August 26, 2005

The Greenspan Era Confab in the Tetons: Easy Money & the Real Estate Bubble

Greenspan's Legacy ConsideredFederal Reserve Chairman Alan Greenspan's warning that the current housing bubble is by no means burst-proof. Home prices could plunge, Greenspan implied, if long-term interests rates go up. Those rates, which are based on finicky international market forces, have been low for some time, in part because investors believe the U.S. economy is healthy and ergo safe for money-lending. But such relatively safe conditions, Greenspan cautioned, are "too often viewed by market participants as structural and permanent."

Speaking at a symposium entitled, "The Greenspan Era: Lessons for the Future," Greenspan went on to praise what he called the "flexibility" of the American economy. Globalization and deregulation have strengthened the markets, he said, leaving them less susceptible to the precipitous boom-bust cycles of the past. What the Post coverage omitted, though, was the chief's noteworthy treatment of the "fear of change," both among American workers and policy-makers. "Increased fear of job-skill obsolescence," he said, has prevented U.S. workers from being competitive in the world labor market—a problem that must "be addressed through education and training."

So, after reading an explanation about how and why real estate agents (not all are "Realtors®" you know!) aren't getting rich with the booming housing bub... er, market, I found it interesting to read remarks by Greenspan about risks to the consumer foundation of the economy. But, first, a couple of choice excerpts from's piece about the housing bubble and how real estate agents aren't getting any richer because no barriers to entry into the profession mean there's less to go around for everybody:

One seemingly obvious path to riches is to become a real-estate broker. For many decades, agents have successfully kept their payments steady as a fixed share of the value of the houses they sell. In most cities, the rate is around 6 percent, split between the buyer's and the seller's agents. The lack of price competition has attracted the notice of anti-trust authorities at the Justice Department who are planning to sue the National Association of Realtors over some of their anti-discounting policies. Economically speaking, it's hard to explain why the steady commissions have lasted so long—perhaps agents band together to blacklist competitors who undercut prices, or perhaps the NAR's extensive "education" program for realtors excels at indoctrination.

Whatever the explanation, the realtors' reliable cut of 3 percent each means that the housing bubble should be all upside for them. If house prices double, then agents make twice as much. Sell a house for $500,000 and keep $15,000; sell the same house for $1 million and keep $30,000. The agents are Levi Strauss without the copper rivets.

There is just one problem with this—a principle that economists term the "zero-profit condition." In a business with free entry, new participants will keep entering until no money remains. And becoming a real-estate agent is almost free. Most states require applicants to take a short class and a test to get a license. For $99, an online company will prepare you to pass. This kind of entry into the housing market is a lot cheaper than, say, building a steel mill. Every month, thousands of new brokers get certified—more than 8,000 in California in May alone.

With all these new agents swarming onto the scene, the price they charge may remain constant, but the number of houses each sells will not. The zero-profit condition predicts that, in locales where housing prices rise, the number of agents will also rise, and acquiring new clients will become that much more difficult. The occasional star agent will always make a bundle. But the theory suggests that the average agent won't make much more in places where house prices have risen than in places where they haven't.

A recently published study bears this out. Enrico Moretti and Chiang-Tai Hsieh of the University of California, Berkeley, studied the real-estate agent business in 282 metropolitan areas during a 10-year period. They compared agents in inflated markets to agents in flat-lining markets and found overwhelming evidence of the zero-profit condition in action. When housing prices rose, the number of agents did as well, and this, in turn, reduced the number of houses each agent sold by almost exactly the same proportion as the price increase. In Moretti and Hsiesh's data, for example, houses cost 5.9 times more on average in San Francisco than they do in Steubenville, Ohio. But the average full-time agent working in Steubenville sells more than 22 houses per year, whereas the same agent in San Francisco sells less than one-fifth as much.* The average income for real-estate work in the two locales is virtually identical. Moretti and Hsieh found that the direct correlation between housing prices and agent productivity held true across all markets. A rise in housing prices in an area has no significant impact on the average wage of the brokers in that market. It's the oldest line in the economics book: No barriers to entry mean no big profits.

Meanwhile, in Jackson Hole, Greenspan delivered a brief history of 20th century economics and monetary policy, followed by an appreciation for his legacy in an era of asset-value accumulation:

The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.

The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.

Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.

