Figures released yesterday from the U.S. Commerce Department showed June new home sales at their next-to-lowest levels since they began compiling data in 1963. The month prior (May) was the all-time lowest at a revised 267,000 annualized sales. June was a skotch higher at 330,000, a 23.6% increase, but with a margin of error of +/- 15.3%. According to the National Association of Realtors, existing home sales are also leveling out or outright declining, as the effects of the government’s $8,000 tax credit for purchaser’s expires.
Demand for houses is declining again, just as it did beginning in late 2007, widely considered to have precipitated the subsequent financial system crisis. It may lead, like declining demand did in the automobile industry, to zero percent financing for homes.
Remember 9/11? When car companies rolled out zero percent financing in order to juice demand? The strategy was illusionist, both for the car company balance sheets, and to the consumer’s buying the cars. Reducing the price of money instead of the price of the car made it appear on the balance sheet as if car prices weren’t declining, while it made customers feel good about getting a “deal” on something, if not the car. Domestic car companies wished to prevent price declines in any way possible. Their cost structure was too high and mostly fixed, making lower prices unfeasible. And since financing was mostly used to pay the purchase prices for new vehicles, lowering prices of new cars would put a great many existing vehicles underwater. Price declines would have smacked huge holes in car company’s balance sheets.
In the bigger picture, price declines for automobiles could have potentially turned a modest decline in market demand into a price rout, with declining prices feeding on themselves, making holding onto money more attractive than spending it on a car, thereby fueling further price declines–a situation known as a “deflationary spiral” by economists.
It was about this same time (9/11)that the Federal Reserve earnestly began an expansive monetary policy, making money ever cheaper and more plentiful, trying to forestall the deflationary forces–including normal product cycles, technological innovations and international wage pressures–facing the economy. With little interruption, the policy has continued until today.
The normal product cycle of any good or service is one of decreasing costs and prices as efficiencies in production are obtained. The personal computer market is a good and recent example. Prices for PC’s have declined, even in spite of the Fed’s expansive monetary regime, as production costs have declined due to commoditization of parts used to make them, and labor costs have declined due to moving production off-shore to lower-wage economies.
Automobiles have not exhibited the same product life cycle as other consumer goods, owing perhaps to their somewhat unique history. The American automobile industry didn’t really get roaring until after World War Two, when the United States was the only major industrialized economy left standing. During the fifties and sixties, domestic car manufacturers enjoyed a virtual monopoly on the production and sale of automobiles in the United States. The United Auto Workers leveraged the domestic monopoly power of the automakers to wring ever higher wages and benefits from the car companies, themselves acting as a monopolist supplier of labor to the companies. Prices didn’t come down as would naturally be expected because they couldn’t in the face of fixed or rising labor costs. So the companies competed on brand and image and planned obsolescence. Tail fins and chrome became all the rage.
The domestic monopoly of the car companies began to crack in the seventies when Japanese companies used their much cheaper labor and more efficient production processes to squeeze their way into the US market with cheap, well-built cars that got good gas mileage. It was a huge threat to domestic manufacturers that they chose to mostly ignore, except in the political arena. They lobbied for and received import tariffs and import limitations to protect a slice of the market for themselves. Japanese companies responded by on-shoring the production of many of its more popular American makes and models, but at non-union factories. The domestic car maker’s slice of the pie got smaller still, but instead of competing on the basis of efficiency and price, domestic car makers pursued their tail-fin strategy to its logical conclusion, building ever bigger and fancier cars and selling them to the American consumer as lifestyle icons. Prices couldn’t come down because costs weren’t coming down. The UAWs’ monopoly grip on supplying labor to domestic manufacturers ensured that a normal product cycle of declining costs and prices such as that experienced in the personal computer market would not be allowed.
When 9/11 temporarily destroyed the demand for automobiles, domestic car companies had enjoyed four decades of ever-rising prices, and were not about to allow prices do what they always wish in times of oversupply. With money from the Federal Reserve plentiful and cheap, it was easy to drop the price of money (i.e., interest rates) in lieu of allowing the price of the vehicle to decline. Thus, zero-percent financing was born. Effectively, if a customer agreed purchase a vehicle at a higher price than market forces would indicate, the car companies would compensate them for the trouble by paying them to borrow money (with zero-percent financing, if there is any inflation, as there was at the time, the real interest rate is effectively negative).
Management had accounting incentives to prevent price declines that were independent of the UAW’s concerns. As mentioned, declining prices for new cars would put many existing owners underwater, and since a goodly portion of vehicle financing was done by subsidiaries of the car companies, an underwater vehicle owner often meant a hole in the car company’s balance sheet. Inventory and floor plan valuations would also require write downs, further distressing the balance sheet.
Zero-percent financing, though not really much of a bargain to consumers, was a good and efficient bargaining ploy that served to jump-start demand, and had the appearance of forestalling price declines that the market was screaming were indicated, at least for a time.
Then in late 2007, the Fed’s easy money policy that had fueled illusory demand in everything from automobiles to kitchen appliances–but especially in the housing market–collapsed on itself. Innate demand hadn’t really grown much at all over the years since 9/11. Appearance of demand growth by dint of increasing or stable prices had been mostly an illusion induced by expansive monetary policy. Zero-percent financing in automobiles came back, and was joined by employee pricing and other gimics. It still was not enough. Demand collapsed anyway. So the government came up with a new gimic–cash for clunkers–which effectively paid the first few thousand of a car’s purchase price. Of course profits are made or lost on the first few thousand, i.e., on the margins, so it helped to make sales that did happen profitable (for the dealers and car companies–not so for the taxpayer). Even that wasn’t enough.
Two of the three domestically-based automobile manufacturers went belly-up, and would have liquidated and gone away, except for the federal government providing massive cash infusions. Through taxpayer largesse, the industry has survived mostly intact until now to build more cars, so the oversupply of overpriced cars is rebuilding. Soon enough, the industry will collapse again. When it does, it may be Humpty Dumptied for good, with all the King’s horses and all the King’s men unable to put it back together again.
Which gets us to the housing market. Just as in the automobile industry, if for different reasons, every last effort is being directed at preventing housing prices from reaching a market equilibrium in the face of massive oversupply and collapsed demand (in the housing market, union labor doesn’t play a role, but banks and the big gse’s, Fannie and Freddie, et al., do–price declines would destroy their balance sheets). Just like after 9/11, the Federal Reserve and Federal Government have massively oversupplied the economy with money and credit. (In the case of the housing market the credit supply is in large measure directed specifically to the market, whereas the automobile industry after 9/11 was the beneficiary of a general oversupply of credit).
So what’s to keep residential mortgage rates from going to zero? Effectively, nothing, particularly in the case of new construction. Housing prices wish to fall. Demand is almost non-existent. There is massive oversupply due to the construction binge of the mid-aughts. The government wants to prevent housing price declines but the market says prices must come down. The only mechanism left is reduced interest rates, perhaps even as low as zero.
This (reduction in rates) is happening even today. According to Bloomberg, thirty-year mortgage rates are today about 4.62%, from 5.44% a year ago. Given an inflation rate of about 1.2% and an average tax rate of about 25%, mortgage rates, after accounting for the mortgage interest deduction, are less than 3%.
All these monetary shenanigans over the last two decades attempting to support prices that naturally wish to decline have yielded nothing more than massive oversupply and prices that desperately wish to crash. Market forces are not long held at bay by such “monetary mischief ” as Milton Friedman puts it. Prices that want to decline because of oversupply will find a way to do so, no matter how much meddling in the market is done by the government.
Zero percent financing might just be the mechanism the housing market decides upon in finding its equilibrium.