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BOOK BUILDING
How asset markets and the economy interact
D. MURALI
Real estate developers work by a simple principle: “If the market value of office buildings in a certain location exceeds the cost of building one from the scratch, new buildings will sprout . If, on the other hand, the market values fall below the cost of constructing a building, new construction will stop.”
A similar correlation exists between stock prices and new machinery orders, says Alan Greenspan, the former US central banker in ‘The Age of Turbulence’ ( www.penguin.com).
Good lead
While that should be a good lead for researchers studying economic activity here, the book has enough and more to say about real estate, housing and home loans.
Don’t be dismayed, though, if many of these wise nuggets from the ex-Fed ring true enough to apply to situation closer home. For instance, in a chapter titled ‘irrational exuberance’, he argues that price stability is central to long-term economic growth. However, there seems to be no agreement on what price stability means.
To most economists, price stability is about product prices – be it the cost of a pair of socks or a loaf of bread. But what about the prices of income-earning assets, like stocks or real estate, asks Greenspan. “What if those were to inflate and become unstable? Shouldn’t we worry about the price stability of nest eggs and not just the eggs you buy at the grocery store?”
Logical anxieties, these are, you’d agree. The US economy faced a major shock on 9/11, yet it carried itself through driven by consumer spending, which in turn was buoyed by housing. Residential real estate saw values surge, ‘energised by the fall in mortgage interest rates’. The market prices of existing homes rose 7.5 per cent a year in 2000, 2001 and 2002, more than double the rate of just a few years before, narrates the author. “Not only did construction of new houses rise to record levels, but also historic number of existing houses changed hands.”
Morale booster
The boom gave a big lift in morale, says Greenspan. “Even if your house was not for sale, you could look down the block and see other people’s homes going for what seemed like astonishing prices, which meant your house was worth more too.”
By 2006, nearly 69 per cent of US households owned their own home, up from 64 per cent in 1994, and 44 per cent in 1940. The expansion of ownership gave more people a stake in the future of the country and boded well for the cohesion of the nation, concludes Greenspan.
When homes changed hands, the buyer almost invariably took out a mortgage that exceeded the unpaid balance on the seller’s outstanding mortgage, explains the book. “The net increase of debt on the house went as cash to the seller.”
Capital gains, especially gains realised in cash, drove up consumer spending, recounts Greenspan. “Some analysts estimated that 3 to 5 per cent of the increase in housing wealth showed up annually in the demand for all manner of goods and services, from cars and refrigerators to vacations and entertainment. And, of course, people poured money into home modernisation and expansion, further fuelling the boom.”
At the time of writing, sub-prime crisis continues to take its toll.
A Bloomberg report dated October 3 says that ‘the number of Americans signing contracts to buy previously owned homes dropped to the lowest level on record in August as the housing recession deepened’.
It quotes Ian Shepherdson, chief US economist at High Frequency Economics Ltd thus: “The existing homes market is now in freefall. The downside from here is still substantial.”
Lessons that drive home a point.
Feed back to dmurali @ thehindu.co.in
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