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Pearlstein

Investment Bubbles

Steven Pearlstein
Washington Post Columnist
Wednesday, March 23, 2005; 11:00 AM

Washington Post business columnist Steven Pearlstein was online to discuss his latest column, which looks at the connection between loose monetary policy and investment bubbles.

A transcript follows.

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About Pearlstein

Steven Pearlstein writes about business and the economy for The Washington Post. His columns on the economy appear every Wednesday and Friday.

Editor's Note: Washingtonpost.com moderators retain editorial control over Live Online discussions and choose the most relevant questions for guests and hosts; guests and hosts can decline to answer questions.

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Charlotte, N.C.: How does the positive differential between cost-to-own and cost-to-rent a home equate to a bubble?

Steven Pearlstein: Glad you asked that. I probably should have explained in more detail in the column.

Generally speaking, rents and carrying costs for similar homes should move in tandem, particularly over the long term. Why? Because if they get out of whack, then in a market where people have choices, enough of them would shift from the higher-priced option to the lower-priced option until the supply and demand for both came into balance at roughly the same price. That's the theory, anyway.

Obviously, there are lots of other factors at work. But the factor right now that seems to be overwhelmingly important is that people perceive real estate to be such a good investment that they are willing to pay more to own a house each month than they ever would to rent it, because they expect the difference is more than made up for by the steady increase in the value of the house. And the expectations for this increase each year are now so high that you can say it has the characteristic of a bubble, which is a market in which the value of something is based primarily on the presumption that another buyer (sucker?) will come along and pay more for it than I have, irrespective of its "economic" value -- that, is what rent it could draw for someone seeking just housing without investment.

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Laurel, Md.: So if America (thinking parochially) has so much investment money available, why isn't more of it being used to repair highways, develop alternative energy sources or improve housing, education and health care for the poor?

That is, of course, a rhetorical question because the answer is obvious -- for 25 years we've been in a pro-business political environment that has emphasized return on capital at the expense of (among other things) the return on labor and provision of government services.

Is there anything Congress can do to drive more investment dollars into things like starting new businesses that create (quality) jobs, as opposed to driving up the price of Key West mansions?

Steven Pearlstein: One thing Congress could do is not borrow so much money, which is stimulating the economy right now to a significant degree. With that going on, the Fed now has to raise rates higher and faster to slow the economy and sop up that excess liquidity.

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Washington, D.C.: Are we sitting on a real estate bubble and will it burst soon? I would like to buy a place but am contemplating waiting and buying after the bubble bursts. I may be able to get somebodies house that foreclosed for a good price. Is this a good strategy? I do not wish bad thoughts for people, but will this work?

Steven Pearlstein: I have a rule about not giving financial advice. But we are in a bubble and at some point you can expect a correction. The hope that prices will simply flatten out I think is misplaced. Now the question, of course, is when will the bubble burst. It could go on for a couple of years more -- they always go on longer than the nay-sayers like me expect. But the longer it goes on, the harder the fall. I think you have to consider seriously the option of renting now and saving your shekels.

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washingtonpost.com: Today's Column: Bubbles Abound In a World of Ready Cash

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Columbia, Md.: Another good column, Steven. I would like to stress more of the 'herd' mentality for the current crisis, and it is a crisis, Greenspan's reassurances notwithstanding.

People are bamboozled into overpaying for their houses by carefully choreographed pronouncements of 'historically low' rates. How a 'low' rate would help you buy a house that is $200K more than you can afford is beyond me, as the benefits of these 'low' rates are far exceeded by the penalty of overpricing in the housing market.

8 years ago, I was laughed out of a bank for requesting a loan of $150K to buy a second home, but now I am bombarded with solicitations of 'no-down' loans which I KNOW I can't afford, but are offered as 'very attractive' loans in these 'historically low-rate' times. Long ago the adage was you could borrow up to 1.5 times your gross income to purchase a house. I admit that was probably a little too conservative, but hearing about people who make $30K/year but are 'approved' for $300K is downright crazy. Thanks for calling the situation by its correct name--a bubble that will burst very soon.

Your admirer in Columbia.

Steven Pearlstein: I'll take all the admirers I can get. Thanks, Columbia.

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Baltimore: I went to the bank the other day to ask about a car loan. The loan officer was trying to convince me to take out a HELOC instead for the full value of my condo. Won't the worst effects of a bursting housing bubble be felt by owners who took out all their equity out of their homes? I know a lot of people who have done that and it seems just crazy.

