Interest Rate Policy In the United States: Fighting a Collapsing Bubble

October 01, 2007

Dean Baker
The Hankyoreh (South Korea), October, 2007

When Ben Bernanke assumed his role as Federal Reserve Board chairman in January of 2006, he assured investors that the situation in the housing market posed no special risk to the economy and that his focus would be on combating inflation. Earlier this year, he acknowledged that there were problems, but he assured investors that they would be restricted to the subprime segment of the housing market, and that his focus would be on combating inflation.

Last month, the Fed cut interest rates by a half percentage point, thereby telling investors that there are very serious problems in the housing market and that they may well throw the economy into a recession. The Fed’s recognition of reality is a step in the right direction, but lower interest rates will not be adequate to counter the impact of the collapsing housing bubble.

The story is that the problems in the U.S. housing market go well beyond the people with poor credit histories who make up the subprime market. The problem with the housing market is that it had become enveloped in speculative bubble that drove prices more than 70 percent above their trend level. Soaring prices led to a huge surge in new construction, as housing starts in the years 2002-2006 were nearly 80 percent higher than their levels of a decade earlier.

For a time, the oversupply was absorbed by speculators, as many middle class families willingly bought second and third homes as can’t lose investments. However, as eventually happens with every speculative bubble, the speculators eventually ran out of money to absorb the excess supply. The nationwide vacancy rate for ownership housing units is now more than 50 percent higher than the peaks hit in any prior housing slump. (Vacancy rates for rental units are also at record highs.)

As a result of this oversupply, house prices are now dropping nationwide, and in any many of the most inflated markets prices are dropping at double-digit annual rates. This is the underlying problem in the housing market. Many lenders made foolish loans to the mostly lower-income home buyers in the subprime market. These loans are now turning bad at rapid rates, but the real problem is falling house prices. If house prices were still rising, even the worst loans could still be paid, since homeowners could always borrow against newly created equity. Bernanke should have recognized this fact – even as he was telling the public that the problem was only restricted to the subprime segment of the market.

The collapsing housing market will affect the economy in three ways. First, it will lead to a further contraction of the housing market. The housing market in the U.S. accounts for 5 percent of GDP (in 2005, it accounted for 6 percent of GDP). Housing construction and sales are likely to decline by a further 20-40 percent over the next two years, which will slow GDP growth by as much as two percentage points over this period.

The second route will be the impact of lost housing wealth on consumption. The bubble created more than $8 trillion of housing wealth. Homeowners borrowed heavily against this wealth for both luxury consumption and also simply to make ends meet. As the bubble unwinds, the loss of this wealth can reduce annual consumption by as much as $400 billion, close to 3 percent of GDP.

While these two factors together are like to throw the economy into a severe recession, there will also be a secondary impact on financial markets as unprecedented wave of defaults make many financial institutions insolvent. This could seriously curtail the future credit flows that the economy will need to restore growth.

Against this cascade of bad news, Bernanke will lower interest rates – a relatively weak weapon. Even here the impact may be less than he would hope. Back in 2005, Greenspan spoke of the “conundrum” that long-term interest rates remained low even after he had raised the short-term rate by more than 3 percentage points.

Bernanke is likely to see the conundrum in reverse. Lower short-term rates are likely to lead to further declines in the dollar, which will cause investors to demand a higher rate on U.S. treasury bonds and other long-term debt. As a result, Bernanke may find that the Fed has little ability to push down long-term interest rates regardless of how much he lowers the short-term rate.

In short, the Fed may be relatively powerless to do much to prevent the collapse of the housing bubble from leading to a recession and quite possibly a very severe recession. As Greenspan has said, the economy was very slow to recover from the recession brought on by the collapse of the stock bubble in 2001. It is likely to be even slower to come out of a recession brought on the collapse of the housing bubble. The near-term future of the U.S. economy looks bleaker than at any point in the last quarter century.

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