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Recession on the Horizon: Interview with Dean Baker

By: 
Left Turn
Date Published: 
March 01, 2006

LT: There's been a lot of speculation the last couple of years that the dollar would be displaced as the currency of choice for global trade and, most importantly, foreign exchange reserves. There seems to be a debate about whether this would have much of an impact on the US economy. What is this debate about and should we be concerned about the ups and downs of the dollar?

Dean Baker: Will the dollar be displaced? It will be used less. It’s not universal today. The Euro is increasingly being used. Obviously for intra-European trade it’s used exclusively and that’s a lot of trade. In China, they trade in Euros, probably not dollars. Increasingly the Euro, even the Yen, and probably before too long, the Chinese currency will be used. The impact of that switch as best as I can tell you is actually small. The transaction demand for dollars is not that large.

There’s a separate issue where you have a lot of central banks holding vast amounts of dollar reserves and they do that for two reasons. One, they don’t want to be in a situation like the East Asian countries were during the financial crisis in 1997. They don’t want a run on their currency and not be able to back it up. The conventional wisdom now is that you need a huge amount of reserves held in dollars because it is a major world currency. So you have it for that purpose.

The second is that you have a number of countries, China being the most obvious, but Japan to a lesser extent, that are holding dollars quite deliberately to hold their currency down and the dollar up. That’s their decision right now. They can change that tomorrow. They have decided they want the US as an export market, so in effect what that means is that they’re paying the US to buy their stuff. For how long, I don’t know. I’m surprised they’ve done it as long as they have but at some point the Chinese government, the Japanese government, and the other countries that are doing this are going to decide they can pay anyone to buy their stuff. They can pay their own people to buy their stuff.

So at some point they will cut back their dollar holdings or at least stop buying more and that’s likely to have a serious impact, leading to a large fall in the dollar and probably radically change our situation in the world economy. We’re going to be a much poorer country at that point because we can’t afford to import 700 billion a year more than we’re exporting—certainly not indefinitely.

LT: Bush's nominee for Chairman of the Federal Reserve, Benjamin Bernanke, denies that there is a housing bubble and even says that if there is one it's not the Federal Reserve’s job to do anything about it. As someone who has been warning the public and government about the housing bubble for several years now, what is your response to Bernanke? Please also give us a little background on this issue. What has been your main argument about the existence of a housing bubble? Why has it not burst?

DB: The main argument is, as simply as possible, if you look back at the period that we have good data, basically since WWII, house prices move pretty much at the same rate as the overall rate of inflation. So you go from 1950 or so to 1997 and the rate of increase in house prices is exactly the same [as inflation]…may be a hair higher, but it’s a trivial amount higher. So basically we can look back over that period and say that house prices move with inflation, with other prices. Since 1997, coinciding with the stock bubble, we have this huge run up in house prices where they increase about 45% in real terms, after adjusting for inflation—an unprecedented run up, creating in the order of $5 trillion in housing wealth.

Now, the question I ask is what changed in 1997. If it’s not a bubble then there must have been some fundamental factor of demand or supply that suddenly caused house prices to go through the roof.

I’ve been on all these panels and people talk about income growth, well guess what, we had really good income growth in the 50s and 60s and we didn’t see this. And income growth hasn’t been good, certainly not the last few years. So that doesn’t explain it.

Population growth was growing much more rapidly in the 70s and 80s when the baby boomers were first forming their own households. That didn’t create a big run up in house prices. We had the Social Security debate, which is about population growth slowing. So it’s a little silly, you have this one debate that says there’s slow population growth and then you go over here and talk to the housing people and they say it’s through the roof. So, on the demand side you’re hard pressed to find anything.

On the supply side there’s this argument that there are restrictions on building, that there’s limited land. Well, there have always been restrictions on building. Gingrich Congress took over in 1994 and they took over a lot of state houses. It wasn’t the hay-day of environmentalism. So you’re a little hard pressed to say what exactly were the new restrictions. And the fact is we’re building over 2 million units a year right now while in the 80s and 90s we were building 1.4 million. So if there are restrictions on building they don’t seem to be too binding. They don’t keep us from building a lot of units.

