Sunday, July 10, 2005

Real Estate Bubble, Demand and Supply

From today's SF chronicle,

"Housing bulls say home prices are soaring not because of a speculative bubble, but for a simple economic reason: Supply has not kept up with demand. ”

Increase in prices of houses is indeed caused by demand and supply imbalance. But the imbalance is not in the demand and supply of lands or houses. Nothing fundamentally has changed there recently. Lack of growth in population, wage, jobs, immigration and rents conclusively buries that argument.

The true imbalance is in the demand and supply of dollar-denominated assets and debt. With soaring trade surpluses, huge foreign investment, lack of domestic consumption and soaring personal savings, Asian demand for dollar assets and US debts has grown enermously in last 5-10 years. They need to buy “something” with their excess dollar and that “something” should not devalue dollar for two reasons -

a) weaker dollar is bad for their exports and consequently GDP growth

and probably even more importantly

b) the assets of central banks are mostly in dollars (dollar being the international standard), but most of their loans are in their local currencies. Should dollar weaken significantly against those currencies, their reserve will not be enough to maintain the fraction (Fractional reserve banking) necessary. It could trigger financial crisis in Asian banks.

The US federal deficit , though gigantic, and the treasury notes are not large enough to meet these demands. Securitized mortgage debts fill this void perfectly. Without the Asian demand for dollar assets, long-term rates would have been much higher by now and would already have bursted the bubble.

Any anti-bubble argument that does not look at US trade deficits, lack of real job growth, Asian demand for dollar assets keeping the long-term rates low is at best naive.

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