From the Home News Tribune:
In 1983, the Bureau of Labor Statistics was faced with an awkward dilemma. If it continued to include the cost of housing in the Consumer Price Index, the CPI would reflect an inflation rate of 15 percent, thereby making the country’s economy look like a banana republic. Worse, since investors and bond traders have historically demanded a 2 percent real return after inflation, that would mean that bond and money market yields could climb as high as 17 percent.
The BLS’s solution was as simple as it was shocking: Exclude the cost of housing as a component in the CPI, and substitute a so-called “Owner Equivalent Rent” component based on what a homeowner might “rent” his house for.
The result of this statistical sleight of hand was immediate and gratifying, for the reported inflation index quickly dropped to 2 percent. (This was in part because speculators needed to offset their holding costs by renting out their homes while their prices skyrocketed, thereby flooding the market with rentals that pushed down the cost of renting a house or apartment.)
While the BLS was correct in assuming that this statistical ruse would fool the average citizen into believing that inflation was only 2 percent (and therefore be willing to accept a meager 4 percent return on his bank savings), what is remarkable is that the ruse also fooled the bond traders, and apparently continues to do so, leading analyst Peter Schiff to describe these supposed savvy bond traders as the “hormonal teenagers of the capital markets.”
The present subprime credit crisis can be directly traced back to the BLS decision to exclude the price of housing from the CPI. It is now clear that the “benign” inflation figures reported over the last 10 years in no way reflected the skyrocketing rise in home prices, with states like California experiencing annual home-price increases of as much as 30 percent. With the illusion of low inflation inducing lenders to offer 5 percent and 6 percent loans, not only has speculation run rampant on the expectation of ever-rising home prices, but homebuyers by the millions have been tricked into buying homes even though they only qualified for the “teaser” rates that quickly escalated to unaffordable levels. As long as home prices continued to skyrocket, buyers could refinance based on the increased value of their equity as collateral; but once home prices stabilized and even declined, many families were forced into foreclosure.
If economic history were a required subject in our public schools, borrowers would be aware of the dynamics of such frequent bubbles that have occurred in the past. In 1624 in Holland, frenzied speculators saw that the price of tulip bulbs was rising and rushed to buy them on the expectation that the price would rise even further and they could make an easy profit. Banks were eager to lend money to such speculators, because they, too, stood to make handsome profits. Oblivious to the underlying value of the bulbs, more buyers entered the market, pushing the price of a single bulb to the preposterous price of 3,000 guilders (equivalent to perhaps $100,000 today).
Houses are today’s tulip bulbs, and in California they are the equivalent of the 3,000 guilder tulip bulb. But instead of letting the bubble play itself out in order to create conditions for long-term economic stability, the Fed, under extreme political pressure from the power brokers and banks, seems determined to keep the bubble from bursting for as long as possible by continuing to lower interest rates and flood the market with liquidity, much as the Dutch banks did in 1624 to keep up the price of tulips. Such a short-sighted strategy will not only keep the price of homes beyond the reach of the average American, but will make the final and inevitable collapse that much more horrendous.