Tim and I started this blog to write about growth, and while much of our blogging is how best to promote growth over the long run, the current economic difficulties are depressing growth now – so much so that many believe the US economy may be headed toward recession (which is roughly when GDP actually falls in two consecutive quarters).
I appreciate Tim’s kind words about my recent talk here in Kansas City about the economy, and especially about how everything started with the decline in home prices and in residential construction. I based those remarks on a draft book I have recently completed with Martin Baily and Doug Elmendorf titled The Great Credit Squeeze. For those of you want to get to the punch line more quickly, and like pictures more than words, see the graphs that follow, which are taken from the book, and for which I credit Martin Baily:
Two of the key charts from that presentation are here:
We agree that the current downturn (or recession) will not be reversed until the housing market stabilizes. This is primarily because housing is so central to the overall economy. By many accounts, the 2002-07 expansion was driven in large part – at least a third and perhaps more – by the increase in residential construction, home improvements and purchases of consumer durables (and even vacations) that easy money helped fuel. Now that housing prices are falling, many homeowners are no longer able to take equity (what equity?) out of their homes to spend on other things, while would-be homeowners or home-switchers are on the sidelines out of fear or waiting for prices to get even better.
Only when housing prices hit rock bottom and buyers begin to push prices back up are we likely to see a bounce-back not only in residential construction and related industries, but also in consumer confidence, and thus consumption more broadly. And consumption accounts for about 70% of GDP.
The open question – to which I do not know the answer – is how far and fast must housing prices fall before we see some stability? In one camp (in which I believe Tim includes himself) are those who believe that the quicker housing prices adjust the better. Lance the boil, bear the pain, and get it over with. Keep the government out of things, and don’t interfere with the necessary market adjustment.
In the other camp are those who believe there is a risk that, in the absence of some kind of braking actions of government, housing prices will overshoot and/or that too rapid an adjustment will so further damage consumer (and business) confidence that consumption will fall further and more rapidly than it otherwise would. In other words, continued downturns in housing prices can lead to a vicious downward spiral in which falling prices lead to further declines in consumption, even larger loan write-offs by financial institutions, further tightening of credit markets, and then yet another round of housing price declines – and so on. It was just such a vicious cycle that the Fed feared if Bear Stearns had not been forced into the arms of J.P. Morgan.
But Tim (and others) might fairly respond that the housing market is not like the market for financial assets. Many sellers tend to hold on to their houses if they don’t get the price they want. This is not like holders of financial instruments who want or have to sell because they need to pay off other creditors.
Yet in a downbeat economy the problem is that many other sellers do have to sell. Homeowners who lose their jobs and who fear foreclosure may try to sell their homes for whatever they can get, if they have any equity left (otherwise, they may and often do simply walk away and leave the keys in the mailbox for the lenders to pick up). Likewise, banks that foreclose on lenders typically turn around, after sprucing up the properties, and try to get back whatever they can salvage. Selling pressure may be localized in areas of high unemployment or where many homes were purchased with little or no money down. In short, there is a significant risk that in bad times prices in some housing markets can overshoot, which is why I believe something like the Dodd-Frank bill to shore up the housing market is appropriate (even though its effects, according to the Congressional Budget Office, are likely to be limited to only about 400,000 homeowners).
Where and when will the housing bottom be reached? I frankly don’t know, but am worried.
Housing afficianadoes know that there are two measures of national housing prices, one issued by the Office of Federal Housing Enterprise Oversight (OFHEO), and the Case-Shiller index, compiled by two eminent economists. The OFHEO index is more geographically comprehensive, but is limited to homes financed by loans at or under the Fannie Mae/Freddie Mac conforming loan (until recently, $417,000). The Case-Shiller index includes homes of all prices, but only for 20 metro areas. Experts continue to argue which index is better.
In any event, if one uses the OFHEO index and compares it to increases in median family income over time, it appears that at their peak in 2007, housing prices were about 25% above the level one would have expected based on income growth alone (see chart). Since 2007, the OFHEO index has fallen by about 5%, suggesting that housing prices have much further to fall before housing prices are more in line with incomes.
Of course, the home price-to-income ratio can also be corrected as incomes rise. But given the bleak economic conditions likely over the next several quarters, I wouldn’t count on income growth to solve the problem.
All of this leads me to believe that any recovery from the current downturn – when it ends – will be slow and protracted. I wish it were otherwise, but the facts seem to get in the way.
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