So I don’t see anything that could explain this one time run up in prices and the last thing I look to is, if this is really fundamental, it should be affecting the sale market and the rental market more or less equally. They don’t move exactly together but roughly together and it stands to reason that if sale prices are high and rents don’t change then you go to rent. Alternatively, from the standpoint of a landlord, if you have vacant units and we have record nationwide rental vacancy rates, you can’t rent your place or you have to get a low price and you can sell it for a fortune you turn it over and sell it. That happens—it takes time but you do it. But we see absolutely nothing going on in the rental market. Rental inflation was a little more than the overall rate of inflation from1998-2000 but since has leveled off and has actually been trailing inflation the last year and half, two years.

Why does it concern me? Well, just like the stock bubble, and again it coincides with the stock bubble, I don’t think it’s an accident. Japan had a real estate and stock bubble going side by side in the 80s. You’ve created on the order of 5 trillion in housing wealth and when that goes, on the one hand, it will be a big hit for a lot of people who are counting on that money to support them in retirement. You have a situation where the house is the major asset for most people in the country so you have a lot of people, particularly baby boomers in their late 40s and 50s, looking to retire in not many years and they think they have 200K-400K equity in their home. If their house falls in price by 25-30%, which will be the case in some of the bubble areas, they’re going to be wiped out. They’re going to have a lot less money for retirement than they were banking on. So as a personal matter, for an awful lot of people it’s going to be a disastrous situation.

From the standpoint of the economy, housing has been supporting the economy since the recession. We’ve had record or near record housing starts, about 6% of GDP directly in construction that can fall back 40% even 50%. Housing has also been supporting the economy through people borrowing against their homes. There’s a wealth effect that’s well documented, usually about 5 cents on the dollar. So you do the arithmetic. If we lose $5 trillion in housing wealth—maybe we won’t lose every cent of it but let’s just say we do—we will lose $250 billion in consumption—about 2% of GDP. So you’re talking about losing 2-3% of GDP in demand on the construction side and perhaps more than 2% on the consumption side. That’s a very big hit, a very severe recession and one that’s probably not very easy to get out of.

Now when Benjamin Bernanke says that’s not the Fed’s business, I want to say, “What is the Fed there for?” and also remind him that his predecessor thought it was the Fed’s business to support the stock market back in 1987. He [Alan Greenspan] got in there at the crash and supported it. I know of no economic theory that says the country has more interest in an over-valued market or over-valued housing market than in an under-valued market. We presumably want it to be properly valued and if you say we should stay out on all sides then fair enough but we didn’t. I’d also like to point out in 1997, [former Treasury Secretary] Robert Rubin, in his book, says that he intervened to try to prop up the stock market after it had a one or two day plunge (I forget for how long). He got Alan Greenspan out and they made some statement that the economy is sound and got the market going again. So the Fed has intervened in the market.

If they felt it was their concern to keep the markets up, they should also feel that it’s their concern to prevent bubbles from getting out of line. And, as I said, this will have an enormous cost for the economy when it collapses, as the stock market did. And one of the things we’re seeing, we were talking about GM, well part of that story is that GM has huge commitments to its retirees, both pension and health care, which they can’t meet in part because they stupidly thought the bubble would persist so they thought they had a lot more wealth in those funds than in fact was the case. So we’re seeing a lot of the implications of the stock bubble still and we’ll continue to see them. All the employment growth since 2001 is accounted for by people over 55 and I’m sure a lot of that is due to the fact that a lot of their 401K’s went thru the floor. Saying it’s not their responsibility, no, it is their responsibility and their decision to ignore it is a very serious one and they should be held accountable.

LT: Iraq, hurricanes, gas prices, massive deficit, weak stock market, and rising health care costs don't seem to be having much of an adverse effect on the economy. Corporate profits are up, inflation is still relatively low, and it seems that unemployment is fairly low. Is the economy fine or is there more to these indicators and figures?

