October 2, 2002
Stephan Roach , chief economist at Morgan
Stanley, has argued that the stock market bubble has drifted over to housing.
He maintains that housing prices since 1998 have increased 35 percent
more than rentals on equivalent homes.
This is one of the largest discrepancies
ever recorded in such a short period of time between asset values and the
earnings those assets generate.
Frankly, the drifting of a bubble from one
area to another is highly unusual. Normally,
bubbles suck liquidity from other parts of the economy. This is why bubbles can be so dangerous.
Their asset values zoom while other values are being distorted in the
opposite direction. When the bubble
bursts, the deflation from a collapsing bubble adds to weakness elsewhere,
threatening the health of the overall economy.
Indeed, to burst a bubble, liquidity must
dry up. This occurs either because
too much liquidity is being used to support the bubble, or policy to defeat the
bubble is draining liquidity from the overall economy. About the only way to "transfer" the bubble would
be to offset the economic impact of the bursting bubble by flooding the economy
The Federal Reserve has been aggressive in
lowering interest rates as the stock market bubble collapsed.
Money growth also has been strong. Yet,
the liquidity growth has had only limited impact upon undermining the value of
the dollar, and virtually no impact upon prices, except for housing.
Certainly, housing prices have one
characteristic of a bubble. They
are rising because they have risen. In
other words, past success has encouraged purchasers to pay more in anticipation
of further appreciation. Purchasers
are not only considering the rental value of the property, but also the salvage
value when they choose to leave. And
that salvage value continues to rise above the purchase price.
The latest report on sales of previously
owned homes shows price gains of 6 percent over the past year.
This is a modest slowing in appreciation from the previous year, but it
certainly remains a sound investment. The
build-up of unsold inventory should be worrisome, but most of the problems are
at the higher price ranges of the housing market.
In short, the housing market is beginning to
show some signs of cyclical fatigue, but that is a far cry from declaring that a
bubble exists in housing values.
Indeed, the reason for the discrepancy in
asset and rental prices is easy to identify.
Consider the house as providing two
benefits. It is a store of housing
services. (That is economist talk
for saying you need to pay to live somewhere and your own home is a good place
to get a roof over your head).
It is also an investment vehicle. In short, you want the house to increase in value relative to
the exhaustion of housing services. (Assume
that normal maintenance and replacement is needed to maintain the desired flow
of housing services. The sale of
the home at anything more than your purchase price would then be a return on
investment, at least after adjustment for inflation).
Because mortgage rates have plunged, mostly
because a weak economy has not provided alternative uses for liquidity, those
housing services have become cheaper. In
short, the cost of holding an inventory of future services has declined.
Indeed, rental rates could even fall in this environment as investors try
to accumulate more rental inventory.
In fact, that is exactly what is happening
to rental rates in many areas. The
investor must pay less per month to hold the rental inventory and provide it to
At the same time, the cost of holding
housing for investment purposes also has gone down.
As a result, investors are less willing to sell their investment at any
prevailing asset price. Thus, the
price of the housing goes up.
In other words, the large discrepancy
between rents and asset prices is not the result of investors paying ever higher
prices for houses to capture the price appreciation.
Rather, it is an increased reluctance to sell at prevailing prices
because the cost of holding has decreased.
At the same time, the cost of providing rental services also has fallen.
Don't get me wrong.
I believe the rising inventory of unsold housing will deter further rapid
increases in prices. At the high
end of the housing market, price declines are possible.
However, this will not be the bursting of a
bubble. Instead, it will be a
normal adjustment to excess supplies that happens in every housing cycle. The only difference is that this time, housing inventory, not
financial restraints, will dictate the peak of the housing market.