from Follow the Money

Specializing in the production of houses

May 3, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Kash provides a pithy summary of the state of the US economy:

"the US economy has slowly been evolving from a goods-producing economy into a house-producing economy"

I suspect Calculated Risk would concur.

The funny thing is that Fed Governor/ CEA chair to be/ future Fed Chairman (?) Ben Bernanke doesn’t really disagree.

Indeed, Bernanke -- correctly -- expresses some concern about the potential difficulties that will arise when an economy that is specialized in housing has to turn around and start producing goods (and services) for export once again.

Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

A third concern with the pattern of capital flows arises from the indirect effects of those flows on the sectoral composition of the economies that receive them. In the United States, for example, the growth in export-oriented sectors such as manufacturing has been restrained by the U.S. trade imbalance (although the recent decline in the dollar has alleviated that pressure somewhat), while sectors producing nontraded goods and services, such as home construction, have grown rapidly. To repay foreign creditors, as it must someday, the United States will need large and healthy export industries. The relative shrinkage in those industries in the presence of current account deficits--a shrinkage that may well have to be reversed in the future--imposes real costs of adjustment on firms and workers in those industries.

I don’t think that many would have successfully predicted the sectoral composition of the current US expansion back in 2001 or 2002. Loose monetary policy (i.e. cutting short-term interest rates) usually stimulates the economy in part by weakening the currency and thus stimulating the exporting/ importing-competing sector. Loose fiscal policy usually drives up interest rates, all other things being equal. So it would have not been unreasonable to have expected that the loose money/ loose fiscal policy mix (Which generated what Ken Rogoff calls the best recovery money can buy) would have had somewhat more of an impact on the US export sector, and somewhat less of an impact on the housing sector.

Of course, some major countries were not willing to let their currencies appreciate against the dollar -- helping to keep US interest rates low and thus helping to generate a housing rather than an export led expansion ...

The big policy question, of course, is what, if anything, the Fed should do (or should have done) to try to limit the risk that the US is becoming too specialized in the production of houses. After all, the easiest way to reduce the incentive to produce houses would be to raise interest rates. By taking away the incentive to borrow against rising home prices to support current consumption, the Fed could bring US demand growth back in line with US income growth (See this FT oped by former Fed international staff director/ Treasury Ast. Secretary Ted Truman).

But in the process, the Fed also might put a damper on employment growth.

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