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Not long ago, a hand-addressed letter arrived
at my home in Brooklyn. “Dear Mr. Cassidy,” it began. “I represent a buyer who is very keen to purchase
a house in your neighborhood. This buyer is willing to pay cash. If you are interested in selling, please contact . . . ” I allowed myself a rueful smile.
Almost five years ago, after driving out to Levittown, New York, and discovering that small ranch houses in that quintessentially
middle-class town were selling for more than $300,000, I wrote an article predicting a real estate downturn. As prices continued
to soar in Levittown and elsewhere, my friends and colleagues didn’t hesitate to tease me about the headline of my piece:
“The Next Crash.”
At the beginning of 2004, at the instigation
of my wife, I swallowed my reservations and bought a decaying Brooklyn brownstone, with the intention of doing it up and renting
out part of it to help pay the mortgage. The purchase price, of just over $1 million, seemed astronomical, but from today’s
perspective, it was a bargain. Houses on my block are now fetching more than $2 million and, as evidenced by the real estate
agent’s missive, demand for them is brisk. I dropped the letter in the trash, turned to my wife, and said, “Thank
God for the Chinese government. It’s made us a million dollars.”
The link between Brooklyn real
estate and policy decisions made in Beijing isn’t immediately obvious, but bear with me. As you may well know, the U.S.
is now the world’s largest debtor. According to the Treasury Department, at the beginning of 2007, Americans—that
includes you, me, Citigroup, hundreds of thousands of other businesses, and the federal government—owed foreigners roughly
$10.7 trillion. (In case you’ve forgotten what 14-figure numbers look like, that’s $10,700,000,000,000.) Now, the U.S. has
the biggest economy in the world. The gross domestic product—the value of all goods and services that we as a nation
produce each year—is about $13.6 trillion, so we can shoulder more debt than other countries. But still, in just three
years, the external debt has shot up by about 55 percent.
The culprit is the chronic
trade deficit, which has been running at almost 6 percent of G.D.P., a level unprecedented in our history. To pay
for the difference between our import bill and our export revenue, we have to borrow from abroad. Most countries with comparable
trade deficits meet a predictable fate: Investor confidence ebbs, capital flees, the currency crumbles, the central bank is
forced to raise interest rates, firms and consumers retrench, and the economy goes into a recession.
Nothing like this
has happened in the U.S.—at least not yet—largely because we have been able to withdraw cash from what is effectively
a giant A.T.M. stocked by the Chinese government, the Japanese government, and other generous lenders. In return, we have
been handing out IOUs, mostly in the form of Treasury bonds. On June 30, 2006, China owned about $680 billion worth of bonds
issued or backed by the U.S., and Japan owned about $800 billion. (These are conservative figures from the Treasury Department.
Many analysts believe the real numbers are much higher.) Other big holders of U.S. debt include Russia and Saudi Arabia, which
are both flush with oil revenue. But even countries such as Brazil, India, and Thailand have been lending us substantial
amounts of money. It is impossible to say precisely what would happen to the U.S. economy if it weren’t benefiting
from the largesse of central bankers bearing yen, renminbi, won, rubles, and riyal. It is pretty certain, though, that mortgage
rates would be appreciably higher.
Back in 2002, I assumed that the Federal
Reserve would raise interest rates, and that once cheap money was no longer readily available, housing prices would fall.
The first part of this prediction proved accurate. Since the middle of 2004, the Fed has taken the federal funds rate—what
it charges banks on overnight lending—from 1 percent to 5.25 percent. Normally, such a dramatic shift would prompt
a sell-off in long-dated Treasury bonds and a rise in long-term interest rates. This time, that didn’t happen. Thanks
to all those central banks stocking up on paper issued by Uncle Sam, the interest rate on 10-year and 30-year Treasurys, rather
than jumping to 7 percent—which might have been predicted based on past experience—stayed closer to 5 percent.
The fixed rate on 30-year mortgages (closely
tied to Treasurys) barely crept above 6.5 percent, creating a floor for real estate prices. Despite all the talk of a housing
slump, there is still no sign of a nationwide crash. In parts of South Florida, there have been significant price reductions,
but Oklahoma City and Albuquerque are still enjoying increases. In my neighborhood, housing prices seem to go up every
week. {This has all changed since when the article was published in June of 06--jk}
If
the sight of the world’s richest nation borrowing heavily from much poorer countries strikes you as strange, award yourself
a jelly bean. Traditionally, the relationship has been the other way around. In the 19th century, when England was the workshop
of the world, British lenders paid for the railways and other capital projects throughout North and South America. After World
War II, U.S. taxpayers financed the reconstruction of Western Europe and Japan.
