Deficits and housing bubbles

I think it's pretty clear to folks that at least parts of the US are in a housing bubble. NY, CT, MA, CA and some other coastal states have experienced dramatic run-ups in selling prices while rents remain stagnant or in decline. This is a bubble and it will correct.

Part of the reason for the housing bubble is low interest rates, but just because housing prices are too high is not to say that interest rates are too low. Some folks say that interest rates are too low because Asian banks (including China) are running current account deficits and trade surpluses with the US (i.e. they are lending the US money at discount interest rates so the US can buy Chinese goods).

Since these loans contain (some) free money, the rational thing for the US to do is to 1) accept the money, and 2) use it to buy stuff. This means running current account surpluses and trade deficits (which it is). It seems that some of this free money is being squandered by bidding up real estate prices. So even though people have more money in their pocket, in part they are no richer because they've just used that extra cash to make real estate more expensive for themselves and everyone else. If they buy other stuff, like TVs, that spending is probably efficient.

The US should also run fiscal deficits. If interest rates are too low, then anything that 1) takes advantages of low rates and 2) pushes them higher is a good thing, which means fiscal deficits. I don't for a moment think that the US is running deficits because it thinks rates are too low -- I think the recession of 2000, the War on Terror, and a unified Executive, House, and Senate have driven spending -- but it is true that the low cost of running deficits comes from low interest rates. Once rates rise, the deficit will become much more expensive and unsustainable.

Besides, the long run fiscal imbalances in the US come from entitlement programs, and Bush has made the Medicare entitlement worse and is trying to make the Social Security entitlement better.

But what would happen if the government stopped running fiscal deficits, as some people clamour for? I guess interest rates would be lower, which means the housing bubble would be even worse. Lower rates may also reduce the capital account surplus because lending to the US is no longer such a good deal. But since China is counting on exports to create jobs at home, it would continue running trade surpluses with the US, maintaining the capital account surplus.

So, I guess the key question is why do rates remain too low? One group says its because China is giving the US free money so they can import stuff. Another group says its because the US saves too little, driven partly by consumer spending but also by government spending. If China stopped giving the US free money, rates would increase. If the US government stopped running fiscal deficits, rates would decrease. If consumers stopped going deeply in hock to buy overpriced housing, rates may or may not decrease depending on whether the savings went to investment or were spent on non-overpriced goods.

Given that rates currently seem to be too low, I find it hard to understand why reigning in the fiscal deficit would be helpful (although I would like to see overall spending lower).