Steven Pearlstein: Obviously, it depends on how much equity they took out, of course, but when people see that it is gone, one thing they will probably start to do is saving more real cash. And when they do, that could seriously slow the economy. The best explanation for the country's low household savings rate right now is that people think they are building up equity in their houses so fast that they are already saving and getting very good returns from it.

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Clarendon, Va.: The article was very interesting. I think I, like most people so not fully comprehend the ways in which the global macro economic factors interact and affect what happens in our daily experiences with the economy. For example, I do not know of many average people who are ‘awash in free cash', as your article describes the global economy. What I do know is that I see people continuing to purchase larger houses, further from their jobs, schools and shopping and then taking on debt, leveraging perceived equity in their new purchases to expand, decorate or equip their new homes. These larger homes cost more to heat and cool and their location means that people --must-- expend more energy to conduct their daily lives - leaving them in a very tenuous position should energy prices continue to rise - which is what many are predicting. All of this debt and inelastic (mandatory) energy use would seem to leave this country in a tenuous, risky position should anything perturb the macro economy, much less having a collapse due to a bubble.

Steven Pearlstein: Ah, an environmentalist! It is not so much that households are awash in cash, particularly U.S. households. It is the world economy that is awash in cash, which is something a bit different. Most of this is savings from households outside the U.S., which money used to pretty much stay in its home country. But today, it is all really one global pool that moves around efficiently and more quickly as a result of the "new technology" of global finance. And it is looking for a good place to earn a good, low-risk return. As for your concerns about households being out on a financial limb because of the expenses associated with their new exurban lifestyle, you've got a good point.

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Washington, D.C.: I wonder whether we really have a bubble in the price of oil, or whether it is more a reflection on the strength of the dollar vs euros. Is the price rise in oil more due to oil speculation or rational expectations about the buying power of the dollar relative to other currencies?

Steven Pearlstein: There are many factors, including a dollar depreciation factor, at work in oil prices (oil prices are set in dollars, so if the dollar goes down, it means that oil producers are worse off). I was pointing out another factor, the impact of futures prices on spot prices. And Phil Verleger makes a good point, I think, that this is the factor that is most driving the recent increase as more and more investors get into playing the commodities markets.

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Arlington, Va. Steven,

Please comment on the realistic impact upon average diversified individual investors if the current economy with mixed numbers, a large deficit and a falling dollar had to absorb an additional crisis with either the hedge fund industry or the housing market.

Thanks, TN

Steven Pearlstein: Big slowdown in economic growth, long bear market in both stocks and bonds. That's the danger.

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Herndon, Va.: In an asset bubble economy, in your opinion, where should an small investor put his money? It seems no place is safe as we move into this uncharted water.

Steven Pearlstein: Banks and stocks in solid, large companies paying nice dividends. Portfolio of diversified corporate bonds, investment grade. Those are some possibilities.

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Alexandria, Va.: My wife and I own a rental property in Alexandria, VA. The current lease runs out in May and we would like to rent it one more year before selling and locking in our equity gains. How worried should we be about the real estate "bubble" talk. I've read conflicting opinions. Some say there is no bubble in real estate and the market may cool but it won't burst. Others seem more cautious. Who is right in your opinion over the short term (i.e. the next 18 months). Thanks for your advice.

Steven Pearlstein: Look, there is a bubble, particularly around here. Let's stop kidding ourselves. That's not to say prices won't continue to rise for a few years, or that they are doomed to fall by 50 percent. But let's learn from the history of the late 80s and call a bubble a bubble when we see it.

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Washington, D.C.: With inflation on the rise, and interest rates headed up, maybe way up, how does the Fed manage to bleed off excess worldwide liquidity without destroying a lot of capital in the bond markets, the stock market, commodities and real estate? And won't turmoil in the capital markets spill over into the economy? Isn't this a really bad situation?

Steven Pearlstein: Yes, turmoil in the capital markets will spill into the "real" economy. And yes, sopping up liquidity will involve destroying some capital. That's what happens when bubbles burst. There's no getting around it. Monetary policy can cushion the blow, and makes sure that the economy doesn't get into a bad, downward spiral that feeds on itself. But it can't prevent the pain, the rebalancing, from coming eventually.

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Rochester, N.Y.: Did your friend torto say whether to sell real estate invest properties?

Steven Pearlstein: Ray is still somewhat bullish on commercial real estate, I infer from talking to him and reading his stuff. He points out to me that I called him 18 months ago and said I thought there was a bubble in office markets like Washington, New York, SF, LA. He said he doubted it. Now its 18 months later, and anyone who had listened to me would have missed out on some sizeable capital gains.

