Ultimately, the source of the Great Recession lies in too many people buying houses they couldn’t afford – in the U.S., in the U.K. and in Ireland, among other places, with knock-on effects elsewhere. To be sure, there was lots of risk-chicanery (it would be far too polite to call it risk-arbitrage) where dodgy loans were swept off book into structured investment vehicles pedalled to institutional investments for a few basis points over T-bill yields.
Would a fundamental analysis have helped? Robert Shiller’s 2000 book Irrational Exuberance suggested price-earnings ratios were out-of-whack with their historical averages, fleshing out the concerns Fed maestro Alan Greenspan expressed in 1996. Shortly after the book was published, markets collapsed. An accident of timing? Perhaps.
Shiller was similarly prescient, when he looked at the housing market in 2006 and found the basic metrics far above their long-term averages. Since then, U.S. housing prices have corrected 32%, – back to their 2003 levels – with more, apparently, still to come as too much supply meets too little demand.
If housing inflation was at the heart of the crash, could policymakers have done something to avert it – by raising interest rates? That wasn’t on offer in 2003, as the Fed, worried about the deflationary consequences of the dot-com bust, kept interest rates at what were then-record lows in the 1% band.
So companies were encouraged to borrow, and so were consumers. And borrow they did, at least U.S. consumers, pushing house price well beyond the usual metrics. Interestingly enough, some regional Fed researchers were seeing signs of overvaluation as early as 2004, looking at price to rent ratios (which should normally be 1).
“The majority of the movement of the price-rent ratio comes from future returns, not rental growth rates. This will not comfort everyone, as it implies that price-rent ratios change because prices are expected to change in the future, and seemingly out of proportion to changes in rental values.”
The Fed was powerless to prick that bubble. CPI doesn’t track housing inflation, as New York Times blogger Floyd Norris points out. It tracks owner’s equivalent rent (as in most OECD countries). The methodology was changed in 1983. As Norris writes, it seemed reasonable:
“The current approach, the BLS says, ‘measures the value of shelter to owner-occupants as the amount they forgo by not renting out their homes.’ The C.P.I. is not supposed to include investments, and owning a house has aspects of both investment and consumption.”
Investment and consumption from a heavily debated terrain. Most municipal tax assessments, for example, are based on some form of market valuation, rather than owner’s equivalent rent. So house owners don’t entirely escape housing inflation volatility in their taxes (well, except for California.)
What’s relevant here is that owner-equivalent rent understates inflation in a boom and overstates it in a downturn. As Norris notes:
“The effect is particularly notable in the core index, which excludes volatile energy and food prices, and which the Fed monitors closely. In 2004, when home prices were climbing at a rate of almost 10 percent a year — more than four times the increase in rents — the core index would have been over 5 percent had home prices been included. Instead, the reported core rate was just 2.2 percent.”
A bubble, in other words, hiding in plain sight. But the Fed is restricted to targeting price and employment stability, not tackling bubbles.
While Canada, so far seems to have escaped the gyrations of a housing bubble, metrics are similarly exuberant, as University of Western Ontario finance professor George Athanassakos recently pointed out.
“Home prices are simply way out of line, especially when viewed in relation to household income. The ratio of house prices to income has historically averaged about 3.5 in Canada. It now stands at about 5.5. It is difficult to see how income growth in the future can bring this ratio close to the historical average within any reasonable period – so it follows that house prices will have to decline.”
Some back of the envelope calculations: Median house prices should be about $285,000 in the Greater Toronto Area, with a 3.5 income to price ratio, assuming a median household income of $72,000. Instead, they are $385,000. Back of envelope because, as some may have noticed, real estate brokers prefer to report average house prices to median ones.
“Signs of stress are already evident,” Athanassakos writes, “especially when you look at household debt levels. In recent years, the gap between house prices and income has been bridged through borrowing. The average Canadian family debt hit $100,000 in 2010. About 17,400 households are behind in their mortgage payments, representing an increase of nearly 50 per cent since the start of the last recession.”
As in the U.S., an interest rate move up in Canada in response to changes in core inflation could have a whipsaw effect and take down the housing market – because it’s not adequately represented in CPI.
Maybe the definition of irrational exuberance – of a speculative bubble – requires further thought. Bubbles, as we have seen with the banks, can take a long time to work themselves out. Their duration seems small in long-term perspective. But in the short term, say five to 10 years, their effects can be quite devastating – the S&P 500 is still underwater compared to its 2000 peak and, as for housing prices, in the Greater Toronto Areas they took roughly a decade to reach their 1989 peaks.