Property Bubbles

Property Bubbles: Beware of Property Bubbles
by Dr. Kurt Richebacher

“Housing bubbles heavily entangle banks and the whole financial system as lenders. For this reason, as a matter of fact, property bubbles have historically been the regular main cause of major financial crises.”

Pondering the U.S. economy’s prospects, the dramatic aggravation of the economic and financial imbalances is most critical. With them, there can never be normal economic growth. The other crucial aspect is the obvious fact that U.S. economic growth depends entirely on the continuation of the frenetic housing bubble.

All bubbles essentially end painfully, housing bubbles in particular. They are an especially dangerous sort of asset bubble, because of their extraordinary debt intensity. The debt numbers speak for themselves: In 1996, U.S. private households borrowed $332.2 billion; in 2000, their borrowing was up to $558.6 billion. With the housing bubble in full force, it hit $1,017.9 billion in 2004.

Property Bubbles: Debt Intensity

This debt intensity has its compelling reason in the particular way that accruing “wealth” has to be converted into cash. In the case of an equity bubble, in general, the owner realizes capital gains simply through selling a part of his stock holdings. No bank and no debt are involved. He directly exchanges stock for cash.

In this respect, a property bubble is a totally different animal. Since homeowners normally want to stay in their house, “wealth effects” have to be extracted through additional borrowing against the inflating property value; that is, through mortgage refinancing. In essence, twofold borrowing is needed: first, to boost housing prices; and second, to withdraw equity.

But this debt intensity finds very little or no attention at all. Yet there is a second, even more dangerous, aspect to housing bubbles: They heavily entangle banks and the whole financial system as lenders. For this reason, as a matter of fact, property bubbles have historically been the regular main cause of major financial crises.

Property Bubbles: Major Financial Crisis

During its bubble years in the late 1980s, Japan had rampant bubbles both in stocks and property. While the focus is always on the more spectacular equity bubble, hindsight leaves no doubt that the following economic disaster was mainly rooted in the property bubble. Both bubbles burst in the end, but the property deflation has continued for 13 years now, with calamitous effects on the banking system through a horrendous legacy of bad loans.

As a result, Japan has been struggling for years with two kinds of endless price deflation: gradually in the prices of goods and services and savagely in asset prices. The main culprit in keeping the economy locked in chronic stagnation is the evil concurrence of protracted property and debt deflation plainly strangling the banking system.

The third victim of a bursting property bubble is the building sector. Japan’s has never recovered from the depression following its excesses in the late 1980s. After all, the property bubble of the late 1980s turned out to be the prescription for a 1930s-style debt deflation. In 2004, residential building contributed 0.51 percentage points to the reported U.S. real GDP growth, compared with 0.03 percentage points in 2000.

Property Bubbles: For Better or For Worse?

We have gone into these details about the dangerous nature of housing bubbles, and property bubbles in general, with one question uppermost in our mind: Is the U.S. economy in better or worse shape today than it was in 2000? Put differently: Is it in a self-sustaining recovery?

In short, it is in dramatically worse shape. Stating this, we have our eyes on the described escalation of the imbalances and, in addition, on the runaway debt growth in relation to income growth.

During the four years 2000-04, total indebtedness ballooned by $9.7 trillion, against a simultaneous increase in national income. For each dollar added to national income, there was almost $6.40 added to overall indebtedness.

Implicitly, the smallest part of this horrendous borrowing binge was spent inside the economy, as reflected in the poor growth of national income. Overwhelmingly, it financed leveraged asset purchases and soaring imports. The former involve no income creation; the latter involve income destruction.

By implication, this borrowing represents entirely unproductive, or dead-weight, debt, yielding to the debtors no future flow of income from which to pay their debt services. Business investment, the sole source of productive debt, was no higher in 2004 than in 2000.

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