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Washington, D.C.: You sort of talked about something that's been a serious worry to me recently. From the time of the bubble market collapse in the equities markets in 2000 until today, the Fed has flooded the economy with cash. Yet the markets don't seem to respond. The NASD is stabilized at around 2000 and the DJIA hovers just over the psychologically important 5-digit 10,000 point. Before, if you had asked any economist what drives the market up most effectively, he or she would have answered low interest rates. Even those who talk about all these market bubbles must either say that the DJIA and NASD are artificially high even today or that these are not efficient markets. How can anyone be right about tomorrow if they were so wrong about the recent past and are also misinterpreting the present?

Steven Pearlstein: I'm not sure the whole thing is that simple, the connection between rates and stock prices.

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Washington, D.C.: I agree with your overall analysis and, like Mr. Buffett, have all my assets tied up (as SJ Perelman said) in a paper bag in the garage. My question for you is more academic: I don't quite see the connection between Chinese yuan and American investment bubbles. Unless banks are holding yuan and counting them as reserves for dollar-denominated loans, the overall liquidity in the American economy should be based only on the supply of Dollars, shouldn't it? Which then leads to the question, where are all these Dollars coming from? Is it treasury that's actually printing more dollars? Or are banks putting out loans with no reserves behind them?

Steven Pearlstein: You ask good questions and I want to be very careful because I only imperfectly understand the money supply, how to measure it and what causes it to go up and down. On the other hand, a lot of really smart people don't know, either. But I can say pretty confidently that what is going on in China is very much related to the liquidity bubble. Any major central bank that is "printing" a lot of money can affect global liquidity. And China's presses are running overtime in trying to buy up all those dollars earned through export with crisp new yuan. Then, because the Bank doesn't want to put those dollars under a mattress, it buys Treasury bonds and Fannie Maes, and that increases the pool of available capital, lowering rates and prompting other investors to look for somewhat higher yields in places like real estate, commodities or emerging market bonds.

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Bowie, Md.: A few weeks ago, you said in a column to the effect that the non-cartelized price of oil should be about $10 barrel. This may seem ridiculous to some, but as recently as 1998 it was $12-15/bbl as gas about $1/gal instead of $2.

What would a sudden "breaking" of the price of oil do to various bubbles?

Steven Pearlstein: Good question. Not sure. But getting the price of oil back to a non-cartel price would surely be good for the global economy in the long run. The economy of Saudi Arabia, however, would surely suffer.

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Arlington, Va.: Steve, what role will rising interest rates play in these bubbles?

washingtonpost.com: Fed Again Increases Key Rate By 0.25%

Steven Pearlstein: Rising rates could, at some point, help burst these bubbles, or slow their growth. But it is clear from the last recession that it takes more monetary stimulus than in the past to stimulate an economy, and I assume the reverse is also true: it will take more monetary tightening than in the past to sop up liquidity than in the past. This is because the role of banks as intermediaries between savers and borrowers has been greatly reduced, replaced by global financial markets, which are not so easy for monetary authorities to control and influence.

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Washington, D.C.: Thanks for an interesting article. If we are indeed in a housing bubble, are there any predictions out there for how much the bubble will deflate, and how long that will last? I am also thinking of buying a condo (but hesitant) - but I hear people say that even if the housing market drops, it would rebound quickly and that in the long run it would still be a good investment.. What is your view on this?

Steven Pearlstein: In the long run, real estate has been a good investment in the U.S. But that doesn't mean markets rebound quickly. If you mean rebound within one or two years, I don't think we can necessarily count on that. Five to seven years -- that's a better bet.

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Clifton, Va.: The so called real estate bubble is dependent on where you live. In the Washington, DC with the creation of jobs and new residents arriving monthly their is a housing shortage. Big correction like back in the early 90's don't think so. Leveling off of increases yes. back in the early 90's you had a lot new developments that opened with lower priced houses because the development co.s picked up the land for a song. This isn't going to happen in Fairfax or Montgomery County. Unless gov't spending changes profoundly there bubble isn't going to burst it just isn't going to grow.

Steven Pearlstein: That's the consensus view among economists and within the real estate industry. And as long as everyone believes that, it will probably happen, since there is a self-fulfilling quality to such expectations in markets like real estate. But let me warn you that consensus forecasts always predict soft landings. They never predict recessions or market crashes, which we know happen from time to time.

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You missed a root cause: The Federal Budget Deficit. The Chinese aren't printing money in droves to support the Yuan in a bubble (sorry). We are borrowing like crazy to give rich people tax cuts. This is clobbering the dollar, and the Chinese are trying to prop it up by buying Dollars with Yuan.

