Since 2000, U.S. real estate markets have experienced a great rise in property prices. This first occurred in spite of high vacancy rates and low rents, except in housing. Recently, the improving U.S. economy has had a positive effect on real estate fundamentals.
A crucial part of this boom has been a huge inflow of capital into real estate, especially housing, largely because alternative investments such as stocks and bonds are considered less desirable. How long can this real estate price boom continue? No one can answer that question reliably. However, the boom will surely end.
Certain trends in the U.S. economy are clearly unsustainable. The most significant are huge deficits in the federal budget and our current account in international trade. Our real gross domestic product (GDP) of around $11 trillion grew about 3.9% in 2004, but the current account deficit was more than 6% of GDP.
In short, our indebtedness from foreign trade is rising faster than national income. In fiscal year 2005, expenditures by the federal government will exceed receipts by around $426 billion, or 3.6% of GDP. Total federal debt will be around $8 trillion, or 72% of our GDP, up from 55.2% in 1990.
Thus, both internationally and domestically, we Americans are living beyond current means by running up ever-larger debts. We are enjoying much higher standards of both consumption and investment than we are willing to pay for. One reason is that the capital other nations send us to buy our Treasury securities — capital earned from exporting to us — helps offset our federal deficits and low savings rate.
So, our rising trade deficit now creates a perception of continuing prosperity — but it cannot last. And looming ahead are even greater federal spending increases on Social Security, Medicare, and Medicaid as the baby boom generation retires.
True, President Bush has focused on Social Security. But his administration and Congress are ignoring the future consequences of the trade deficit and big federal entitlement spending. Instead, Congress passed more tax cuts and slashed Medicaid assistance for the poor, while raising spending on defense and Homeland Security.
The exchange value of the U.S. dollar has fallen about 10% in the past few years against the overall value of other currencies, and more against the Euro.
According to the Bank for International Settlements, net inflows from abroad financed 83% of the U.S. current account deficit in 2003. Several nations want to keep the U.S. dollar from declining in value so their countries can continue exporting to the U.S.
But how long will foreign nations keep sending us their manufactured goods and raw materials in exchange for U.S. paper securities with low interest rates when the dollar value of those securities is almost certain to fall further? Eventually, those nations will demand higher and less risky returns.
Thus, an adjustment is in order. Expect a further decline in the exchange value of the dollar, raising the cost of our imports but lowering the prices of our exports. U.S. interest rates will rise to keep the dollar from collapsing too sharply. This will cause a slowdown in U.S. economic growth, possibly leading to a recession.
No escaping the pain
Another adjustment will occur when our debt securities become less acceptable to both foreign and domestic lenders because they fear further dollar declines. Consequently, we will have to pay much higher interest rates. That will make our huge federal deficits much more costly, pressuring us to reduce those deficits. The sooner we do so, the less severe will be this adjustment.
But Congress has shown almost no willingness to control federal spending. The only other way out will be substantial increases in federal taxes. Yet our elected officials are not even considering such a policy change. They believe the American electorate is unwilling to accept either lower spending or higher taxes. Yet when the crunch comes, there will be no alternative to some combination of both.
Slower growth, higher interest rates, and higher taxes are not a recipe for prosperity. So, real estate will be part of the broader economic suffering required by the adjustments our economy must make. Most financial experts I know believe strongly that these adjustments are unavoidable. The only question is when.
That probably will not occur for at least another year. Right now, there is a huge supply of capital looking to buy real properties. That is why this is a good time to sell those real properties you do not want to keep over the long run. No one can say exactly what will set off the dramatic series of adjustments outlined above. But, when that time comes, the market for selling properties will not be nearly as favorable as it is today.
Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].