Thursday, April 07, 2005

Why The Dollar Could Demolish Your Home

Oxford Analytica

During last year's presidential campaign, the Bush Administration's economic record was widely assailed by Democrats. In large part, this was because the United States suffered a net job loss during President George W. Bush's first term. This is the first time the economy has lost jobs during a single presidential term since the Great Depression. However, a key factor, which has received comparatively little attention, and which may well have offset this in the perceptions of many voters is the large increase in house prices in recent years.

U.S. residential real estate values increased by about 36% from 2000 to 2004. In addition to this housing boom, the U.S. ratio of home ownership has risen to 68.3% (in 2003) from 63.9% in 1989. In highly rural and suburban states such as New Hampshire, the ownership ratio is nearly 75%. Low interest rates have made it possible for more low-income families to afford a home. The Administration has greeted increased home ownership as part of a larger program of promoting its so-called "ownership society."

Congress gave a boost to the housing market in 1997 by enacting a tax law that allows couples to withdraw $500,000 of capital gains from a property tax free (this can be done every two years without purchasing another residence). Homeowners previously had to purchase another house in order to roll over capital gains tax-free. However, the main factors that have driven the large house price gains center on monetary policy.

Following the capital-spending slump that began in 2001, the Federal Reserve began to reduce interest rates and then further decreased them following the September 11, 2001, terrorist attacks. By June 2003, interest rates had fallen to only 1% (the lowest level in a half-century). This monetary easing helped trigger an upsurge in home sales and house prices.

It also helped sustain the growth of consumption by encouraging the greatest mortgage-refinancing boom in U.S. history. In 2002 and 2003, the U.S. populace refinanced $2.5 trillion and $3.5 trillion of mortgages respectively. Total mortgage issuance rose to 7% of gross domestic product from an average of 3% to 5% during the second half of the 1990s. The wealth gains that accrued helped to sustain consumption despite large wealth losses in the stock market. In the absence of the housing boom, the economy would have experienced a harder landing in response to the collapse of the technology bubble and wider stock market falls in 2001 and 2002.

House prices are likely to stabilize or even decline in Bush's second term. The Fed has raised interest rates by 175 basis points since June 2003 and will tighten them further.

The United States is experiencing large and sustained dollar devaluation because of its huge current account deficit. The deficit is equal to about 40% of the value of all U.S. manufacturing output. If the deficit is reduced by 25%, capacity utilization will rise from 78% to 86%. If the deficit is cut in half, the utilization rate could rise to 93%. The Fed regards a utilization rate above 84% as potentially inflationary; so if it rises to such a high level, it is likely to boost short-term interest rates to 5% to 6%. In such a scenario, mortgage rates could rise to 7% or higher and undermine the housing market.

The United States does not have sufficient industrial capacity to eliminate the current-account deficit easily because it has long been scaling back manufacturing investment and employment. Only about 13% of the populace are now employed in manufacturing compared to 23% two decades ago. Resources are being reallocated from domestic consumption to tradable goods exports and import substitution in order to reduce the current-account deficit. The Fed is playing a role in this process by pursuing policies that restrain domestic spending as the utilization rate increases. The adjustment will include interest rate increases large enough to depress the housing market, reduce capital gains on property and increase the private savings rate.

The Administration could help to facilitate the adjustment process by taking new measures to bolster manufacturing investment. In 2003, Congress approved a 50% tax allowance for new capital goods purchases, but it permitted the allowance to expire earlier this year. Bush could ask his tax reform commission to help strengthen manufacturing by restoring the tax allowance or boosting it to 100% first-year depreciation, as the United Kingdom did during the 1960s and 1970s. The more rapidly the United States can expand its manufacturing capital stock, the easier it will be to reduce the external deficit without a strong slowdown in domestic spending.

It remains unclear precisely how the United States will manage the process of exchange rate adjustment to the current account imbalance. The dollar has become strongly devalued against the euro, the pound and the floating exchange rates of the U.K. Commonwealth countries of Australia, Canada and South Africa.

The countries of East Asia, led by Japan and China, have intervened to hold their currencies stable against the dollar. These states are concerned that exchange rate appreciation could undermine their industrial competitiveness. Treasury Secretary John Snow has encouraged Asian countries to let their currencies appreciate, but he has attempted to do so through gentle persuasion. If the current-account deficit expands to $700 billion, the Treasury could become more aggressive at promoting dollar weakness.

The successor to Alan Greenspan as Fed Chairman could also play a major role. One contender is Harvard Professor Martin Feldstein. He has been vocal in calling for a large dollar devaluation to reduce the external deficit. If he became Fed chairman, he might concern markets by suggesting the Fed would encourage dollar depreciation.

There is thus considerable uncertainty over how U.S. policymakers will manage the exchange rate. However, a falling dollar will probably eventually encourage an increase in bond yields that would undermine the housing market.

House prices are likely to stabilize or even decline in Bush's second term. The current-account deficit is driving dollar devaluation and this, along with robust GDP growth, will result in tighter monetary policy, undermining the housing market. As the dollar weakens further, bond yields may well rise, intensifying pressure on the Fed to raise rates.


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