DB: Well it is a more complex picture. The economy has been moving at a relatively healthy pace over the past year, year and a half. The unemployment rate is fairly low but the thing I’ve looked and a number of other people (in fact Benjamin Bernanke made this point at a talk I heard him give a couple years ago) is that the unemployment rates are still way down from where they were in 2000. So what’s happened is a lot of people have simply stopped looking for work. Presumably they think they can’t find a job or find a good job. So if people were taking part in the labor force at the same rate as they were in 2000, the unemployment rate would be about 2 percentage points higher. So that’s a lot of missing jobs. We’re still missing about 3-4 million jobs from where we were in 2000.

LT: Because the rate measures just those actively looking for work?

DB: Yeah. So the question you’re asked is were you working last month? If you weren’t working, were you looking for work? If you weren’t looking for work you’re out of the picture. So it’s only those who say they were looking for work and couldn’t find a job. So in that sense there’s still a lot of unemployment but we’re seeing a respectable rate of job growth.

Yes, profits are good, but the flip side is that wage growth has been bad. Wages have not been keeping up with inflation. Either wages will start to rise more rapidly and that will put more pressure on inflation (I actually think that is happening now—I think that in just the past few months there’s been an up-tick in wages). Workers are still not keeping pace with inflation, they’re not making up for the big rise in energy prices but they’re making a little headway. They’re not losing as much, I should say, as they had been earlier this year or last year. So that will put upward pressure on prices. So I think there is more inflationary pressure in the economy than most people recognize.

That doesn’t bother me at all, but I do think that will bother the financial markets. So even as Greenspan has been raising the short-term rate—we’re now at 4% and we were at 1% in June of 2004—long-term rates have barely moved. Just recently, in the last month or two, they have started to bump up. So the 10-year treasury is about 4.5%. It was under 4% as recently as this summer, which is an extremely low rate. My guess is that it will continue to rise and that will likely have a very big impact on the housing market and that’s the surest way to burst the bubble. If you get mortgage rates, which tend to follow long-term rates, rising to more normal levels—they don’t have to go through the roof but if the 10 year treasury goes to 5%, 5.25%, which most economists actually predict will go up to 7%, which is fairly low by historical standards—I think that will burst the bubble and then we start to see a very severe downturn. So that’s my guess as to where we end up going.

The flip side is that let’s say that wages don’t keep up with inflation—we don’t see any up tick in wages. The way consumption has been sustained is people have been borrowing against their homes and I think that’s coming to an end simply because even if the bubble doesn’t burst it’s very clear from the data that we have that house prices are not rising at the rates they used to. So as long as house prices were going up 10% a year people could always borrow more against their home. Once they stop rising they reach limits as to how much they can borrow.

So I think we are hitting an end. How long that takes, there’s a lot of uncertain factors. If Japan and China stop supporting the dollar—they’ve been buying up the long bond, basically counteracting Greenspan, who has been trying to raise rates—so if they stop doing that, you can see the rates rise fairly quickly. And if that happens I think the recovery will come to an end fairly quickly.

But we have a number of unsustainable trends going. One being the housing bubble, the other being the trade deficit. Those being the two biggies and where we hit the point where they can go no further is hard to say. Just as if we were having a conversation in 1999 and talking about the economy—it looked good, all sorts of really good growth—but the point was that it was dependent on the stock bubble [and] it was going to run out at some point. But it turned out that if we were having the conversation in 1999, it had a full year to go. It didn’t start to unravel until March of 2000 and it didn’t have that much of an impact on the economy for another year after that.

So the exact timing is going to be very hard to tell due to events that are to a large extent random. But my guess is that it won’t be too much longer but again I would’ve probably said the same thing 2 years ago.It’s going to depend on the housing market basically, that’s the long and short of it. If the housing bubble bursts then that’s virtually guaranteed to be a full recession and probably worse than a stock bubble.

For more information about Dean Baker and the Center for Economic and Policy Research, go to www.cepr.net .