Morgan Stanley
December 3, 2004
<>Global: Bubble Day
Stephen Roach (New York)
December 1, 2004 could well go down in history as yet another important milestone for America’s bubble-prone economy. No, I am not referring to the 162-point surge in the Dow Jones Industrial average that occurred on that day. Instead, my focus is on two widely overlooked statistical reports put out by US government statisticians -- the latest tallies on home prices and personal income. Collectively, these reports paint a worrisome picture of an asset economy that has now truly gone to excess. As was the case in early 2000 when Nasdaq was lurching toward 5000, denial is deep over the potential downside of yet another post-bubble shakeout. That’s what worries me the most.
The just-released report on US house prices for the third quarter of 2004 was a shocker -- an 18.5% annualized surge from the second quarter and a 13.0% increase from year-earlier levels, according to the tabulation of the Office of Federal Housing Enterprise Oversight (OFHEO). That represents a stunning acceleration from the 9.8% Y-o-Y increase of the second quarter and pushes nationwide house price appreciation to a 25-year high. It’s an even larger rise in real, or inflation-adjusted, terms. The surge over the past year is now running nearly five times the 2.7% annualized increase of the non-housing components of the CPI.
Housing analysts and central bankers often chide those of us who draw macro conclusions from a highly fragmented US real estate market. In the housing business, where "location" matters, concerns over nationwide trends are often dismissed out of hand. In a recent speech, Federal Reserve Chairman Alan Greenspan noted while discussing housing prices, "Overall while local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely in the United States, given its size and diversity" (see his October 19, 2004 speech, The Mortgage Market and Consumer Debt, at America’s Community Bankers Annual Convention, Washington DC). It’s a nice theory, but the risk is that it may now be wrong. According to the latest OFHEO tally, house-price inflation over the past year has run at double-digit rates in 25 out of 50 states plus the District of Columbia. In six states -- Nevada, Hawaii, California, Rhode Island, Maryland, and Florida --- home prices increased by 20%, or more, over the past year. Housing is an asset class that is just as prone to excess as are stocks, bonds, currencies, or commodities. If it feels like a bubble, acts like a bubble, and looks like a bubble, it probably is one.
Meanwhile, also on December 1, the Bureau of Economic Analysis of the US Department of Commerce released its regular monthly update on personal income. The stock market loved the October numbers -- stronger-than expected gains in both income (+0.6%) and consumption (+0.7%) that were perceived as signs of ongoing resilience of the indefatigable American consumer. I found the report appalling. What caught my eye was a further reduction in the already sharply depressed personal saving rate -- down to 0.2% in October from 0.3% in September. The September numbers were widely thought to have been distorted by temporary hurricane-related losses to personal income. Most expected personal saving would rebound from this artificially-depressed reading. There was no such bounce in October. The consumer saving rate has now basically gone to zero.
Nor is the profligate American consumer the only source of the US saving shortfall. A day earlier -- November 30, to be precise -- the government also released its third-quarter report on national saving. This broad measure of saving -- the combined saving of households, businesses, and the government sector -- is most meaningful when expressed on a "net" basis by taking out the depreciation that goes toward replacement of worn-out, or obsolete, capacity. The resulting concept of net national saving measures the saving left over to fund the net growth in productive capacity -- the sustenance of any economy’s long-term productivity and growth potential. On this basis, America’s net national saving rate fell to just 1.2% in the third quarter of 2004 -- down 0.9 percentage point from the already depressed second quarter reading and nearly back to the record low of 0.4% recorded in the first quarter of 2003. The rest of the story is all too familiar: Lacking in domestic saving, the US must then import surplus saving from abroad in order to grow -- and to run massive current-account and trade deficits to attract that capital. In other words, a further sharp reduction in national saving is not exactly a desirable outcome for an already unbalanced US economy.
The key to this puzzle is to recognize that the housing bubble and the saving shortfall go hand in hand. The "asset economy" is a conceptual framework that brings these two seemingly disparate trends together. As seen through this lens, "rational" consumers take their income-based saving rates to zero only if asset-based saving provides an offset. As long as asset markets keep rising, that makes perfect sense. However, when asset markets correct, this decision can backfire. That was the case when the equity bubble popped in 2000 and could well be the case following the bursting of today’s rapidly expanding US housing bubble. That’s why the latest trends in house prices and saving are so disturbing. In my view, they underscore the distinct possibility that America’s asset economy is in the midst of yet another bubble-induced blow-off.
Not surprisingly, these circumstances put the Fed in an especially difficult position. That’s because the US monetary authority used up most of its basis points in order to contain the damage from the equity bubble. Unfortunately, in doing so, the Fed kept interest rates at extraordinarily low levels for far too long -- setting the stage for the housing bubble that was to follow. The risk all along is that the Fed had only a one-bubble damage containment strategy -- leaving itself with little ammunition to deploy in the event of another serious problem. While the US central bank has tightened to the tune of 100 basis points over the past four months, a federal funds rate of 2% hardly offers much leeway for easing should conditions take a turn for the worse. Yet there’s an added complication to all this: The housing bubble-induced saving shortfall has pushed America’s current account deficit into uncharted territory -- raising the risks of a sharp correction in the dollar and a related back-up in longer-term interest rates. The last thing America’s housing bubble needs is an interest rate shock. That is a classic recipe for a sharp decline in US housing prices -- an outcome that might spell curtains for an overly-indebted American consumer.
Ironically, there have been a number of positive developments that have fallen into place recently -- an orderly depreciation in the dollar, sharply declining oil prices, and grounds for encouragement on the prospects for a soft landing in China. But America’s imbalances have taken a turn for the worse, and the housing bubble could well be the final straw. Income-short consumers are playing this bubble for all it’s worth -- enjoying the psychological benefits of the so-called wealth effect and utilizing the technology of refinancing and second mortgages to extract purchasing power from this over-valued asset. Unfortunately, these trends have led to the virtual elimination of US saving -- triggering a classic current-account-adjustment dynamic with attendant risks to the dollar and interest rates. That makes the downside of this bubble potentially far worse than that of the equity bubble. That would be an especially worrisome development for the US economy, since household real estate holdings of some $14 trillion currently are almost double the aggregate size of equity portfolios.
While it has only been four and a half years since the bursting of the equity bubble, memories have already dimmed of that extraordinary speculative excess. Yet in retrospect, that may have only been the warm-up for the main event. Bubbles have a way of feeding on each other -- ultimately compounding the problem and leading to an even more treacherous shakeout. That’s certainly the lesson from Japan and could well be the case in the United States. America’s housing bubble is now in the danger zone. So is its saving rate, current account deficit, and overhang of consumer indebtedness. It’s been a US-centric world for so long, that everyone takes it for granted. Yet global rebalancing poses challenges for all major countries in the world. Saving-short America will not be spared -- especially if it must now come to grips with the biggest asset bubble of them all.
