boom -- supported by increased homeownership, immigration, low unemployment, and, of course, low interest rates. And there are those who repeatedly caution against characterizing property as a broad asset class -- especially in the context of fragmented real estate markets that are always distinguished by their "local" idiosyncrasies.

This is rubbish -- five years ago and, again, today. In March 2000, not all stocks had risen to dot-com excesses. But enough of them did to take the overall S&P 500 index down by 49% in the bubble carnage that followed over the next two and a half years. Today, nationwide US house-price inflation is at a 25-year high in real terms. That doesn't mean every home in the country has hit bubble-like valuations. But in the first quarter of 2005, double-digit house-price inflation was evident in 23 states plus the District of Columbia. In 25 of the top 100 metropolitan areas, the rate of home price appreciation was at least 20%. Investors -- not owners -- are currently accounting for 11.5% of newly-originated conventional mortgage loans; that's up from a 2% low in late 1995. And mortgage financing has shifted dramatically in recent years into exotic and risky floating rate obligations such as interest-only and negative-amortization loans; moreover, as Tom Lawler of Fannie Mae notes, this shift into floating-rate borrowing cannot be explained by the factors that traditionally drive such trends -- the level of mortgage rates and yield curve spreads. Something else must at work.

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That something else is a bubble. Residential property has become the asset of choice for investors in a low-return world awash in liquidity. As The Economist has long stressed, this property bubble is global in scope -- by their reckoning, "the biggest financial bubble in history". The worldwide scope of this asset bubble makes it tempting to dismiss America's problem as part of a broader, more powerful trend. Again, I would argue this is nonsense. The US is very much in control of its own destiny insofar as coping with the excesses in asset markets. In that important respect, America's equity and property bubbles have one key ingredient in common: The principal blame for both bubbles, in my view, lies with the Federal Reserve.

Unlike most other major central banks, the Greenspan Fed has long maintained that asset markets are not within the purview of its policy mandate. The Bank of England, the Reserve Bank of Australia, and, belatedly, the Bank of Japan all believe differently. Ottmar Issing of the European Central Bank has argued that asset markets pose one of the greatest challenges for modern-day monetary policy -- that central banks must now weigh "the risks associated with asset-price inflation and subsequent deflation (see Issing's 18 February 2004 editorial feature in the Wall Street Journal, "Money and Credit"). America's Federal Reserve sees it differently. But it wasn't always that way. Long ago, when America's Asset Economy was in its infancy, Alan Greenspan worried about "irrational exuberance." But he quickly changed his mind and went on to champion the equity culture spawned by the New Economy. In my view, that was a policy blunder of monumental proportions.

The rest is history -- and a sad history at that. By electing to condone the greatest equity bubble since the late 1920s, the Fed has been snared in a low real interest rate trap -- in effect, locking itself in to a serial bubble-blowing strategy. To counter post-equity bubble aftershocks, the Fed slashed its policy rate by 550 basis points to 1% -- vowing that it had learned the tough lessons of Japan. And then in the face of a full-blown deflation scare -- a classic and predictable symptom of a post-bubble shakeout -- the Fed maintained an uber-accomodative policy stance that is still in place today. It pushed the real federal funds rate into negative territory for three years (2002-04) before finally taking it up to the zero threshold, where it remains today.

Bubble after bubble has since percolated to the surface during this period of extraordinary monetary accommodation -- especially in a multitude of fixed income products (i.e., Treasuries, investment-grade corporates, high-yield bonds, emerging market debt, and a host of credit instruments). With overnight money basically free in real terms, the "carry trade" was a no-brainer -- investors and speculators alike could pocket the spread anywhere on the yield curve. This created an artificial demand for fixed income securities that was quick to take on bubble-like implications of its own.

