Rightways to Success: Great Depression

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Friday 30 December 2011

Why Americans Should Wait To Buy A House?

by Michael Sanibel

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Click for full photo gallery: Cities Where Housing Prices Are Still Dropping

The U.S. government is doing its best to convince the American public that there’s an economic recovery underway, but is that really true? The economy is being artificially propped up by $1,500 billion in annual debt, and the Federal Reserve has printed trillions of dollars to keep banks afloat. It was too much debt that got the country into trouble to begin with, yet the government is essentially saying that even more debt is needed to fix the problem. This is one of the fundamental pillars of the theory developed by economist John Maynard Keynes in the early 1900s.

Not everyone agrees with Keynesian economic theory. Free market capitalists believe that markets should be unfettered by government intervention and allowed to reach equilibrium on their own. Their argument is that supply and demand should set asset values and prices without interference by artificial stimuli and freshly printed cash. (To learn more, read How To Buy Your First Home: A Step-By-Step Tutorial)

When analyzing whether or not to buy a house in this economic environment, the best approach is to focus on reality, not the talking points offered by politicians. Here are some factors to consider before taking the plunge with a new mortgage.

The Bubble
The housing bubble was caused by a lethal combination of easy credit, low interest rates and rampant speculation. This “perfect storm” reached its pinnacle of power in four states: California, Nevada, Florida and Arizona. The landscape of these states is littered with unfinished housing developments and empty condominiums. Even though prices have dropped 50% or more in some areas of these states, they are all plagued by debt-to-income ratios (DTI) that are still higher than the historical norm of three to one. This will continue to put downward pressure on prices.

Nationwide, the inventory of unsold homes was 3.33 million at the end of October 2011, an eight-month supply at the current sales rate. While this is a positive downtrend from the inventory peak of 4.58 million units in July 2008, the inventory overhang is still having a negative effect on prices. The median existing home pricewas $162,500 in October for all housing types nationwide, a drop of almost 5% from a year ago.

Prices are also being impacted by the high rate of contract failures, which is almost double that of September, and four times what it was one year ago. These failures represent canceled sales contracts resulting from unqualified mortgage applications, appraisal values below the sales price, unsatisfactory home inspections and unfulfilled contract contingencies. One-third of all sales contracts in October did not make it to closing, causing those homes to re-enter the market and increase the unsold inventory.

100-Year Trend
Yale economist Robert Shiller, known for the Case-Shiller price index, has calculated that U.S. home prices rose an average of 3.35% per year during the period 1900-2000. This timespan includes extended periods of both falling and rising prices, from the Great Depression up to the bull markets of the late 1980s and late 1990s. (For related reading, see Understanding The Case-Shiller Housing Index.)

In January 1998, just before the bubble started to inflate exponentially, the price index stood at 82.7. If prices had followed the 100-year trendline over the next 12 years, the index would have reached 126.7 in October 2010. Instead the index hit 159, a full 25% above the long-term trend. So, even though prices have already dropped more than 30% nationwide in the past five years, data suggests that the bubble has not been deflated and more price drops could be on the way.

Important Factors
There are many forces at work contributing to instability in home prices:

Continued high unemployment, with weekly unemployment claims consistently hovering around 400,000
The possibility of higher interest rates to combat inflation fueled by the increased money supply
Strategic defaults, foreclosures and short sales all force prices lower
High levels of underwater mortgages
A “shadow” inventory of unsold homes held by banks will put pressure on prices when these homes are marketed
Stricter mortgage qualification requirements, including bigger down payments, higher credit scores and verifiable income
Lower conforming loan limits as of Oct. 1, 2011
Continued high levels of government and personal debt
The threat of more U.S. credit rating downgrades
The potential for a European financial collapse rippling through the U.S. economy and financial institutions
Changing demographics, slowing population growth and smaller families are causing reductions in overall demand
Many baby boomers are downsizing their lives, including the size of their homes
Possible future actions by the government between now and the 2012 elections: tax policy changes, stimulus spending, mortgage modification programs, etc.

The Bottom line
The evidence suggests that without government intervention, home prices would be much lower than they are now. Record low interest rates, the homebuyer tax credit, mortgage assistance programs and bailouts for Fannie Mae and Freddie Mac have all softened the freefall in prices. These actions have not changed the fundamentals of a weak economy that relies heavily on consumption for GDP growth and too little on industrial production.

Price stability is not likely to be reached until the excess is wrung out of the bubble that expanded by a breathtaking 19.2% per year between 1998 and 2006. Government policies have slowed the correction, but not stopped it. This has kept wary buyers out of the market because they don’t believe the market has hit a true bottom. This has delayed a sustainable housing recovery and prompted potential buyers to wait for lower prices next year. (To learn more, check out The Truth About Real Estate Prices.)

