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It's Not the Housing Market That Threatens the US Economy

Economics / US Economy Aug 14, 2007 - 12:54 AM GMT

By: Gerard_Jackson


The reported collapse of the mortgage market has clearly spooked markets and the great majority of analysts. We are even told that this financial ‘disaster' is rippling through Europe and Asia, forcing their central banks to pump up the money supply. But belief that the bursting of a housing boom could send the US economy into recession is, in my opinion, a complete fallacy.

Those who argue otherwise claim that a collapse in the housing market would severely dampen consumer spending and this would depress economic activity. Now what is being said is that a rising demand for housing stimulates those industries that produce the necessary outputs for the building industry. It follows that, according to this line of reasoning, a drop in the demand for housing will have the reverse effect. Moreover, it would also reduce consumption further by having a negative influence on the ‘wealth effect' .

This reasoning is very plausible — it is also utterly wrong. What we have here is the old consumption-drives-the-economy fallacy dressed in new garb of which GDP is an integral part. Now GDP is supposed to be a fairly accurate measure of the annual value of the economy's output. The problem with GDP is that it is not a gross figure. It is in fact a net value-added figure. This is because it omits spending on intermediate goods on the fallacious grounds that it would be double counting to include them. (Any accountant who swallowed this would quickly find himself unemployable).

A truly gross figure would more than double the GDP figure. It seems that the Bureau of Economic Analysis agrees with this view. Although GDP for 2000 was about $13 trillion the bureau's figure came in at nearly $23 trillion. The bureau makes it clear that it is trying to measure output. But the Austrian approach is directed at total spending, which is taken to be a measure of aggregate economic activity. My own estimate puts total spending at about $28 trillion.

So where does this leave the housing market? During the 1990s residential ‘investment'* averaged about 4 per cent of GDP while today it is about 5 per cent. Although that 1 percentage point difference does not appear significant our doomsayers would stress that it is a 25 per cent difference with a huge multiplier effect should the difference disappear. This is because consumer spending is about 66 per cent to 70 per cent of GDP.

But as we have seen, total spending is at least double the GDP figure. Therefore, if gross spending is 300 instead of 100 then current residential ‘investment' drops from 5 per cent to 1.7 per cent total spending. And if this spending were to shrink by 25 per cent — which no one is suggesting for a moment — it would fall to 1.3 per cent of aggregate spending, a difference of 0.43 per cent. It's simply ridiculous to argue that a 0.43 per cent drop in spending on houses would send the US economy into a recession, let alone the rest of the world. Housing bubbles are symptoms not causes. Benjamin M, Anderson noted how the monetary expansion of 1924-28 ignited a massive real estate boom, and that the foundations of many skyscrapers were laid down during the period 1927-29. As real estate values rocked

real estate mortgages of all kinds were so rapidly multiplied that in 1932-33 the widow might well have wondered whether she would not have done better to sell her mortgage in 1929, buying stocks with the money. (Benjamin M. Anderson Economics and the Public Welfare , Liberty Press, 1979, p. 204. First published 1949).

All of this brings right back to monetary policy — or what passes for monetary policy at the Fed. For sometime our economic commentariat has demonstrated it's ignorance of a fundamental principle of economics by continually referring to the massive amounts of bank credit that have been injected into the international economy as “excess savings”. The Economist (Jan 4th 2007) used the world-wide supply of US dollars as a proxy to measure global liquidity. It estimated that since 2003 liquidity rose by an annual average of 18 per cent. It should beggar belief that anyone with an economics degree could possibly call this massive monetary expansion “excess savings seeking a home”. If they had been properly taught they would have immediately recognised the inflationary dangers. They did not. Ricardo and his contemporaries understood that expanding the money supply does nothing to improve the general welfare. As he himself put it:

The successive possessors of the circulating medium have the command over this capital: but however abundant may be the quantity of money or of bank-notes; though it may increase the nominal prices of commodities; though it may distribute the productive capital in different proportions; though the Bank, by increasing the quantity of their notes, may enable A to carry on part of the business formerly engrossed by B and C, nothing will be added to the real revenue and wealth of the country. B and C may be injured, and A and the Bank may be gainers, but they will gain exactly what B and C lose. There will be a violent and an unjust transfer of property, but no benefit whatever will be gained by the community. ( The High Price of Bullion , 1810).

There is no doubt in my mind that the rise in interest is the principal reason for the giant sell-off in shares and the king hit the housing industry took. But the older economists knew that loose monetary policies eventually resulted in higher interest rates. Despite the 5.25 per cent target for the fed funds rate banks had by Friday raised overnight loans to each other by more than 6 per cent. A clear indication that banks had a liquidity problem. Therefore, any anticipated rise in the rate on overnight loans is bound to hit mortgages and share prices. So what did the fed do? What it does best and that is inflate the currency further. (Other central banks did likewise).

Last Thursday saw the fed supporting US banking system by expanding its reserves by $24 billion. The following day it injected something like $38 billion into the market. That this monetary manoeuvring will drive down interest rates again is indisputable. But the question remains: For how long? (We should also consider the possibility that the fed will lower its funds rate). In the meantime it is likely that any fall in rates will encourage more people to enter the housing market in the belief that financial disaster has been averted.

However, the immediate effect of these monetary injections would be to lift the stock market, which now appears to be the case. Come last Saturday the indexes for the Dow, the S&P and Nasdaq had risen. Even the Russell 2000 index that tracks the performance of the 2,000 smallest companies in the Russell 3000 Index experienced a marginal rise

In all the excitement — should that be panic? — the commentariat overlooked the state of US manufacturing. The ISM (Institute for Supply Management) reported that manufacturing had expanded for the sixth consecutive in July, though it had slowed somewhat. The ISM said that its index registered 53.8 in July against 56 per cent in June. Any point above 50 indicates growth while any reading below 50 indicates contraction.

It's my belief that the manufacturing index reveals that there could still be a lot of steam left in the current boom, assuming the fed allows the monetary expansion to continue. Commentators need to be reminded that not only is it business spending that drives the economy, it was manufacturing that was hit first in 1929. By July manufacturing was shedding labour, suggesting that it had started to contract by at least June. However, the stock market did not occur until October.

I think we could all be in for a rather bumpy ride.

*Capital goods are future goods. This means they are intermediate that goods that are eventually transformed into consumer goods. Put another way, the services of consumer goods are directly consumed while the services of capital goods serve consumers indirectly. According to this definition durability does not define capital goods but the position in the capital structure does. What is more, the good must be reproducible , i.e., land is not capital. Oddly enough Hayek considers houses to be capital goods “so far as they are non-permanent”. Additionally, “we have to replace them by something if we want to keep our income stream at a given level…” ( The Pure Theory of Capital , The University of Chicago Press, 1975, pp. 77-78). But the same thing can be said of cars, televisions, books, furniture. In fact, just about any household appliance.

Huerta De Soto adapts the same approach as Hayek with respect to durability as a definition of a capital good:

Fourth, durable consumer goods satisfy human needs over a very prolonged period of time. Therefore they simultaneously form a part of several stages at once: the final stage of consumption and various preceding stages, according to their duration. ( Money, Banking and Credit Cycles , Ludwig von Mises Institute 2002, p. 300)

My criticism of Hayek's ‘durability approach' holds for De Soto's. The fact that my fridge is extremely durable does not make it a capital good. It's services are consumed directly by myself and my wife


Gerard Jackson

Gerard Jackson is Brookes economics editor.

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