The U.S. economic bubble

Chief Executive, The, August-Sept, 2005 by William J. Holstein

I hope I'm wrong, but I have a bad feeling about the housing bubble. I hear all the Don't-Worry-Be-Happy talk about economic growth running at 3.4 percent and about financial markets being at four-year highs. But I suspect we're living in a fool's paradise.

We've lived through bubbles and should have learned a few lessons. During the Internet bubble, it was obvious that the people rushing into day trading were crazy and that the valuations for dot-coms were insane. The IPO frenzy was clearly overheated. I suspected there would be a correction, but I thought investing in Cisco, Lucent and Nortel was reasonable. Surely, they would be spared any pain. Of course, I was wrong, and so were a lot of other people. The bubble was much broader and deeper than anyone recognized.

Now we're seeing similar kinds of bubble behavior. Consumers are buying homes with no money down and taking huge loans on which they pay only interest for five years. Other homeowners are using their equity to buy other properties for speculative investment. They're leveraging up.

The Federal Reserve has tried to dampen this activity but has failed. It has raised short-term interest rates 10 times, but long-term rates are driven by the market--and those are the rates that affect mortgage rates and housing activity.

I think it's a big deal that the Fed has essentially lost control of interest rates. The people driving the 10-year Treasury note market are the Chinese (who hold $710 billion of U.S. government debt), the Japanese (who hold even more) and oil producing nations who have reaped windfalls thanks to crude oil at more than $65 a barrel.

One theory for why these folks are parking their money in our government paper is that they can't intermediate that wealth fast enough at home. Another is that the Chinese and Japanese want to keep the dollar about where it is. Whatever the explanation, the hot money is fueling the U.S. housing boom. That, in turn, has become one of the biggest engines of the U.S. economy.

We know there will be a correction--but will it only affect the biggest cities and poshest suburbs where the latest outbreak of irrational exuberance has gone furthest? No, the lessons of history suggest that it's going to be much broader.

I think many CEOs have similar misgivings. Even though earnings are strong, why are so few companies spending the huge piles of cash they have accumulated?

The toughest question is what you should do about the bubble. I suspect most CEOs believe their companies can ride out whatever happens and don't really have a stake in trying to persuade policymakers to do a better job.

But I'd argue that's a mistake: If the U.S. economy were to tank, that would hurt even the most global U.S. companies. There would be nowhere to hide. So I think some percentage of your time ought to be spent explaining the dangers to the nation's political leadership. They obviously don't understand the risks at hand.