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May 29, 2005


I have lived through at least two previous housing bubbles here in California. There was a big housing bubble in the late 70s that collapsed in the early 80s. Lot of people buying multiple houses with zero down and flipping them a few months latter for profits, lots of foreclosures when the bubble collapsed. There was another bubble in the late 80s that collapsed in the early 1990s too. The current bubble started in the late 90s, was slowed by the collapse of the dot.com bubble, but low interest rates post 9/11 re-ignited it.

Housing bubbles are not as bad as some other bubbles. Not everyone has bought their house recently or refinanced based on inflated values. Lots of people do own only one house and live in it. Even if housing prices drop 20%, they will still have positive equity. When housing prices start to fall, and I think it is only a question of when, not if, there will be some buyers who are waiting to take advantage. I would expect prices to slowly decline by 15-25% over a year or so, then to remain essentially flat for a number of years. This will shake all the speculators out of the markets, freeing up housing for real buyers.

One point is home mortgage interest is really tied to long-term Treasury bill rates, not the short-term rates the Fed has control over. Right now the Fed is raising rates, but for some reason, the long-term T-bill rates have only gone up a little. The long-term rates are mainly set by the T-bill auctions, and it is somewhat of a mystery why the rates are so low in spite of the trade and budget deficits. Many of the buyers at those auctions are Asian Central banks (China, Japan), and it could be they just have so many dollars to invest because of the trade deficits that they are keeping long term interest rates down and holding up the housing bubble.

I suspect that there would be many Americans who would express extreme concern (at least) at the thought of there being one man such as Greenspan or even a small group such as the Fed Bank being able to direct the US economy.

There is a similar mechanism being used here in NZ. It differs in that the Reserve Bank (RBNZ - the NZ equivalent of the Fed) has the responsibility of controlling inflation within a government determined range (1% to 3% at the moment).

There is a fundamental linkage (part of Economics 102) that runs through -

Interest rates -> Investment -> Production -> employment -> spending -> borrowing -> inflationary pressures -> interest rates

Note that some of these relationships are "direct" - increasing employment will lead to increasing spending - and some relationships are "inverse" - increase interest rates will decrease capital investment.

There are some side-links as well which need to be considered. For example there is a fundamental link (in smaller economies at least) between interest and relative exchange rate. Increase the base rate of interest and the relative value of the currency will also increase. That has the effect of decreasing import costs (lowering inflationary pressure a little) and decreasing returns to exporters (lower profits and pressure on employment).

The interest rate mechanism, in this country at least, has been working quite well over the past twenty years or so. The debate at present is whether the current interest rate is sufficient to encourage people to save rather than spend, discourage the use of credit for asset purchases (thus in theory taking the pressure off the local property market), and at the same time not over-cook the currency to the detriment of our exporters.

Between those also floats the inflation rate, factored by such influences as "imported inflation", demand led price inflation, cost pressure inflation each of which can be seen as by-products of the basic interest function.

So, rather than being concerned, one would hope that in the interests of a "free-market" economy the powers of individual influences such as the Fed were limited.

The dangers that mikeca speaks of - property bubbles etc - come from imprudent investment. If you own only one hen who produces twelve eggs a day then you could be in egg heaven for a while. If that hen gets sick or starts pining for the rooster and goes off lay then you lose. If you own eight hens that produce one egg a day each, there is a lower total return, but the return is more secure long term.

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