By Robert J. Shiller

THE future of the housing boom, together with the possible financial repercussions of a substantial price decline in the coming years, is a matter of mounting concern among governments around the world.

I learnt this first-hand while attending this year’s Jackson Hole Symposium in the remote wilderness of Wyoming where, ironically, there are almost no homes to buy. The howls of coyotes and bugling of elk rang out at night. But, by day, everyone was talking about real estate.

This conference has grown to be a major global event for government monetary policymakers, with governors or deputy governors of 34 central banks attending this year. Roughly two-thirds of these countries have had dramatic housing booms since 2000, most of which appear to be continuing, at least for the time being. But there was no consensus on the longer-run outlook for home prices.

Of all these countries, the United States appears to be the most likely to have reached the end of the cycle.

According to the Standard & Poor’s/Case-Shiller US National Home Price Index, US home prices rose 86 per cent in real, inflation-corrected, terms from 1996 to last year, but have since fallen 6.5 per cent – and the rate of decrease has been accelerating.

That looks like the beginning of the end of the boom, though, of course, one can never be sure. I presented a bearish long-run view, which many challenged, but no one obviously won the argument.

Nevertheless, an outside observer might have been struck by the weight given to the possibility that the decade-long boom might well suffer a real reversal, followed by serious declines.

Weaker standards

THERE seems to be a general recognition of substantial downside risk, as the current credit crisis seems to be related to the decline in US home prices that we have seen.

The boom, and the widespread conviction that home prices could only go higher, led to a weakening of lending standards. Mortgage lenders in the US seem to have believed that home buyers would not default, because rising prices would make keeping up with their payments very attractive.

Also, the boom resulted in some financial innovations, which may have been good ideas intrinsically, but which were sometimes applied too aggressively, given the risk of falling prices. Mortgage- backed securities were urged onto investors for whom they were too risky. As with homebuyers, all would be well, the reasoning went, on the premise that home prices continue to rise at a healthy pace.

At the Jackson Hole conference, Mr Paul McCulley of Pimco, the world’s largest bond fund, argued that in the past month or two we have been witnessing a run on what he calls the ‘shadow banking system’, which consists of all the levered investment conduits, vehicles and structures that have sprung up along with the housing boom.

The shadow banking system, which is beyond the reach of regulators and deposit insurance, fed the boom in home prices by helping to provide more credit to buyers.

Bank runs occur when people, worried that their deposits will not be honoured, hastily withdraw their money, thereby creating the very bankruptcy that they feared. It is no coincidence that this new kind of bank run started in the US, which is the clearest example of falling home prices in the world today.

When home prices stop rising, recent homebuyers may lose the enthusiasm to continue paying their mortgages – and investors lose faith in mortgage-backed securities.

Loose policy

THE US Federal Reserve is sometimes blamed for the current mortgage crisis, because excessively loose monetary policy allegedly fuelled the price boom that preceded it. Indeed, the real (inflation-corrected) federal funds rate was negative for 31 months, from October 2002 to April 2005. The only precedent for this since 1950 was the 37-month period from September 1974 to September 1977, which launched the worst inflation the US had seen in the last century. What then helped produce a boom in consumer prices now contributed to a boom in home prices.

Loose monetary policy is not the whole story. The unusually low real funds rate came after the US housing boom was well under way. According to the Standard & Poor’s/Case-Shiller US National Home Price Index, home prices were already rising at almost 10 per cent a year in 2000 – when the Fed was raising the federal funds rate, which peaked at 6.5 per cent. The rapid rise thus appears to be mostly the result of speculative momentum before the interest-rate cuts.

Former Fed chairman Alan Greenspan recently said that he now believes speculative bubbles are important driving forces, but at the same time, the world’s monetary authorities cannot control bubbles. He is mostly right: The best thing that the monetary authorities could have done, given their other priorities and concerns, is to lean against the real estate bubble, not stop it from inflating.

Today’s fall in home prices is linked just as clearly with waning speculative enthusiasm among investors, which is likewise largely unrelated to monetary policy. The world’s monetary authorities will have trouble stopping this fall, and much of the attendant problems, just as they would have had stopping the ascent that preceded it.

The writer is professor of economics at Yale University and author of Irrational Exuberance And The New Financial Order: Risk In The 21st Century.


Source: The Straits Times 19 Sept 07

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