For the past decade, U.S. real estate markets have been dominated by a flood of financial capital from foreign and domestic sources. Market prices of housing and commercial properties have soared while cap rates compressed.
This flood of capital has largely been generated by a huge long-term global financial trading imbalance among nations, plus the stock market crash of 2000-2002. The United States has been running enormous trade deficits by importing far more than it was exporting. To pay for that imbalance, Americans issue debt to foreign firms and governments, mainly as U.S. Treasury securities.
Offsetting America's excess consumption is plenty of savings by citizens and firms in other nations. The savers are in China, India, Japan and Europe. Chinese households save heavily because their government does not offer them any social safety net programs like retirement and health benefits.
Japanese households save heavily because the country's aging population relieves many households from raising children, and because Japan has traditionally relied on export surpluses to keep its workers employed.
Meanwhile, China buys more U.S. Treasury securities because it needs to keep expanding its industrial exports to provide more jobs for the millions of farm workers migrating into its cities. These capital sources were augmented by surplus savings from oil exports and by investors fleeing from falling stock prices.
The remedy for the U.S. trade deficit? In its 2007 volume of “The World Economic Outlook,” The International Monetary Fund described two basic scenarios.
The first scenario involves a gradual rise in domestic consumption and investment by many nations now running export surpluses with the U.S. This would reduce their savings. It would occur because Japan and Europe's economies are growing faster than they were, and because Chinese households would raise their spending as their incomes increased.
A gradual depreciation in the international value of the U.S. dollar would accompany this shift. Since 2002, the dollar has declined in value by 39% against the euro, 31% against the British pound, and 11% against the Japanese yen. Lower U.S. federal deficits would also decrease our net borrowing. That would reduce America's trade deficits by raising our exports because of a depreciated dollar, without causing a panic from rapid disinvestment in U.S. Treasury securities by overseas nations.
If these gradual trends persisted for two decades or so, a more balanced relationship between the U.S. economy and the rest of the world would slowly emerge without any upsetting economic catastrophes. This scenario would also gradually reduce the size of the capital flows seeking investment in U.S. real estate markets.
The second scenario assumes the adjustments described above do not occur and the U.S. continues to run large trade deficits and save little, while other nations continue to achieve high-level savings. Hence, the value of the U.S. dollar plunges so rapidly that many foreign holders of Treasury debt try to dump those holdings to avoid further capital losses. This produces an even more precipitous fall in the dollar and an international trading crisis.
In response, the Federal Reserve raises U.S. interest rates rapidly to slow the sell-off of U.S. dollar holdings by foreigners. The resulting high-level interest rates choke off economic activity in the U.S. — especially in real estate — and cause a serious U.S. recession. Falling consumption and investment in the U.S. spread this recession until it is worldwide.
It is in the best interests of the U.S. real estate industry, the U.S. economy and the world to adopt policies to maximize chances for the gradual scenario. Those policies in America include much smaller federal deficits, a gradual depreciation in the value of the dollar, and continued emphasis upon open international trade so that the U.S. can increase exports and reduce imports.
Even so, it's still possible the U.S. economy might experience one or more slowdowns or mild recessions. Yet that outcome would be greatly preferable to a sudden drastic plunge in the value of the dollar followed by a worldwide recession.
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 anthonydowns@csi.com.