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How asset markets and the economy interact
Real estate developers work by a simple principle: “If the market value of office buildings in a certain location exceeds the cost of building one from scratch, new buildings will sprout up. If, on the other hand, the market values fall below the cost of constructing a building, new construction will stop.”
A similar correlation exists between stock prices and new machinery orders, says Alan Greenspan, the former US central banker in ‘The Age of Turbulence’ ( www.penguin.com).
While that should be a good lead for researchers studying economic activity here, the book has enough and more to say about real estate, housing and home-loans. Don’t be dismayed, though, if many of these wise nuggets from the ex-Fed ring true enough to apply to situation closer home.
For instance, in a chapter titled ‘irrational exuberance’, he argues that price stability is central to long-term economic growth. However, there seems to be no agreement on what price stability means.
To most economists, price stability is about product prices – be it the cost of a pair of socks or a loaf of bread. But what about the prices of income-earning assets, like stocks or real estate, asks Greenspan. “What if those were to inflate and become unstable? Shouldn’t we worry about the price stability of nest eggs and not just the eggs you buy at the grocery store?” Logical anxieties, these are, you’d agree.
At a dinner meeting in December 1996, he posed an unsettling query to the audience: “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?”
Where do we draw the line on what prices matter, he wondered. “Certainly prices of goods and services now being produced – our basic measure of inflation – matter. But what about future prices? Or more importantly, prices of claims on future goods and services, like equities, real estate, or other earning assets?”
Since there are complex interactions between the asset markets and the economy, stability in the prices of assets such as real estate is essential, he insisted.
The US economy faced a major shock on 9/11, yet it carried itself through driven by consumer spending, which in turn was buoyed by housing. Residential real estate saw values surge, ‘energised by the fall in mortgage interest rates’. Market prices of existing homes rose 7.5 per cent a year in 2000, 2001 and 2002, more than double the rate of just a few years before, narrates the author. “Not only did construction of new houses rise to record levels, but also historic number of existing houses changed hands.”
The boom gave a big lift to morale, says Greenspan. “Even if your house was not for sale, you could look down the block and see other people’s homes going for what seemed like astonishing prices, which meant your house was worth more too.”
By 2006, nearly 69 per cent of US households owned their own home, up from 64 per cent in 1994, and 44 per cent in 1940. The expansion of ownership gave more people a stake in the future of the country and boded well for the cohesion of the nation, concludes Greenspan. “Home ownership resonates as deeply today as it did a century ago. Even in a digital age, brick and mortar (or plywood and Sheetrock) are what stabilise us and make us feel at home,” he reasons.
People were not only buying homes for residing, but as investment too. When the US property market was at its height a few years ago, purchases for investment or speculation rose from the usual 10 per cent to nearly 30 per cent. “They became a force in the market, driving up turnover of existing homes by almost one-third.”
When homes changed hands, the buyer almost invariably took out a mortgage that exceeded the unpaid balance on the seller’s outstanding mortgage, explains the book. “The net increase of debt on the house went as cash to the seller.”
Capital gains, especially gains realised in cash, drove up consumer spending, recounts Greenspan. “Some analysts estimated that 3 per cent to 5 per cent of the increase in housing wealth showed up annually in the demand for all manner of goods and services, from cars and refrigerators to vacations and entertainment. And, of course, people poured money into home modernisation and expansion, further fuelling the boom.”
D. MURALI
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