Economic theory says wealthier countries
should provide capital to poorer ones, because that’s where the highest potential returns are. Today, however, the U.S.
doesn’t have much savings to lend anybody. The personal-savings rate is negative (people spend more than they earn),
the federal government runs a big deficit, and American firms are using much of their surplus cash to finance buybacks of
their stock.
There is a neat phrase to describe the relationship between the U.S. and its Asian creditors: vendor financing.
The governments in Tokyo, Seoul, and Beijing lend us money; we use it to buy Lexus cars, Samsung cell phones, and all manner
of Chinese products. It seems obvious that such a one-sided arrangement can’t last, but predictions of its imminent
demise haven’t fared any better than my real estate call in 2002. In February 2005, Nouriel Roubini, an economist at
New York University, and Brad Setser, a senior economist at the website RGEMonitor.com, predicted that within two years, America’s lenders would balk at providing additional funds and the U.S. economy would
risk a recession. Oh really? In 2006, China bought an estimated $250 billion in dollar assets. In the first quarter of 2007,
it purchased at least $100 billion more, according to Setser.
Some analysts did recognize the potential
durability of vendor financing. In a series of articles published in 2003 and 2004, Michael Dooley, David Folkerts-Landau,
and Peter Garber, three economists then connected to Deutsche Bank, argued that it could last a generation, until the Chinese
economy had absorbed the country’s enormous pool of rural laborers into factories.
The trio explained how China benefits from
financing our profligacy. In the past two decades, it has transformed itself from a rural country into the world’s second-largest
exporter, after Germany (the U.S. now ranks third). From the perspective of Beijing, investing hundreds of billions of dollars
in low-yielding Treasury bonds is a modest price to pay for keeping U.S. markets open to Chinese goods and gaining access
to U.S. industrial technology.
Media accounts of Sino-U.S. dealings tend to ignore this reality. Treasury Secretary
Hank Paulson flies to Beijing to chide China for not instituting more reforms, including currency revaluation. Chinese vice
premier Wu Yi politely tells him to shove off. (Cue headlines about rising tension between Washington and Beijing.) But the
very idea of Paulson lecturing the Chinese is an absurdity akin to a shopaholic lecturing his credit-card company on the need
for lower monthly interest rates. The Treasury secretary’s trip was an elaborate charade designed to discourage Congress
from slapping tariffs on China.
The U.S. and China have a symbiotic relationship
that neither side can afford to disrupt. Partly for this reason, much of Wall Street is remarkably sanguine about the U.S.’s
growing indebtedness. A while ago, I had dinner with a big-time investor, who told me to quit worrying: The foreigners won’t
stop buying Treasurys anytime soon, he said. They need to park their money somewhere, and the U.S. still provides the most
hospitable environment for itinerant capital.
Perhaps my dinner partner was right. He’s made a lot of money betting
on his optimistic outlook. Many of the skeptics, meanwhile, have been silenced. In April, Stephen Roach, the veteran chief
economist at Morgan Stanley—who in November 2004 predicted an “economic Armageddon”—was “promoted”
to head the firm’s Asian operations, a position in which he no longer opines on behalf of the company.
Given my sorry record as a real estate
prognosticator, I should probably leave it at that, but I can’t resist adding a historical note: During any period of
intense speculation, there are signs that a peak is approaching. These include relaxed credit standards, a glut of inexperienced
buyers, elaborate theories that justify rising prices, a lack of dissent, and more and more media outlets focused on the speculation.
During the bull market of the mid-1980s,
stock-market newsletters proliferated. In the late ’90s, there were CNBC and financial bulletin boards on websites like
Yahoo Finance, where small investors swapped stories about high-flying internet stocks. There are dozens of real estate websites
that critique and track the progress of new listings in Brooklyn. My wife and many of our neighbors obsessively monitor these
sites, which have names like Brownstoner, Curbed, and Property Shark. “Did you see the news about 152 Dean?” they
whisper to each other when they meet on the street. “It just sold for $2.45 million—$150,000 over asking.”
Suffice it to say, I do not take these communications
as a bullish signal. I would develop this argument further, but my wife just asked me to look at a recent posting on Brownstoner.
There’s a three-story fixer-upper close to the heavily polluted Gowanus Canal that’s a real steal at $1.1 million . . .
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