Of course, our profligate and (IMO) stupid fiscal policies have put us well on the way to ceasing to be the world reserve currency. Worldwide Central banks are quietly shifting to the Euro. When that tipping point is reached, the Dollar will collapse (you think its bad now? Ha!), as all those excess dollars parked in global reserves are sent back here.

That will be what blows up our local bubbles. That's also why I'm hoarding cash and knocking off debt. I'll be happy to buy a foreclosed townhouse for dimes on the present dollar price. Sure interest rates will be high...but that means they can only eventually go down, and you re-fi.

People forgot...better to buy on a low price and high interest than the reverse. If rates are high, you can later re-fi. If rates are low, you go bankrupt when they go back up.

Steven Pearlstein: All interesting points. I'd particularly point to your final one, which is the asymmetry involved in refinancing. Mortgage rates are up in the last six weeks and some people may believe that they will drop back down again. I wouldn't bet on that.

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Richmond, Va.: I've noticed quite a number of "will buy your house" signs in various neighborhoods. Down in Williamsburg, someone has been leaving their business card on the doors of homes with a note saying he will buy their property immediately.

I've also noticed a pattern where people will purchase a home then immediately post in the paper as rental property. Flipping also seems to be a problem. To me, in aggregate, it looks like price fixing. Families seem to be spending 50% to 80% of their take home pay either on the mortgage or on rent.

It appears such speculative behavior in a fragile housing market (looking at the foreclosure trend) will only hasten a crash. And then when I look at the mess at Fannie Mae, it just gets worse... Agghh...

Steven Pearlstein: The behavior you site is a pretty reliable indicator of a bubble, no matter what the real estate industry cheerleaders say. And I'm glad you mentioned Fannie Mae. Because if there is a market correction in mortgage debt, I can assure you that that is precisely the time we want Fannie and Freddie around as the buyer of last resort. When the banks decide that they don't like mortgages any more (they've been loading up like crazy over the last two years), they won't hesitate to dump them -- and once one or two do it, they all will move in that direction. Banks don't care a whit about maintaining the supply of capital for mortgages. They care only about next quarter's earnings.

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Orange County, Calif.: With real wages stagnate over 30 years & the stock market's loss of appeal (after the sham of its recent bubble) isn't it in a sense mastery by this administration to feed a huge housing bubble to misdirect populace into wanting to risk more than they can afford if favor of free market capitalism? If 2/3 of families own homes & one creates a short term method to double home's asset value (low int. rates, easy lending practices), allowing them to increase debt by 20% (& pay off loans they otherwise couldn't have) - isn't that a net short-term positive for economy? And so, if the housing bubble pulls back even 30% aren't these homeowners who have been greatly enabled still better off? Sure, those who have squandered their newfound wealth, as well as those who were on the sideline, will & have lost BIG TIME, but - there are always losers. The better question becomes how large a home price correction will we see? If it's less than 30%, it seems the administration obviously wins, but if it's closer to 50% isn't country likely to fall into a general malaise similar to Japan's? Again obviously, isn't administration betting bigtime that Greenspan will be able to stop this needed correction on a dime?

Steven Pearlstein: Interest calculations. I won't quibble. But why do you have to see this through a political/administration win or lose prism? I don't see the relevance.

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Arlington, Va.: I do think there's a bubble, but I think people out in Loudoun and Prince William Counties are in deeper trouble then people in close. My partner and I own an investment townhouse near the Pentagon, and we feel we can wait out a correction as people will still want to rent a historic, comfortable townhouse close to DC in a well-run jurisdiction.

Steven Pearlstein: That's a fair assumption.

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Dickerson, Md.: How do you see the divergence of income/debt ratios changing in the future and what is the current maximum income/mortgage debt assumed by the average homebuyer?

Is there anyway for someone who is not able to sell there home to hedge against a drop in home values? I remember hearing something about new style hedge funds that would serve this purpose in the future.

Thanks

Steven Pearlstein: That would be interesting, if there were such a thing. You can probably do that for bundles of mortgages. But I'm not sure you can hedge a price decline on a single residence in any way other than selling it, or selling an option to buy it at a price near today's price. Maybe there is a business opportunity there.

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Bethesda, Md.: One thing puzzles me -- with easy money abounding throughout the world, why are we witnessing inflation principally in asset markets, resulting in bubbles, but we're not witnessing rapidly accelerating inflation in goods markets -- which is the conventional or traditional manifestation of excessive rates of money growth?

Steven Pearlstein: Now there is the $64,000 question. And this is important because the Fed says it only looks at the prices of goods and services, not assets, and will take aggressive action only when it sees increases in those indices. And that's where I part company with them. Because our recent experience is that recessions happen when asset bubbles burst. They have to keep an eye on asset prices just as they keep an eye on prices in the real economy.

