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The Progressive Economics Forum

Bubble trouble

Dean Baker has a gloomy take on the impact of the housing bubble bursting:

After the Housing Bubble Bursts
By Dean Baker
t r u t h o u t | Perspective

Tuesday 24 October 2006

Every new release of data on the housing market provides more evidence that the housing bubble is finally bursting. Compared with year-ago levels, nationwide housing starts are down 18 percent, sales of existing homes are down 13 percent, and new homes sales are down 17 percent. Inventories of both unsold new and existing homes are at record levels. Prices have already begun to fall in many parts of the country, and seem certain to fall much further before the market stabilizes.

The housing downturn will almost certainly lead to a recession, and most likely a severe recession. Housing construction and sales directly account for more than 6 percent of GDP. In the recessions in the mid 70s and early 80s, housing fell off by close to 50 percent. However, the impact of a downturn in housing is likely to be more severe this time around. House prices had not gotten so out of line with fundamentals in these earlier periods, nor had housing wealth fed so directly into consumption.

Homeowners have been borrowing more than $700 billion a year from the equity in their houses. This borrowing has pushed the savings rate into negative territory for the first time since the beginning of the Great Depression. As a result of this massive borrowing, the ratio of mortgage debt to home values has never been higher. With home prices falling, millions of homeowners will soon lose the ability to borrow against their homes. This will force people to curtail their consumption. It many cases, it will cause people to lose their homes, as they will not be able to maintain their mortgage payments.

The economic picture over the next couple of years is likely to be one of rapidly falling house prices, rising default and bankruptcy rates, which will be associated with job loss and sharply higher unemployment. The soundness of banks and other financial institutions that are heavily dependent on mortgage debt may be jeopardized. This is not a pretty picture.

Not many economists are projecting this sort of dark future. Economists never seem to project anything other than clear skies, even when the clouds are right upon them. In the fall of 2000, six months after the stock market crash and just a few months before the beginning of the last recession, not one of the “Blue Chip” 50 economic forecasters saw a recession on the horizon. In fact, the most pessimistic forecast for the next year was that the economy would grow at a modest, but respectable, 2.2 percent pace.

The downturn following the collapse of the housing bubble is likely to be far more severe than the downturn from the stock bubble. Housing wealth is far more evenly distributed than stock wealth – most middle class families own a home, relatively few have any significant wealth in the stock market. The other reason that the collapse of the housing bubble is likely to have more severe consequences is that there is not likely to be another bubble to inflate to pull the economy out of the downturn. The Federal Reserve Board relied on the booming housing market to lift the economy in 2002-2003 when it otherwise would have been stuck in the water. There is not another obvious asset category that could play the same role in the wake of a collapse of the housing bubble.

If the pain of a housing crash is unavoidable at this point, it is important to at least do some accurate scorekeeping. The fact that the housing market was experiencing an unsustainable bubble should have been apparent to any competent analyst. House prices nationwide (there are always large regional differences) had always tracked the overall inflation rate. In the years since 1997, house prices rose by more than 50 percent after adjusting for inflation. No one had any remotely serious explanation for a fundamental supply or demand factor that could explain this run-up in prices, leaving a speculative bubble as the only plausible story.

For whatever reason, the vast majority of economists and policy analysts devoted their attention to far less important issues. The analysts who did focus on housing insisted that there was no bubble, with very few exceptions. As a result, there were no warnings; in fact, many homebuyers were urged into this inflated market, sometimes with a big push from the government, or even non-profits trying to promote wealth building.

Tens of millions of families bought homes at bubble inflated prices and now face the prospect of seeing their life savings disappear in the housing crash. We may not be able to get these people’s money back, but we should at least be clear on who sent them down the wrong path. Hopefully, the economists, bankers, realtors and other bubble proponents will not be in a position to wreck economic havoc yet again.

My sense is that Canada is not in as deep trouble as the US in terms of a housing market correction. While prices are sky-high in Vancouver, which worries me a lot, price increases in the rest of the country do not appear to have surged as much as in the US. Cheap money has largely been limited to lower interest rates (though the punch bowl disappeared from the table with Bank of Canada rate increases earlier this year), whereas in the US they have been accompanied by innovations like negative amortization and interest-only mortgages.

Compounding it all is that US consumers are spending way more than they are taking in, reflected in the truly massive current account deficit that many economists fear could itself be ripe for a correction. A major devaluation of the US dollar would be another big shock to absorb, though a lot depends on Asian central banks’ willingness to prop up the dollar. A smooth transition would be nice but adjustments never seem to be that orderly in financial markets.

That all said, even if Canadian government budgets and current account are in surplus and our housing situation is not as bad, the impact of a US downturn on Canadian fortunes cannot be overstated. If everything breaks our way, a Canadian downturn will be softer than in the US, as was the case in 2001, but this could just be a matter of relativity. If things get ugly in the US, we are not very insulated up here in the Great White North. Hold onto your hats.

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