Out of this same mania, the property bubble was borne. Behavioral economics tells us the American consumer should have been decimated once the equity bubble popped in 2000 -- the pain of loss should have been far greater than the ecstasy of gain. But US households never skipped a beat. House price inflation took over where the equity bubble left off, and the Fed's post-bubble rescue plan facilitated the greatest bonanza of them all -- a massive wave of home mortgage refinancing that became a powerful supplement for an income-short US consumer. The home became the cash machine -- the manna from heaven that drew its sustenance from rock-bottom interest rates. And it became contagious -- as most bubbles do. The more consumers succeeded in extracting purchasing power from their assets, the greater the demand for the asset. Once borne out of a legitimate effort at post-bubble life-style defense, the asset-based consumption mindset took on a life of its own. Like the carry trade in fixed income, this phenomenon created an artificial demand for the underlying asset. We now call it a property bubble.

Dangers cumulate as one bubble follows another. That's because debt invariably enters the equation. And that has certainly been the case in recent years. Not only does the outstanding volume of household sector indebtedness now stand at a record of nearly 90% of GDP, but this ratio has soared by 20 percentage points over the past five years (2000-04) -- equal to the rise that took place over the preceding 15 years (1985-99). Moreover, household sector debt-service burdens are at historic highs when scaled by disposable personal income -- truly astonishing in a climate of rock-bottom interest rates. That means it wouldn't take much of a back-up in rates to put a real squeeze on the over-extended American consumer. Moreover, given the low "teaser" rates that have lured increasingly large numbers of homeowners into floating rate mortgages in recent years -- the ARM share of newly originated mortgage loans recently hit 40% -- there are new risks to this debt binge; it is quite conceivable that "automatic resets" will push mortgage interest payments up sharply in the not-so-distant future, even if market interest rates don't budge. (Note: The increasingly popular option ARMs -- basically negative amortization loans -- are especially vulnerable to payment shock; see the 20 June 2005 Fitch Ratings report, "Option ARM Risks and Criteria"). Here as well, history screams out the warning that has gone unheeded -- debt bubbles and asset bubbles go hand in hand.

The exit strategy has always been the most problematic aspect of this scenario. Not only is that true of overly-indebted borrowers, but it's also true of central banks. The Fed prides itself in having learned the lessons of Japan. But, in fact, the game-plan is woefully incomplete. Yes, the US central bank learned that it pays to move quickly once a bubble bursts. But then what? Unfortunately, there was nothing further to learn from the Bank of Japan other than it's very tough to wean a post-bubble, deflation-prone economy from low nominal interest rates. Some 16 years after the Japanese bubble popped, the BOJ is still stuck with its policy rate at zero. Five years after the US equity bubble popped and the Fed is not a whole lot better off, with its policy rate still hovering around zero in real terms. As bubble follows bubble, the consequences of normalizing interest rates become more and more severe -- not just for the US but also for a US-centric world that now believes the American consumer is "too big to fail." The resulting moral hazard dilemma only reinforces the belief that low interest rates are here to stay. In the meantime, asset and debt bubbles keep feeding on themselves.

This is a sad and depressing tale -- especially for the world's unquestioned economic leader. Alas, bubbles and imbalances are one and the same. Even Alan Greenspan has finally admitted that the property-based equity extraction of an asset economy pushes income-based saving rates lower and lower -- thereby reducing national saving and resulting in an ever-wider current account deficit (see his 4 February 2005 speech, "Current Account"). One of the great mysteries of asset bubbles is what causes them to pop. Yale professor Robert Shiller has long argued that asset bubbles invariably implode under their own weight (see Irrational Exuberance, Princeton University Press, first edition, 2000). Another possibility in the current climate is the inevitability of a US current account adjustment -- a rebalancing that entails mounting pressure on the dollar and US real interest rates. Such an outcome could very well put the US on a collision course with ever-expanding asset bubbles. We all hope for the benign endgame. But the bigger the bubble and its associated imbalances, the less likely that becomes.

Don't kid yourself. America's property bubble didn't just appear out of thin air. It is traceable directly to the equity bubble of the Roaring 1990s -- and to a central bank that remains steeped in denial. The real lesson of Japan is that there may well be no easy way out.

By Stephen Roach (New York), Morgan Stanley economist, on the Global Economic Forum