Housing Crash: Why a 'Soft Landing' is Unlikely
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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.
It is difficult to see how these trends can continue to keep the economy afloat. Consumers can only borrow so much on their credit cards -- and with incomes stagnant, a weakening labor market, and falling house prices, it's hard to see how consumers can spend enough to head off a recession. Businesses are not going to keep increasing their fixed investment in the face of economic weakness and low consumer confidence. And local governments will be hit by falling property tax revenues.
President Bush's plan this week to freeze the interest rates on some subprime mortgages would affect an estimated 12 percent of these borrowers- not enough to make a big dent in the fallout from the housing crash.
The Federal Reserve, after being repeatedly surprised by the impact of the bursting housing bubble, now appears sufficiently scared of a serious downturn to settle into an interest-rate-cutting mode. Although from their "why worry about employment or wages?" point of view, it is a painful choice, since they know that the lower dollar, even if it were to fall no further, is going to add to inflation - their real enemy. But their interest rate cuts may not do the trick, for a number of reasons.
One is that the Fed controls only short-term rates, and the long-term rate now depends heavily on the demand for 10-year U.S. Treasury bonds from other Central Banks such as that of China, Russia, and other oil-producing or trade-surplus countries. These central banks could at any time reduce their accumulation of Treasury bonds and thus send long-term rates upward. Also, even if long-term rates can be kept low (as they are now), it is not going to have anything like the effect that it did a few years ago on consumers' home-buying, mortgage refinancing, borrowing or spending, under current conditions.
It's too early to tell how bad things will get before they start to get better. But those who are involved in the politics of the coming election year might want to start thinking about the kinds of solutions they want their government to implement. Otherwise, we may end up with more "throwing money at problems" - more tax cuts for upper-income taxpayers, more wasteful military spending, or other vices.