Speculative Bubbles in the US Housing Market
As the prices of housing increase, it turned to expectations, making people buy more homes at the present in fears of higher house prices in the future. The Fed explained that the aggressive monetary policy in 2002 and 2003 was motivated by (1) weak economic recovery after 2001 recession (GDP growth was just above 2, unemployment reached 6), and (2) fears of deflation. More so, they have explained thru the Taylors rule that there is no significant link between monetary easing and appreciating house prices. However, the Austrian School argues that if the Fed did not use monetary policy easing, bubbles like the tech bubble of the late 90s and the recent mortgage crisis could have not happened. The theory believes that the new money directed to housing will eventually lead to bubbles, which led the housing market reached its performance threshold in 2005, until everything collapsed on its path.
The shift from rental market to residential market was popular it brought more homes in the market but this actually stresses the notion that artificially low interest rates by the Fed discourage people from saving money and give them the incentive to borrow more for consumption and speculation. The high demand for homes due to cheap credit has invigorated a loan-hungry economy making more Americans indebted as a result.
Speculative Bubbles in the US Housing Market
Introduction
The very recent recession was a reminder of how markets can get spent when policies and financial instruments dictate the behaviour of the common man. The crisis was famously perceived as the brainchild of the sub-prime mortgage fiasco. The increase in homeownership according to the Goodman and Thibodeau (2008) may be due to (1) lowest interest rates in decades, (2) higher demand for homes by single-person households, (3) eradication of the wealth constraint for buying homes in the US mortgage market, (4) continued popularity of the sub-prime mortgage market, and (5) rise of the home-equity mortgage market. The root of the crisis was indeed the housing bubble, and the root of the housing bubble was, interestingly, another bubble.
The Bubble
Baker (2008) argued that the bubble in the housing market started in the mid-90s when stock prices also increased beyond normal levels. By virtue of this increased wealth from stock earnings, consumption readily stepped up, slowing savings rate borne out of disposable income. A bigger home was on the list. Hence, the great tumble of 2007-2009, nearly realizing Great Depression version 2.0. The domestic crisis spilled world over making it the worst in the Post-World War II era (Bernanke, 2010).
The second phase of the bubble according to Baker (2008) was state-led. The slow recovery of the US in the 2001 recession paved the way for the Fed to lower interest rates. This pressured housing prices to move upwards. From 2002-2006, there was about 30 increase in house prices (see Figure 1). Eventually, more construction was seen. To make matters worse, consumption boomed further as savings slid deeper. Goodman and Thibodeau (2008) said that during the first half of the decade, rate of homeownership in the US went up from 66.9 in 1999 to 69 in 2005. A percentage increase is equivalent to roughly 1 million units of houses owned. On the supply side, input costs also increased during the said period.
The last phase of the bubble was the burst in 2007. During this period, housing was overdone as an over-supply of homes could no longer support prices (Baker, 2008). Resident population in the US was 282,403,000 in July 2000 increasing to 296,639,000 in July 2005 (Goodman and Thibodeau, 2008). They also obtained estimates on the number of households, which was recorded at 104.7 million in March 2000 and 113.15 million in 2005. So there is a 5 increase in resident population as opposed to an 8.1 increase in households. This is attributed, according the US Census, to a decrease in the average household size.
Comparative Statics Equilibrium Analysis
In the short run, using supply and demand analysis, supply of homes was relatively fixed (in the discussed scenario). So the increase in demand for homes catapulted the price of homes (see Figure 2). As the prices increase, it turned to expectations, making people buy more homes at the present in fears of higher house prices in the future. So we can see here a two-step effect of an increase in demand for houses direct increase in price and an indirect effect on prices due to future consumer expectations.
With the high demand for homes spilling over until the early part of this decade, producers cramp up to build more, making the second phase of this housing bubble a supply-side affair. Housing in 2002 was 25 more than the years 1993 to 1995, the start of the bubble. In Figure 3, simultaneous demand and supply effects are imperative in long run equilibrium analysis. Here, a new equilibrium is reached at higher prices as increases in demand for housing exceeds the increases in the supply of housing.
The Warring Schools of Thought Bernanke Economics and the Austrian School
Bernanke Economics
Bernanke (2010) contested that regulation is key to curb another crisis. Financial regulators and the private sector must be more watchful in monitoring and controlling risk-taking. He said that the lesson learned from this recession is that it did not only expose weaknesses in regulator oversight but also gaps in the way financial regulations are built. He however dismisses the conjecture that excessively easy monetary policy by the Fed caused the bubble in house prices.
The Fed explained that the aggressive monetary policy in 2002 and 2003 was motivated by (1) weak economic recovery after 2001 recession (GDP growth was just above 2, unemployment reached 6), and (2) fears of deflation (Bernanke, 2010).
