by Eric Englund
2005, my clients – contractors of all trades, fabricators,
and suppliers – have watched housing continue on its tear.
Housing demand seems insatiable. Residential, commercial,
and public works contractors are busy all across the U.S.
When housing subdivisions and condominium complexes are built
out, commercial and public works projects often follow. Strip
malls, supermarkets, restaurants, and department stores are
constructed to serve these new population centers – much to
the delight of the commercial construction trades. With these
new population centers comes the "need" for new
public schools and other public infrastructure. Public works
contractors get a piece of the action as well. Most of my
clients are quite busy and turning nice profits. However,
during a recent business trip, a common theme emerged in meeting
after meeting. My customers are seeing severe shortages in
building materials and quality labor. Many are outright stating
that the heady pace of construction is simply unsustainable.
In turn, some of the more seasoned contractors are predicting
a bust – but they just don’t know when; yet I will hazard
meeting notes, I found that contractors were running into
shortages of the following (pre and post-Hurricane Katrina):
architectural designs and plans (indicating a strained architectural
shortages, the one causing the most frustration pertains to
a dearth of quality labor. Contractors, frequently, have little
choice but to load their construction budgets with ample overtime
pay in order to keep quality (and often shorthanded) crews
together for the duration of a project. One client quipped:
"This constant battle for labor and materials can’t go
on forever. Things have to cool down sooner or later. But
precisely when the bust will occur, this is not knowable.
As to why boom turns into bust, only the Austrian Theory of
the Trade Cycle provides the intellectual framework allowing
one to understand the boom-bust cycle. What we will find,
as explained by Roger Garrison, is that central banking is
at the epicenter of the business cycle. Dr. Garrison provides
the following explanation in the Mises Institute’s fabulous
Austrian Theory of the Trade Cycle:
Austrian theory of the business cycle emerges straightforwardly
from a simple comparison of savings-induced growth, which
is sustainable, with a credit-induced boom, which is not.
An increase in saving by individuals and a credit expansion
orchestrated by the central bank set into motion market
processes whose initial allocational effects on the economy's
capital structure are similar. But the ultimate consequences
of the two processes stand in stark contrast: Saving gets
us genuine growth; credit expansion gets us boom and bust.
the current American housing boom has not been built upon
a foundation of savings – keeping in mind that, presently,
America has a negative savings rate. This boom has been fueled
by the Federal Reserve’s aggressive creation of money and
credit. Correspondingly, the federal funds rate hit a low
of 1% in June of 2003 – about the same time the housing boom
began to accelerate.
money and credit can be created out of thin air, yet building
materials and other resources cannot, does it not stand to
reason that relentless credit creation would lead to resource
shortages? Of course, the answer is "yes" – and
Austrian economists know this. Accordingly, Roger Garrison
covers this issue in his excellent book Time
and Money: The Macroeconomics of Capital Structure:
sum, credit expansion sets into motion a process of capital
restructuring that is at odds with the unchanged preferences
and hence is ill-fated. The relative changes within the
capital structure were appropriately termed malinvestment
by Mises…The boom is unsustainable; the changes in the intertemporal
structure of production are self-defeating. Resource scarcities
and a continuing high demand for current consumption eventually
turn boom into bust.
not often one finds an economic theory that describes reality
– and Austrian theory does so magnificently. In fact, from
the labor and materials shortages my clients have described,
it would seem the bust phase of the business cycle is nearly
widely considered to be among the world’s greatest real estate
investors, wittingly or not, has an Austrian perspective as
to why the United States’ real estate/housing boom will soon
come to an end. He stated the following, about real estate,
in a recent Fortune
article: "There’s too much money chasing too few good
deals, with too much debt and too few brains…. That’s why
I’m getting out." Tom Barrack certainly understands the
dangers of high-octane credit expansion. Yet, what about the
inevitable resource scarcities caused by the Federal Reserve’s
accommodative credit policy and how will this affect the housing
bubble? In the following excerpt, from this article, Mr. Barrack
hits the ball out of the park:
sees the bubble deflating soon. Barrack thinks the catalyst
will be a trend that few others are talking about, a steep
rise in the price of building materials and labor. "Construction
costs have spiked 30% in the past nine months," he says.
The reasons: shortages of labor and materials like lumber
because of the building boom, and increases in the price
of oil, needed to produce everything from plastic piping
to insulation to shingles.
slump will show up first in speculative hot spots like Miami
and Las Vegas, he says, where condo developers are preselling
their projects for what look like big profits. When they
actually build the units over the next year or two, he predicts,
they will end up spending more than the units are now selling
for. At that point, says Barrack, the developers will try
to raise prices. "But most of these buyers are speculators,"
he says. "They will either sue the developers to get the
original prices or get their deposits back and walk away."
The developers will then put the units back on the market,
and the glut of vacant condos will drive prices down. "It's
the busted deals caused by construction costs that will
cause a turn in the market," he predicts.
sure, the severe construction labor and materials shortages,
seen throughout the U.S., signify the housing boom is nearing
its end. Not surprisingly, Austrian economic theory predicted
such shortages would emerge before boom turns to bust.
measure, let’s throw in the following housing affordability
and financial-stress factors into the fray – which also point
to the impending demise of the housing bubble:
average American household has $10,000 of credit card debt
and, due to pressures brought to bear by the Office of the
Comptroller of the Currency, minimum payments are now doubling.
energy prices are going to make for financially punishing
heating bills this winter – McMansions are energy hogs.
Federal Reserve just raised the fed funds rate to 4%. Hence,
there should be no surprise that mortgage interest rates
are at 15-month highs.
inflation is much higher than Uncle Sam’s Consumer Price
Index suggests – just go to the gas station and to the grocery
ratio of house prices to rental values is at an all-time
ratio of house prices to disposable income is highly elevated.
about my promise to hazard a guess as to the timing of the
bust? After all, Tom Barrack indicated that he sees enough
busted deals materializing, over the next year or two,
to bring about a downturn in the real estate market.
to make a reasonable prediction, I am going to bring into
the mix a September 2005 Federal Reserve discussion paper
titled House Prices and Monetary Policy: A Cross-Country
Study. Per this discussion paper’s abstract: "This
paper examines periods of pronounced rises and falls of real
house prices since 1970 in eighteen major industrial countries,
with particular focus on the lessons for monetary policy."
Here is what I found to be most interesting: "House price
booms are typically preceded by a period of easing monetary
policy, with policy rates bottoming out about the same time
that house prices take off, about three years before house
prices peak." Considering the fed funds rate did not
bottom out, at 1%, until June of 2003 (and remained at 1%,
until June of 2004, before being ratcheted upwards) one could
reasonably surmise house prices will peak somewhere between
June of 2006 and June of 2007 – and then, of course, will
break downwards (for the reasons mentioned above).
a plausible timeframe in hand, I am predicting the housing
bubble will begin to burst within the next 14 months – perhaps
by around December of 2006. Ultimately, we have a housing
boom built on credit (and not savings) which has lead to labor
and materials shortages and has lead to overleveraged consumers.
This is why I see a bust – as indicated by accelerating mortgage
defaults and a general decline in housing prices – commencing
well before June of 2007. To close, always remember Austrian
theory allows us to know there will be a central bank-induced
bust. As to timing, I am only providing an educated guess.