The reason excess liquidity is causes inflation in asset prices but not other prices is that there is excess world capacity in many industries that is holding down increases, particularly in the price of traded goods and services. And what is traded is now a much larger subset of the economy than ever (i.e. Indian programmers). Furthermore, much of this money is really savings, and savings seeks investment opportunities.

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Espoo, Finland: The NASDAQ bubble burst in 2000, about 3 years after the famous "irrational exuberance" remark. One can see the foundations of the present asset bubble being laid down in Fed governor Ben Bernake's speech in October 03 implying that the Fed stands ready to buy risky assets if need be to avoid deflation. Fiscal and monetary authorities do not really want to prick asset bubbles. Intuitively the intention is more to contain them. Probably the current imbalances will continue for 2-3 years.

Steven Pearlstein: Interesting analysis. If three years is the magic number, however, I'd say we are at least halfway through.

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Arlington, Va.: Well all right then, let's look at the long view - seems to me that investment "bubbles" are a regular cycle in the economy. How are these last two (the stock market in 2000-01) and the current real estate "bubble" now any different from those we've seen historically? If its all musical chairs, are the only choices money managements accounts and savings bounds (for the patience conservative investor), or really good luck knowing when to get in and out of the market (for the speculator)?

Seems to me the real estate market is still location more stable. You can't live in/on your stocks and you have to live somewhere. Second, the Federal Government and the myriad of related industries just seem to continue to grow in this area, those folks have to have employees and they have to live somewhere.

Thx.

Steven Pearlstein: Well, that's the popular view. And there is some truth to it. But, of course, you could say that when three-bedroom rambler in Arlington is priced at $400,000. Or $800,000. Or even $1.2 million. At some point, the price simply gets so high that all those federal employees and contractors you talk about just can't afford it. And when that realization dawns on people and they realize that the price was really based on the assumption that some greater fool will come along and buy it at a price higher than before, the price can fall pretty fast.

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Arlington, Va.: In your column today, you noted that Adam Posen recently wrote an article that exonerated central bankers from blame over what certainly appears to be several asset price bubbles. Can you summarize his argument or provide a link to it.

Personally, I doubt that asset bubbles could continue to grow for an extended period of time if the monetary environment had been relatively tighter, and would like to hear a well-formulated counter argument.

Steven Pearlstein: Adam's research, which I'm sure is quite thorough and mathematically correct, is that there is no correlation between loose money and bubbles. He finds that it is neither necessary nor sufficient. I can't do the math and the regressions so I can't quarrel with that. But it seems to me that, in the present instance, loose monetary policy is a significant factor in the current bubbles.

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La Jolla, Calif.: Loved the article, I also am sitting on loads of cash. For all the reasons you suggest. So now where to put it?

Steven Pearlstein: That's the problem -- if there were such an ideal place, maybe there wouldn't be real estate and oil bubbles.

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Fairfax, Va.: Remember the time when the stock market was going up and up and didn't seem like it was ever going to come down? Remember those educated economists who called it the Super Economy which turned out to be a bubble?

(few years from now...)

Remember the time when the real estate price was going up and up and didn't seem like it was ever going to come down? Remember those who said there's a shortage in housing and land and kept on building millions houses which turned out to be a bubble?

Steven Pearlstein: Thanks for that.

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Fairfax, Va.: Your article is very interesting. It touches on some of the economic fundamentals that we don't have answers and I believe they deserve further research to understand their implications. For a while, I have been wondering what would happen as the world's major economies converge. Your article confirms my belief that the world major economic markets (i.e., US, EU, emerging third-world markets like China) have already began to merge and now we are living in this new landscape that no one knows what would happen next (inherently stable or unstable world economy, hard or soft-landing in the next 12 months as inflation picks up).

Flooded by cheap mortgages, the US current housing market is unreal. Just last last year alone, average housing price appreciated 24% in the Washington DC metro area. Anyone has lived in the same house for the past five years has seen their house equity double (that is a lot of free equity). Now as long as China, Japan, and other countries keep buying US mortgage bonds to offset the their currency appreciation, there will still be plenty of cheap money flowing into the US to support the crazy housing market. But will it last, particularly in light of rising inflation and commodity prices (i.e., copper, lead, steel, oil, etc)? Are we heading into a big correction? please comment.

Steven Pearlstein: Well put. And, yes, it seems to me that we have to have some correction within the next 18 months.

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Steven Pearlstein: Thanks folks. Good discussion on a difficult-to-understand and difficult to write-about topic.

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