Figure 4 shows the yearly increase in nominal house prices from 1978-2010. House prices in the late 90s regained lost ground after some years of slow growth. Prices grew at 7-8 annually in 1998 and 1999, and ranged from 9 to 11 in 2000-2003. So the increases in housing prices came before the period of highly accommodative monetary policy. The most rapid price gains were in 2004 and 2005, when the annual rate of house price appreciation was between 15 and 17 percent. Thus, the timing of the housing bubble does not rule out some contribution from monetary policy (Bernanke, 2010).
Figure 5, on the other hand, explains the nations position relative to the world in terms of monetary easing. The cross-country comparison evidences the link between monetary policy and house price appreciation. The y-axis shows the change in real (inflation-adjusted) house prices in each country from the fourth quarter of 2001 until the third quarter of 2006, a period that spans the sharpest period of price appreciation in most countries. Countries further above the scatter plot exhibit higher housing price appreciation. The US is located way below although large in absolute terms. The x-axis of the figure shows the degree of monetary policy ease or tightness in each country, measured by the average deviation of policy in each country from the prescriptions of a standard version of the Taylor rule over the corresponding period. Nations, like the US, on the left of the y-axis have more accommodative policies as per Taylor rule prescriptions. It is interesting to note that all countries have easy monetary policies as they mostly converge to that region. Nevertheless, as shown by the r-squared (which is just 5), the relationship between monetary easing and house price appreciation is very weak, and thus, insignificant (Bernanke, 2010).
Following the Austrian business cycle theory (ABC theory), if the Fed did not use monetary policy easing, bubbles like the tech bubble of the late 90s and the recent mortgage crisis could have not happened (Thornton, 2010). The theory believes that the new money directed to housing will eventually lead to bubbles, which led the housing market reached its performance threshold in 2005 (Baker, 2007). The incremental resources for the housing sector will be more compared to other sectors, e.g. manufacturing. As a result, construction speeds up, while other sectors like manufacturing will suffer from high input costs and lower outputs (Thornton, 2010).
In a bubble, home prices increase, Thornton (2010) explains. This will fuel more constructions as labour migrates to the well-funded sector, and as a result, an increase in wages and prices of materials and land to keep up with the rising prices. The shift from rental market to residential market was popular it brought more homes in the market (Baker, 2007). The Austrian approach is however not conservative (Thornton, 2010), as it does not only look at prices to determine bubbles but also the inflating quantity (number of homes). Overbuilding in the prior years of the bubble was evident, as vacancy rates increase (Baker, 2007). So in the eye of the Austrian thinkers, a misallocation of resources was the real culprit.
The Austrian school uses savings rate as a measure to test the existence of a bubble. Figures 6 and 7 shows the effect of the interest rate-led easing to the savings rate of Americans. It is apparent in Figure 6 that Americans lost much of their savings in exchange of the investment promises of housing. Figure 7 shows the positive relationship of low mortgage rates (price of borrowing for home loans) to saving rate. The financial industry contributed heavily to the bubble as they offered attractive mortgage instruments to cater the skyrocketing housing needs of the population (Baker, 2008). From just fixed rate mortgages to adjustable rate mortgages, it went further until sub-prime mortgages and Alt-A mortgages were issued. These are mortgages designed for those with poor credit histories. Alt-A mortgages are for those with mixed credit records. This further stresses the notion that artificially low interest rates by the Fed discourage people from saving money and give them the incentive to borrow more for consumption and speculation (Thornton, 2010).
Figure 8 shows the credit market debt outstanding of Americans from the 1950s to the present. It is very clear in the graph that the American people have borrowed too much increasing its pace the last three decades. The high demand for homes due to cheap credit has invigorated a loan-hungry economy making more Americans indebted.
Conclusion
Fundamental economic analysis can rigorously describe speculative bubbles in the housing market. Price appreciations, according to some critics especially state policy purists or interventionists, that can no longer be controlled by the invisible hand or are no longer self-correcting maybe needs more than government help, but also assistance from the consumers who are directly affected by banes inherent in the impure market economy. The psychology of the consumer can be tapped by producers but can never be stopped when it comes to spending habits. So the initial step always rests on the producers, and then the state.
The US housing bubble can be alternatively analyzed as the crest and the crisis or recession as the trough of business cycles. There will be times when an economy inflates or when it deflates. However, central to the goals of economists and governments is how to curb such events from happening and thereby lessening, or at best avoiding, its impacts. The Feds efforts may have been challenged by workable and valid economic theories but in all prudence, its job to secure a better future for Americans (and consequently the rest of the world) must first be prioritized. It suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates (Bernanke, 2010). In a way, the Fed is better in providing solutions than explaining itself from previous actions. Is that the reason why it is deemed as a super-regulator The answer, nevertheless, remains to be seen.