INTEGRAL ECONOMICS

Unprecedented Fundamentals
Daniel O'Connor | Integral Ventures, LLC

A Federal Reserve analysis of the housing bubble hypothesis

ignores the Fed's own role in creating the unprecedented
fundamentals on which this entire market trend is based.
Unprecedented Fundamentals

Daniel O'Connor | Integral Ventures, LLC

With housing prices showing year after year of

unprecedented growth across most of the United
States, some have begun to wonder if housing
might be in a bubble similar to the technology
stocks bubble of the late 1990s. In response to
these questions, the Federal Reserve has just
released a new study that addresses this "housing
bubble" hypothesis:1
"Home prices have been rising strongly
since the mid-1990s, prompting concerns
that a bubble exists in this asset class and
that home prices are vulnerable to a
collapse that could harm the U.S.
economy."
The Fed adopts the definition of “bubble” offered by
Joseph Stiglitz:
"If the reason the price is high today is only
because investors believe that the selling
price will be high tomorrow—when
'fundamental' factors do not seem to justify
such a price—then a bubble exists."
This is a fine definition for a pure market economy,
in which any bubbles, manias, or panics can be
attributed to the animal spirits of market
participants. But we do not live in a pure market
economy and the recent trends in home prices are
driven in part by global, multi-state interventions in
the markets for money and credit which have,
among other things, created some unprecedented
fundamentals for the housing market. Whether this
constitutes a bubble depends upon your definition
of a bubble. However, the above definition side-
steps the critical issue of whether the so-called
fundamentals are themselves the products of
unsustainable government policies which, when
they eventually fail, will create entirely different
fundamentals for this asset class.
"A close analysis of the U.S. housing
market in recent years, however, finds little
basis for such concerns. The marked upturn
in home prices is largely attributable to
strong market fundamentals: Home prices
have essentially moved in line with
increases in family income and declines in
nominal mortgage interest rates."
Yes, and home prices have also moved in line with
increases in mortgage debt levels, facilitated by an
easing of credit standards by mortgage lenders and
an unsustainable period of low mortgage rates,
which is just one manifestation of the stable
instability created and maintained by central bank
interventions in the markets for money and credit.2
The recent trends in home prices
are driven in part by global,
multi-state interventions in the
markets for money and credit which
have, among other things, created
some unprecedented fundamentals
for the housing market.
The Fed's own monetary policy and its many
manifestations throughout money, credit, and asset
markets are the fundamentals that explain in large
part why home prices have sky-rocketed in recent
years. But in calling them fundamentals and ignor-
ing its own role in creating them, the Fed implies
that they are durable, time-tested, sustainable,
economic bedrock. Just don't mention the fault lines
and occasional tremors.
"Moreover, weaker economic conditions are
unlikely to trigger a severe drop in home
prices. Historically, aggregate real home
prices have fallen only moderately in
periods of recession and high nominal
interest rates."
I would suggest that we’ve never really been
through this current scenario, so a profile of past
recessions is not particularly relevant. The recent
alignment of central bank interventions and other
economic factors that is fueling the growth curve in
mortgage debt and housing prices has to my
knowledge never before appeared in the US, so it
would make more sense to study the current
configuration and develop scenarios for how it may
change in the years ahead. This graph from The
Economist is at least suggestive of the novelty in
our current monetary situation:

Page 1
Furthermore, homeowners are not particularly
interested in fictitious statistics for “real” home
prices, by which the Fed apparently means
objective, measurable, nominal home prices minus
a fabricated index of price inflation in a basket of
goods curiously devoid of homes. Homeowners care
about nominal prices because that’s what they paid
for their homes, that’s what they’ll get if they sell
their homes, and they don’t get to adjust their
mortgage balances and payments to remove the
Fed’s price inflation and ease the debt burden when
asset price deflation sets in.
I find it less than reassuring,
though not at all surprising, when a
Federal Reserve analysis of the
situation ignores the Fed's own role
in creating the unprecedented
fundamentals on which this entire
market trend is based.
That said, it is heartening to see in the Fed study
that in past recessions even nominal home prices
have not fallen too dramatically. Nevertheless, I
would be interested to see an analysis that takes
into consideration other factors unique to this
current cycle, including the global glut of liquidity,
the very low household saving rate, the prevalence
of adjustable rate mortgages, the lower credit
standards used by lenders, the high percentage of
second home or investment properties, the
popularity of housing speculation and "flipping," and
the fact that home prices did not fall but actually
rose in the last recession.
"While such conditions could lead to lower
home prices in states along the east and
west coasts—areas where an inelastic
supply of housing has made home prices
particularly sensitive to changes in
demand—regional price declines in the past
have not had devastating effects on the
broader economy."
So, having concluded that the recent double-digit
growth rates in home prices along both east and
west coasts—which includes the urban and sub-
urban communities in and around Boston, New
Daniel O'Connor is the managing director of Integral
Ventures, a strategy consultancy committed to foster-
ing more innovative and sustainable ways of doing
business. He has been a pioneer in the development of
integral praxis in business and economics, having
authored numerous articles and essays in this
emerging field.
email: daniel@integralventures.com
website: www.integralventures.com
Page 2
York, Philadelphia, Washington, Miami, San Diego,
Los Angeles, San Francisco, Oakland, Portland, and
Seattle—are due for a reversal even in a standard-
issue recession like the ones we’ve had in recent
decades, the Fed still doesn’t expect such a
“regional” price decline to have a “devastating”
effect on the national economy. What a relief.
This begs the question of just what impact such a
contraction in home prices along the bi-coastal
"inelastic supply curve" might have if it falls just
short of nationwide economic devastation. Does this
mean we’re all going to be fine as long as things
don’t get worse than nationwide economic havoc?
Is regional economic devastation acceptable as long
as it can be averaged out by incorporating another
region experiencing only a modest economic set-
back? Seriously, for the final bullet point in what is
supposed to be a definitive refutation of the
“housing bubble” hypothesis, this is a most
disconcerting conclusion.
Just to be clear, I personally remain agnostic about
the future of the housing market, bubble or no
bubble. Preferring multiple scenarios to single
predictions, I simply don't know exactly how the
stable instability between market and state, among
homeowners, mortgage lenders, and central
bankers, between American consumers and Asian
savers, will resolve itself. But I find it less than
reassuring, though not at all surprising, when a
Federal Reserve analysis of the situation ignores the
Fed's own role in creating the unprecedented funda-
mentals on which this entire market trend is based.
This April 2005 work is licensed under a Creative Commons
Attribution-Noncommercial-No Derivative Works 3.0 License.
1
Jonathan McCarthy and Richard W. Peach. (2005). “Are Home
Prices the Next ‘Bubble’?” Federal Reserve Bank of New York
Economic Policy Review. December 2004.
http://www.ny.frb.org/research/epr/04v10n3/0412mcca.pdf.
Retrieved April 1, 2005.
2
Daniel O'Connor. (2005). “Stable Instability.” Catallaxis.
http://www.catallaxis.com/2005/02/stable_instabil.html.
Retrieved April 1, 2005.
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