Resident Fellow Desmond Lachman
At this August's Jackson Hole gathering of the world's leading central bankers, Ed Leamer presented a compelling paper emphasizing the close link in the United States between the housing market cycle and the overall economic cycle. He found that major falls in home building immediately preceded eight of the 10 postwar US recessions. The only two exceptions were those cases where major wars in Korea and Vietnam provided the economy with strong offsetting economic stimulus.
The risk that the present US housing market downturn precipitates a recession is heightened by the very severity of that downturn. Following their spectacular 80 percent run-up in inflation adjusted terms between 2000 and 2006, US home prices are now declining on a sustained basis for the first time in over seventy years. And there is every reason to expect that US home prices will continue to fall at an accelerating pace over the next year or two as a host of negative forces come into play.
Goldman Sachs is forecasting that home prices will decline by between 15 and 30 percent over the next few years.
Among the more important factors likely to drive down US home prices is the abrupt contraction in sub-prime and Alt-A mortgage lending, which between them accounted for as much as 40 percent of overall mortgage lending in 2006. It will do so as the badly burnt sub-prime mortgage originators continue to rapidly exit this market. Further compounding the housing market's woes will be the prospective resetting of an increased volume of Adjustable Rate Mortgages at higher interest rates, the belated regulatory tightening in mortgage lending standards, and the return to an already saturated market of an ever-increasing volume of foreclosed properties.
The housing market's gloomy fundamentals are now leading many economic analysts to expect that home prices will fall for a prolonged period of time. Goldman Sachs is forecasting that home prices will decline by between 15 and 30 percent over the next few years. For its part, the futures market in the Schiller-Case home price index is now implying that home prices in most US metropolitan areas will be experiencing cumulative double digit percentage declines over the next two years.
The Wall Street optimists minimize the present housing market woes by emphasizing that residential construction accounts for less than 5 percent of the overall US economy. They go on to assert that even were there to be a severe housing market downturn, resilience in the rest of the US economy would prevent it from tipping into recession. In so doing, not only do they ignore the strong historical link between US housing market busts and overall economic recessions. Rather, they also overlook two crucial factors that this time around make the US economy even more vulnerable to a housing market bust than is normally the case.
The first point overlooked is the extraordinary boost that US consumption, which accounts for no less than 70 percent of the overall US economy, has received from home equity extraction over the past five years. Such mortgage equity withdrawal has allowed US households to keep consuming at a faster pace than their income was rising. With home prices now falling, the mortgage equity withdrawal spigot to consumption is rapidly being turned off. Indeed, already by the middle of this year, mortgage equity withdrawal had dwindled to an annual rate of US$150 billion, down sharply from US$700 billion in 2006. And it must be expected to fall further as home values fall below the amount of debt taken out on homes.
The Wall Street optimists also overlook the likely negative impact that falling home prices will have on the credit crunch already so clearly in evidence. At the heart of the credit crunch are fears about mortgage lending losses that are embedded in complex financial structures. Surely one should expect those fears to be intensified as it becomes increasingly apparent that home prices will not be stabilizing anytime soon and that financial-system losses from mortgage lending are likely to be at least double the Federal Reserve's present US$100 billion estimate.
If the US economy is now indeed slipping into recession, this will not be the first time that the stock market continued rallying at the onset of a recession. Such were the cases in both the 1980 and 2001 recessions. Which all has to raise the basic question as to what might stock market investors have learnt from the past?
Desmond Lachman is a resident fellow at AEI.