The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher.5 The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions.6 The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

Broad economic forces are continuously at work, shaping the environment in which the Federal Reserve makes monetary policy. In recent years, the U.S. economy has prospered notably from the increase in productivity growth that began in the mid-1990s and the enhanced competition engendered by globalization. Innovation, spurred by competition, has nurtured the continual scrapping of old technologies to make way for the new. Standards of living have risen because depreciation and other cash flows generated by industries employing older, increasingly obsolescent technologies have been reinvested to finance newly produced capital assets that embody cutting-edge technologies.

But there is also no doubt that this transition to the new high-tech economy, of which expanding global trade is a part, is proving difficult for a segment of our workforce that interfaces day by day with our rapidly changing capital stock. This difficulty is most evident in the increased fear of job-skill obsolescence that has induced significant numbers of our population to resist the competitive pressures inherent in globalization from workers in the major newly emerging market economies. It is important that these understandable fears be addressed through education and training and not by restraining the competitive forces that are so essential to overall rising standards of living of the great majority of our population. A fear of the changes necessary for economic progress is all too evident in the current stymieing of international trade negotiations. Fear of change is also reflected in a hesitancy to face up to the difficult choices that will be required to resolve our looming fiscal problems.

The developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks. If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment.

The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances. That process of correction limits the size and the consequences of cyclical imbalances. Enhanced flexibility provides the advantage of allowing the economy to adjust automatically, reducing the reliance on the actions of monetary and other policymakers, which have often come too late or been misguided.

In fact, the performance of the U.S. economy in recent years, despite shocks that in the past would have surely produced marked economic contraction, offers the clearest evidence that we have benefited from an enhanced resilience and flexibility.

Taking into account both documents above, I tend to agree with the Washington Post analysis of his remarks:

Federal Reserve Chairman Alan Greenspan warned Friday that recent gains in U.S. home prices, stock values and other forms of wealth may be temporary and could easily erode if long-term interest rates rise.

Households and businesses have been able to spend more by transforming houses, stock and other assets into cash, he noted. But Americans should not assume that such good times will roll on forever.

"What they perceive as newly abundant [cash] can readily disappear," Greenspan said.

His words followed statements the Fed chief has made in recent months that housing prices in some markets have risen to unsustainable levels and that individuals are taking on increasingly risky mortgages. But Greenspan's comments Friday represent a broader warning, with the Fed chief indicating he believes much of the run-up in housing and stock prices over the past decade has been due to low long-term interest rates, which could rise if global financial conditions shift.

"History has not dealt kindly" with those who underestimate such risks, Greenspan said in remarks delivered at the opening of an economic conference here focused on his 18 years as Fed chief.

Stock prices fell in trading Friday after Greenspan suggested that the value of such assets may be headed lower in the future. Financial markets have responded to Greenspan's warnings in the past, only to shrug them off subsequently. In 1996, he famously warned that "irrational exuberance" might be pumping up stock prices; stocks fell briefly only to climb almost continuously for the following three years.

At the conference's opening session Friday, Greenspan was lauded by current and former colleagues and other analysts for his performance and wisdom as Fed chief. "When the score is toted up, we think he has a legitimate claim to being the greatest central banker who ever lived," wrote former Fed vice chairman Alan S. Blinder and Ricardo Reis, both Princeton University economists, in a paper presented Friday.

The Fed has been raising its benchmark short-term rate for more than a year and has signaled that it probably will keep lifting it in the months to come to keep the lid on inflation. But the Federal Reserve does not set long-term rates, such as those that determine mortgage rates and corporate borrowing costs. Those are affected by international financial markets in response to many factors.

Long-term interest rates remain very low, in part because inflation has remained tame outside of energy costs. Overseas investors have been pouring money into U.S. stocks and bonds, helping dampen long-term rates. But Greenspan said low long-term rates also reflect investors' belief that the U.S. economy is so healthy that there is little risk in lending money here.

Thus, lenders set rates lower because they demand a lower "risk premium," Greenspan said.

"This vast increase in the market value of [stocks, bonds, houses and other assets] is in part the indirect result of investors accepting lower compensation for risk," Greenspan said. "Such an increase in market value is too often viewed by [investors] as structural and permanent."

- Arik

Posted by Arik Johnson at August 26, 2005 05:50 PM