Housing Crash: Why a 'Soft Landing' is Unlikely

If you are like most Americans, you are probably wondering what the hell is going on with the economy. Good question. Since July, when the credit crunch hit, caused by the collapse of all those suddenly not-so-good mortgage-backed securities - often referred to as the "sub-prime" crisis - there have been a lot of pessimistic stories in the business press. The London Financial Times was running front page headlines like "Gloom Envelops World Markets" (November 9) with alarming regularity. The stock market (as measured by the Dow) officially had a "correction," defined as a dip of ten percent or more, between October 9 and November 26.

Of course the stock market is not the economy, as much as the TV news makes us think it is. Nearly half the people in this country don't own any stocks, even in retirement accounts. And most of what is owned by the other half belongs to a fraction of those owners. Not only that, but the stock market can go up because of factors that don't help and that possibly hurt the majority of people: when there is a speculative bubble (as in the 1990s) or because profits are growing relative to wages and salaries.

Still, it is one indicator of what investors think, and in the last two weeks the stock market has been rebounding. It appears that many forecasters and investors think that we can avoid a recession altogether, despite the bursting of an enormous housing bubble and the associated freezing up in credit markets. Some even think that the housing slump may have bottomed out. This would all be great news if it were true, since a recession is a very painful event in which millions of people lose their jobs and many other bad things happen.

However, a "soft landing" doesn't seem likely. Aside from the problems in the financial system and credit markets - which do not seem to have passed -- there is the problem of falling home prices. Just as the fantasy-based prices of the late 1990s stock market were much broader than a "tech bubble," this is not just a "sub-prime" problem. In fact, foreclosure rates on prime mortgages - borrowers with good credit - are now hitting the level of sub-prime borrowers three years ago. From 1995-2006, house prices nationally rose by 70 percent more than inflation. To get an idea of how big a bubble this created, consider that they hardly rose at all, adjusted for inflation, for the previous 45 years. This indicates that some 4 to 8 trillion dollars in bubble wealth was created - comparable in size, at the upper end, to the stock market bubble.

When the stock market bubble began to burst in 2000, it caused a recession in 2001. The housing bubble began to burst last year, but there is still quite a bit more to go. House prices year-over-year are only down about five percent from their peak in July 2006. That is bad - the worst since the Great Depression -- but most likely just a first installment on what's to come, given the unprecedented price explosion of the last decade. The price declines will further constrain consumer spending, which accounts for about 70 percent of the economy. Remember that this current economic recovery, now six years old, has been driven primarily by consumers borrowing on the rising value of their homes, and spending this cash. The big increase in residential construction, as well as the real estate and related sectors, also kicked in. All of these factors - plus the credit crunch - are now working in reverse.

The economy (GDP) has been slowing through last year and into the beginning of this year (0.6 percent annualized growth for the first quarter). Then, in the last two quarters growth picked up (3.8 and 4.9 percent). A big chunk of this growth (about a third) was net exports. This is the result of a 24 percent drop in the value of the dollar (against the currencies of our trading partners) since its peak in early 2002, making U.S. exports more competitive in the world economy. Business investment (especially in structures) as well as government spending and a rise in inventories also contributed to the last six months of growth, making up for relatively weak consumer spending and falling residential construction.