There is a useful piece by Floyd Norris in this morning’s NY Times about the Fed’s response to the housing bubble. It echoes the larger debate, which has flared up again with his PR blitz, over whether Greenspan was fiddling while Roman property values went through the roof.
Let’s step back for a moment and consider the larger context. The US has been running a very large current account deficit. Here are the quarterly data since 1990 courtesy of the BEA:
US Current Account Balance as a Percent of GDP
If this were the total story, the US economy would have been moribund since the late 1990s when the deficit really took off. This fraction represents income that leaves the country rather than making purchases that would support domestic employment.
But this is only half the picture. The other half is the return of this money via the capital account, in the form of purchases of debt, like treasury bonds, and assets. This return flow not only finances the current account deficit, propping up the dollar, but also makes possible continued US economic growth. For instance, the willingness of foreign central banks to accumulate treasuries means that the Bush crowd can borrow freely to finance the federal government deficit without fear of pressure on interest rates. (This is not to say that the fiscal deficit is too high in any general sense, which it isn’t.) The infusion of foreign finance also sustains asset prices, like stock values, above what they would otherwise be. This generates capital gains for those who have positions in these markets and also encourages borrowing against paper wealth.
The housing bubble could be seen as a bit of both of these. Foreign purchases of mortgage-backed securities injected large amounts of money into the housing market, so that the demand for loans, no matter how outlandish, never exceeded the supply. This in turn fueled a bubble in the existing housing stock. Now that the bubble is bursting, there are fears of a general financial crunch.
Perhaps, but there is still one more river to cross. If the central banks and oil funds that currently finance the US external deficit continue their willingness to hold dollar assets, the money will simply have to go somewhere else. It can finance government and corporate debt, driving down interest rates. It can go into purchases of US companies, goosing the stock market. As long is it has to go somewhere it will.
The risk, of course, is that at some point the sovereign entities on the receiving end of the massive dollar flow will decide that enough is enough. Perhaps the extent of losses they will suffer due to the mortgage meltdown will force them to pull back. Maybe a private sector stampede, sparked by further bad news about defaults, will overwhelm the ability of CBs to stem the tide and sustain US financial markets.
The larger story, however, is that, as long as the US economy chugs along in a temporary equilibrium of massive external borrowing, bubbles of one sort or another are inevitable. That’s why it’s an equilibrium and also why it’s temporary.