Published: August 26, 2007 08:22 pm            

Arthur Foulkes: Why all the fuss about the housing market?

The news has been full lately of reports and worry about “subprime” mortgages, rising foreclosure rates and a collapse in the housing market.

Why is all this going on?

Some people argue that too many people want expensive homes with little ability to pay for them. I call this the “people are living beyond their means” explanation of the housing market’s troubles.

Another theory is that predatory lenders are targeting poor, vulnerable people, loaning them money and then gleefully foreclosing on their homes. I call this the “predatory lender” theory.

Both of these theories are inadequate because neither explains why the housing market problems are happening now and why to such a degree. In other words, neither theory explains why lenders are only now becoming predatory and why vast numbers of borrowers are only now desiring to live beyond their means.

First, let’s get a little perspective.

Home foreclosures are definitely rising. According to RealtyTrac, there were 430,000 foreclosure filings in the United States in the first quarter of 2007. That was up 35 percent from the year before. RealtyTrac estimates nearly half of those foreclosures were in subprime mortgages — that is, mortgages made to people with little or no credit, often outside traditional banks.

The number of subprime mortgages also has been growing. Around 35 percent of all mortgage-backed securities sold in 2006 were made up of less-than-prime mortgages, up from 13 percent in 2003.

Certainly some lenders, appraisers and others are acting unethically just as surely as some borrowers are being irresponsible.

But to understand why the housing market as a whole has started to buckle in so many ways all at once, a broader theory is called for.

Something called Austrian business cycle theory sheds important light on what’s happening in the U.S. housing market right now.

Originated by economist Ludwig von Mises and continued by Nobel Prize-winning economist F.A. Hayek, the Austrian theory focuses on the role of money, and more specifically the creation of new money, by central banks to explain widespread fluctuations in business activity — namely economic “booms” and “busts.”

The United States central bank, known as the Federal Reserve or “Fed,” creates new money out of thin air. It does this by writing checks to banks and brokerage houses in exchange for U.S. Treasury notes. The rapid creation of new money causes interest rates to be lower than they otherwise would be, meaning more lending and more borrowing than otherwise would be the case.

For the past 20 years, the Fed, with the exception of a slight slowdown in the 1990s, has been increasing the money supply at a relatively rapid rate. Indeed, the U.S. money supply (as measured by “money of zero maturity”) has grown by 390 percent since 1984 and by 25 percent between 2001 and 2003, alone.

In addition to devaluing the purchasing power of existing money, artificially lowering interest rates and thus discouraging savings, this new money also has created price “bubbles.”

There was the stock market bubble of the 1980s, the NASDAQ bubble of the 1990s, and today there is the housing bubble.

How has the Fed created the housing bubble?

As economist Mark Thornton explains, by rapidly creating new money and credit, the Fed has provided “excess loanable funds.” To lend these extra funds, “banks must reduce the interest rates they charge, reduce the credit quality requirements of borrowers, or both.” The result has been too many mortgages sold to too many people without the ability to pay them.

While the Fed’s expansionist policy set the stage for the housing market troubles, some other factors, Thornton notes, helped “light the fuse” for the current problem.

These factors included a big capital gains tax exemption for housing passed by Congress in 1997 (which made housing investments more attractive relative to other forms of investment) and an increase in purchases of mortgage-backed bonds by the quasi-governmental credit corporations Fannie Mae and Freddie Mac.

Auburn University economist Roger Garrison also notes the role of Fannie Mae and Freddie Mac in the housing bubble.

Because these agencies, which are the primary issuers of mortgage-backed securities, have implicit government support, they can acquire capital at an effectively subsidized rate. In short, thanks to Freddie and Fannie, taxpayers assume much of the risk that investors in mortgage-backed securities should shoulder.

Keen observers of the Fed, who also are aware of the effects of its inflationary policies on creating artificial “booms” and “busts,” have long seen the coming of the current trouble in the housing market. In addition to Thornton, economist Frank Shostak and banker Christopher Meyer were among many who saw the emerging bubble at least five years ago — all attributing the bubble to loose monetary policies at the Fed.

Perhaps not surprisingly, until quite recently the Fed itself was denying even the existence of a “housing bubble.” Fed economists and two different Fed chairmen, as recently as 2004 and 2005, have said the housing bubble either didn’t exist or, if it did, it was nothing to worry about.

Now the Fed is starting to show a real interest in sustaining or even bailing out the mortgage mess it created. It can do this by buying mortgage-backed securities that no one else wants, further injecting even more new money into the system.

Recently, the Fed temporarily bought billions of dollars of mortgage-backed securities, something its own rule prevented it from doing until only a few years ago.

As foreclosures rise and housing markets continue to falter, politicians, media pundits and others look for someone to blame. Predatory lenders and irresponsible borrowers are the standard scapegoats.

But in fact, the Fed, by distorting interest rates and thus housing prices, is truly to blame for the current trouble. And, as long as most of us point the finger of blame in other directions, we can expect only more inflationary policies, more bailing out of irresponsible investors and more ultimately painful economic distortions in the long run.



Arthur Foulkes is a Terre Haute native and longtime resident. The Tribune-Star reporter writes a weekly column on business and economics. He can be reached at (812) 231-4232 or arthur.foulkes@tribstar.com.

        

• Click to discuss this story with other readers on our forums.