September 06, 2007
|Dire Scenarios From Two Top Economists||Economy|
The US economy has been fueled in recent years by a housing/credit bubble that has made homeowners feel rich, causing them to take equity out of their homes and spend it. Two top US economists warn that that's coming to a screeching halt. FinFacts:
US homes may lose as much as half their value in some US cities as the housing bust deepens, according to Yale University professor Robert Shiller. Meanwhile, Martin Feldstein of Harvard University says that experience suggests that the dramatic decline in residential construction provides an early warning of a coming recession. The likelihood of a recession is increased by what is happening in credit markets and in mortgage borrowing. Feldstein says that most of these forces are inadequately captured by the formal macroeconomic models used by the Federal Reserve and other macro forecasters.
"The examples we have of past cycles indicate that major declines in real home prices — even 50 percent declines in some places — are entirely possible going forward from today or from the not too distant future," Shiller said in a paper presented last Friday at the Federal Reserve Economic Symposium in Jackson Hole, Wyoming.
Falling real-estate values may undermine consumer spending by spurring households to save more and by preventing them from tapping home equity.
Because price gains were larger and more widespread this time compared with past speculative booms, the risk of "substantial" price declines is greater, wrote Shiller. [...]
Last week the S&P/Case-Shiller Home Price Index posted a record annual decline in Q2 2007 - the worst since 1987. [...]
He said that 50 percent declines in the worth of some cities' homes wouldn't be unprecedented. Prices in London and Los Angeles fell by almost that amount from the late 1980s to mid-1990s. [...]
Harvard University Professor Martin Feldstein, who is a member of a group that calls the timing of recessions, said that the housing contraction threatens a broader recession, and the Federal Reserve should lower interest rates. [...]
"The economy could suffer a very serious downturn," Feldstein said. "A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome."
Feldstein said that Shiller's analysis began with the striking fact that national indexes of real house prices and real rents moved together until 2000 and that real house prices then surged to a level 80 percent higher than equivalent rents, driven in part by a widespread popular belief that houses were an irresistible investment opportunity. How else could an average American family buy an asset appreciating at 9 percent a year, with 80 percent of that investment financed by a mortgage with a tax deductible interest rate of 6 percent, implying an annual rate of return on the initial equity of more than 25 percent?
"But at a certain point home owners recognized that house prices – really the price of land – wouldn't keep rising and may decline. That fall has now begun, with a 3.4 percent decline in the past 12 months and an estimated 9 percent annual rate of decline in the most recent month for which data are available. The decline in house prices accelerates sales and slows home buying, causing a rise in the inventory of unsold homes and a decision by home builders to slow the rate of construction. Home building has now collapsed, down 20 percent from a year ago, to the lowest level in a decade.
"...[S]uch declines in housing construction were a precursor to 8 of the past 10 recessions. Moreover, major falls in home building were followed by a recession in every case except when the Korean and Vietnam wars provided an offsetting stimulus," Feldstein said.
"Why did home prices surge in the past 5 years?" Feldstein asked.
"While a frenzy of irrational house price expectations may have contributed, there were also fundamental reasons. Credit became both cheap and relatively easy to obtain. When the Fed worried about deflation it cut the Fed funds rate to one percent in 2003 and promised that it would rise only very slowly. That caused medium term rates to fall, inducing a drop in mortgage rates and a widespread promotion of mortgages with very low temporary teaser rates," he said. [Emphasis added]
First, we learn all over again that bubbles are a fool's paradise. Everybody thinks the party will last last forever, and then it doesn't. Suddenly it's the morning after, hangover time. Which is to say, you mostly can't get something for nothing. Duh. Sure, some people get out in time, but most people don't. It cannot be otherwise, since when people start heading for the exits in droves, that's what pops the bubble. Who's going to buy your seat once the theatre's on fire?
Second, this didn't happen all by itself. The Fed and other banks created massive amounts of money out of thin air in the form of credit — i.e., debt (see this). All that new money created an impression of wealth, but since it didn't correspond to increases in actual wealth — since it was just numbers on paper and on computer hard drives — it was just so much hot air. Monopoly money. Which created all manner of market distortions, prompting people to do all sorts of things they otherwise wouldn't have done — building houses that weren't needed, taking out loans they couldn't afford, and so on. People who took the equity out of their homes and spent it all are going to wake up and find they have negative equity when their home value comes back down to earth. And then they're going to spend years digging their way out of the hole. As will a lot of home builders. A form of slavery, self-induced. And people think the Fed's their friend.