Wolfgang Munchau provides a sober comment at the Financial Times. He agrees with our view (shared by other) that the central bank actions of last week to try to stimulate more interbank lending (which will show up as a fall in the spread between Libor and risk-free rates) are likely to be ineffective and that central bankers have less power than is widely believed.
Munchau also does an analysis of UK housing prices and concludes they tend not to change much over time and bubbles revert to the mean. This is in keeping with Robert Shiller’s finding that housing prices since 1890 (no typo) have increased 0.4% a year on an inflation-adjusted basis. Housing is better regarded as a store of value than an investment. although leveraging a modest return always makes it look more attractive.
Munchau forecasts that central bankers will permit a short-erm increase in inflation to temper the nominal fall in housing prices. I am skeptical of their ability to engineer a temporary rise. Inflationary expectations tend to accelerate (remember cost-push inflation?).
From the Financial Times:
This has been the year when many deeply held beliefs have been challenged. One such belief was that central banks have the toolkit to sort out any conceivable economic or financial crisis.
Last week’s co-ordinated liquidity action by five central banks taught us that this is not the case. The idea was that a co-ordinated response would reassure the markets, but it had the opposite effect. It turned out that market participants are not infinitely stupid. They know by now that this is not a liquidity crisis at its core. If it had been, it would be over by now.
It is a fully fledged solvency crisis that has arisen because two giant and interlinked bubbles burst simultaneously – one in property, one in credit – leaving banks and investors on the brink of bankruptcy, some hanging on by their fingertips. Yet there is nothing the central banks are offering at this stage to alleviate a solvency crisis.
So the message from last week is that central banks have no game plan. Expect continued stress in financial markets for most of next year and possibly beyond. Expect also further declines in property prices in the US and the UK and spill-overs to the real economy.
As the European Central Bank correctly noted in last week’s financial stability report, the crisis is not going to be over until and unless there is a turnround in the property sector. But we are not going to see this for quite some time, not even in the US where the property market downturn began in 2006. In the UK, property prices have only recently started to fall.
I looked at the Nationwide house price index for the UK, which goes back to the early 1950s. After adjusting for inflation, the result is a line with two interesting characteristics. The first is that there is a surprisingly stable linear trend, with only a moderate upward shift. Real prices go up over time but not by much, and any deviations from the line are followed by a return to trend. The second is that past bubbles were relatively symmetric – both in extent and in time.
In the UK the latest upward movement has lasted 10 years and on my calculation prices started to rise above the trend line somewhere between 2000 and 2002. That would suggest that the downturn phase is going to last as long – possibly longer since downward moves often undershoot the trend line. Unless there has been some structural shift, there is going to be one of the most serious housing downturns ever.
Homeowners and mortgage lenders are always clinging to the hope that there may have been a structural shift. But even then, it is not at all clear whether such a shift would necessarily raise the position or the slope of the trend line. For example, an increase in housing supply or some regulatory restriction on credit may well lower it.
In an environment in which central banks target a low rate of inflation, the lion’s share of the adjustment will have to come from falling nominal house prices. That was different in the 1970s, when high inflation took care of the real price adjustment. But an inflation-targeting central bank cannot allow that to happen.
This raises the question of whether central banks, or governments, should consider raising their inflation targets. That would be a huge mistake, in my view, but I expect such a debate to hit us next year. Higher inflation would make it easier for indebted mortgage holders to cope with a multi-annual fall in real house prices.
Here is the basic arithmetic. Let us assume that the housing downturn is going to last eight years. A 2 per cent annual inflation rate – the target of many central banks today – adds up to 17 per cent inflation for the entire period; and a 4 per cent annual rate adds up to 37 per cent. So if UK house prices have to fall 40 per cent in real terms – which is not exaggerated given the extent of the bubble – an annual inflation rate of about 4 per cent would take care of the problem. Nominal houses prices would then not have to fall.
This is an experiment I would dearly love to watch, though preferably from outer space. A hypothetical increase in inflation targets would, I think, turn the current episode of turmoil into an uncontrolled financial crisis. Bonds would become the next asset class to crash and we could also expect violent adjustments in global exchange rates.
I suspect that central banks would dearly love to choose the semi-soft option – to allow a temporary overshoot in inflation targets and pray that people do not raise their inflation expectations. But that option has already been over-stretched, given that inflation expectations are already rising everywhere.
The bottom line is that inflation-targeting central banks will end up doing little more than swamp the financial markets with liquidity, and defend themselves against accusations that they had anything to do with this mess.
“Here is the basic arithmetic. Let us assume that the housing downturn is going to last eight years. A 2 per cent annual inflation rate – the target of many central banks today – adds up to 17 per cent inflation for the entire period; and a 4 per cent annual rate adds up to 37 per cent. So if UK house prices have to fall 40 per cent in real terms – which is not exaggerated given the extent of the bubble – an annual inflation rate of about 4 per cent would take care of the problem. Nominal houses prices would then not have to fall.”
Here’s some more basic arithmetic. 2 – (-2) = 4. So one can get a 40 per cent fall in real terms by having an inflation rate of 2 per cent and a fall in nominal prices of housing at a rate of 2 per cent a year. The financial system should be able to take that as well as four per cent inflation.
Munchau’s math is a little off. The implied inflation over the period would need to be 66%, not 37%, for a 40% drop real prices to keep the nominal price more or less constant. The inflation rate required to bring nominal prices back quickly after a 10% or 15% one year decline is never going to be a central bank target. Anyway, if one asset class deflates while others inflate, the loss is still very much there and readily noticed by both the equity (home) owner and the lender.
Perhaps we should attempt to consider the present crisis as non-systemic (though widespread). More like a sector recession, in this case finance and housing. Maybe we are mistaken about how crucial the New York based finance system is. The partial buyout of Citi indicates that there are other sources of capital in the world. Maybe a growth scenario is conceivable even if English and American financial sectors are in recession. So maybe anxiety about the lack of central bank control is misplaced. Maybe this should be celebratged — at least from an economic perspective.
“Inflation”” can mean a lot of things. This is a truly “simplistic” view of things. If inflation goes up, the value of housing goes up. However, what everyone is missing here is that “inflation” can mean simply that energy and food costs are going up. Absent an increase in income, where is the spending for housing going to come from? In fact, even with an increase in income, if it gets eaten up by all the other inflationary costs how can there be gains in housing? I think everyone needs to step away fro their spreadsheets and trend lines for a moment and start re-thinking the basics here. Housing is not really an “asset” except in the sense that it provides “shelter.” In much the same way, my flat screen TV is an “asset” in that it provides “entertainment.” The demand for all of this stuff can change over time. Not to mention that the higher carrying costs involved with bigger housing could decrease the demand for space.
Simply “allowing” home prices to “appreciate with inflation is an extremely simplistic approach. This would imply that allowing the fed to stoke inflation would “solve” the housing crisis. If the”inflation” does not also include higher wages for homeowners (as opposed to simply going to the top 1% in the form of higher profits) it will have no impact and could possibly boomerang given that the higher inflation could actually lower the value of houses because of the higher costs of ownership.
Again, I am not suggesting that what I am saying is dogma, merely that it is time to step away from the spreadsheets and have a good think about this stuff.
The problem with housing is that prices are out of line with incomes and ,until that is corrected, all else is BS. Inflation will do the job IF and only if median wages (not Goldman bonus pools) track inflation – not likely in a global economy especially one in recession.
IMO, housing will find a bottom when the mortgage payment on a median home equals one weeks take home pay of the median household. This was the standard for my adult life until recent years. Expect this process to playout over many years.