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 with liquidity. 

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 prospective tenants. 

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. 

Of course, rapidly rising interest rates would accentuate any housing weakness, but why should that happen in the absence of a strengthening economy?  There is no housing bubble to burst.

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