The Frenzied Housing Market Redux

A few days ago I wrote about the growing imbalance in many residential real estate markets and theorized that housing prices were going to have to decline sooner or later.

But I couldn’t figure out exactly what would cause this “irrational exuberance” to snap. Obviously a huge spike in interest rates would do it, but how would such a thing come about?

I think I found my answer in a Reuters article about foreign money coming into U.S. financial markets. Unfortunately I can’t find the article now–it was on my Palm VII PDA–but others have voiced basically the same thought.

The United States accounts for about 30% of the world’s wealth, but we consume about 80% of global capital. This makes sense, because not only has the U.S. historically been a good place to invest, but it’s also been relatively safe and stable. For most of the 20th century, there was simply no better place to put your money.

But that seems to be changing. First, U.S. markets are experiencing increased volatility. Second, the appreciation of domestic investments over the past couple of decades points toward a need for foreign investors to rebalance their portfolios. And third, new international markets are emerging as an viable alternative to the U.S.

The significance is that foreign investors are getting nervous about their sizable investments in Treasury notes and the U.S. dollar. They simply have too much of their net worth riding on the U.S. economy. If they take their money elsewhere, it might prove difficult to find buyers for American dollars and bonds. If we can’t sell those bonds, the Treasury Department will have to raise interest rates to make the bonds more attractive.

Now you’ve got higher interest rates, which means home buyers will have to pay more for that overpriced $500,000 ranch house. That should push prices down.

The only question is how severe the spike in interest rates will be. The key metrics are likely to be the amount of debt the U.S. needs to finance (at this rate, a hell of a lot) and the performance of the dollar, which has been poor.

Individually and as a nation, we’ve been financing our comfortably lifestyle for 40 years using foreign capital. Just think what would happen if the rest of the world suddenly wasn’t interested in investing here anymore.

On the other hand, it’s possible foreign investors could get burned while the U.S. economy comes away scot-free. This happened in the 1980s and 90s when Japan invested heavily in U.S. commercial real estate and bought out many large American companies like Universal only to sell them a few years later at a huge loss.

I’m not predicting doomsday. Americans are a free and diverse people; this translates into supreme resiliency for our economy. There’s never any telling just how it will reinvent itself. Who would have predicted the demise of the manufacturing base, the efficiency of the service sector that would supplant it, or how things like the internet would pop out of nowhere to revolutionize business?

Final message: it may not be smooth sailing for the housing market over the next few years, but don’t bet against the U.S. economy in the long term.


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