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Friday 7 October 2011

Bleed the Foreigner!

Harold James

PRINCETON – Today, the world is threatened with a repeat of the 2008 financial meltdown – but on an even more cataclysmic scale. This time, the epicenter is in Europe, rather than the United States. And this time, the financial mechanisms involved are not highly complex structured financial products, but one of the oldest financial instruments in the world: government bonds.

While governments and central banks race frantically to find a solution, there is a profound psychological dynamic at work that stands in the way of an orderly debt workout: our aversion to recognizing obligations to strangers.

The impulse simply to cut the Gordian knot of debt by defaulting on it is much stronger when creditors are remote and unknown. In 2007-2008, it was homeowners who could not keep up with payments; now it is governments.

But, in both cases, the lender was distant and anonymous. American mortgages were no longer held at the local bank, but had been repackaged in esoteric financial instruments and sold around the world; likewise, Greek government debt is in large part owed to foreigners.

Because Spain and France defaulted so much in the early modern period, and because Greece, from the moment of its political birth in 1830, was a chronic or serial defaulter, some assume that national temperament somehow imbues countries with a proclivity to default. But that search for long historical continuity is facile, for it misses one of the key determinants of debt sustainability: the identity of the state’s creditor.

This variable makes an enormous difference in terms of whether debt will be regularly and promptly serviced. The frequent and spectacular early modern bankruptcies of the French and Spanish monarchies concerned for the most part debt owed to foreigners.

The sixteenth-century Habsburgs borrowed – at very high interest rates – from Florentine, Genovese, and Augsburg merchants. Ancien régime France developed a similar pattern, borrowing in Amsterdam or Geneva in order to fight wars against Spain in the sixteenth and seventeen centuries, and against Britain in the eighteenth.

The Netherlands and Britain, however followed a different path. They depended much less on foreign creditors than on domestic lenders. The Dutch model was exported to Britain in 1688, along with the political revolution that deposed the Catholic James II and put the Dutch Protestant William of Orange on the English throne.

Indeed, the Glorious Revolution enabled a revolution in finance. In particular, recognition of the rights of parliament – of a representative assembly – ensured that the agents of the creditor classes would have permanent control of the budgetary process.

They could thus guarantee – also on behalf of other creditors – that the state’s finances were solid, and that debts would be repaid. Constitutional monarchy limited the scope for wasteful spending on luxurious court life (as well as on military adventure) – the hallmark of early modern autocratic monarchy.

In short, the financial revolution of the modern world was built on a political order – which anteceded a full transition to universal democracy – in which the creditors formed the political class. That model was transferred to many other countries, and became the bedrock on which modern financial stability was built.

In the post-1945 period, government finance in rich industrial countries was also overwhelmingly national at first, and the assumptions of 1688 still held. Then something happened. With the liberalization of global financial markets that began in the 1970’s, foreign sources of credit became available. In the mid-1980’s, the US became a net debtor, relying increasingly on foreigners to finance its debt.

Europeans, too, followed this path. Part of the promise of the new push to European integration in the 1980’s was that it would make borrowing easier. In the 1990’s, the main attraction of monetary union for Italian and Spanish politicians was that the new currency would bring down interest rates and make foreign money available for cheap financing of government debt.

Until the late 1990’s and the advent of monetary union, most government debt in the European Union was domestically held: in 1998, foreigners held only one-fifth of sovereign debt.

That share climbed rapidly in the aftermath of the euro’s introduction. In 2008, on the eve of the financial crisis, three-quarters of Portuguese debt, half of Spanish and Greek debt, and more than 40% of Italian debt was held by foreigners.

When the foreign share of debt grows, so do the political incentives to impose the costs of that debt on foreigners. In the 1930’s, during and after the Great Depression, a strong feeling that the creditors were illegitimate and unethical bloodsuckers accompanied widespread default. Even US President Franklin Roosevelt jovially slapped his thigh when Reichsbank President Hjalmar Schacht told him that Nazi Germany would default on its external loans, including those owed to American banks, exclaiming, “Serves the Wall Street bankers right!” In Europe today, impatient Greeks have doubtless derived some encouragement from excoriations of bankers’ foolishness by German Chancellor Angela Merkel and French President Nicolas Sarkozy.

The economists’ commonplace that a monetary union demands a fiscal union is only part of a much deeper truth about debt and obligation: debt is rarely sustainable if there is not some sense of communal or collective responsibility. That is the mechanism that reduces the incentives to expropriate the creditor, and makes debt secure and cheap.

At the end of the day, a collective, burden-sharing Europe is the only way out of the current crisis. But that requires substantially greater centralization of political accountability and control than Europeans seem able to achieve today. And that is why many of them could be paying much more for credit tomorrow.

Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. He is the author of The Creation and Destruction of Value: The Globalization Cycle.