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As they failed to spot the bubble, most economists seem oblivious of the threat of further market falls to come
How many economists does it take to see an $8tn housing bubble?
The answer to that question has to be many more economists than we have in the United States. Very few economists saw or understood the growth of the $8tn housing bubble, whose collapse wrecked the economy. This involved a degree of inexcusable incompetence from the economists at the Treasury, the Fed and other regulatory institutions who had the responsibility for managing the economy and the financial system.
There really was nothing mysterious about the bubble. Nationwide house prices in the United States had just kept even with the overall rate of inflation for 100 years from the mid 1890s to the mid 1990s. Suddenly, house prices began to hugely outpace the overall rate of inflation. By their peak in 2006, house prices had risen by more than 70%, after adjusting for inflation. Remarkably, virtually no US economists paid any attention to this extraordinary movement in the largest market in the world.
Had they bothered, they would have quickly seen that there was no plausible explanation for this jump in prices in either the supply or demand side of the market. There were no major new restrictions on supply, with the builders putting up homes at near record rates. Nothing on the demand side suggested that prices should rise. The healthy income growth of the late 90s was followed by stagnation in the last decade and population growth was relatively subdued. Finally, there was no unusual rise in rents, which just slightly outpaced inflation over this period.
Therefore, it should have been easy for any competent to economist to recognise the housing bubble. Moreover, the dangers for the economy should also have been apparent. The boom in construction (both residential and non-residential) had raised its share of GDP by more than 3 percentage points above its long-term average. In addition, the creation of $8tn in housing bubble wealth predictably led to a consumption boom, as households spent on the basis of the new equity created by the bubble.
All of this presaged disaster for the time after the bubble burst. Construction spending was sure to plummet to below normal levels as the market recovered from the long period of overbuilding. Consumption would also fall back as households adjusted to the disappearance of the housing wealth that they expected to be available to them in future years.
Yet, almost no economists saw what was clearly in front of their eyes. They thought everything was just fine, until the house of cards eventually collapsed in 2007-2008.
Unfortunately, the reign of error is not over.
House prices in the United States are again declining and most of the economics profession remains clueless. The Case-Shiller 20-city house price index for October (the data is released with a two-month lag) showed a decline of 1.3% from September. This implied an acceleration from the prior month's decline, which is now reported as 1.0%. In other words, house prices are again declining at double-digit rates. A more careful examination of the data reveals the underlying logic. Prices are declining most rapidly in the bottom third of the market. Prices for this bottom tier of the market were in freefall in recent months in several cities.
The reason is that a first-time buyers' tax credit ended in June. This credit caused many buyers to move their purchase forward. People who might have otherwise bought in the second half of 2010 or in 2011, instead bought in the first half of 2010.
This tax credit had the effect of ending the plunge in house prices in 2009, and even leading to small rise in the second half of the year. But with the credit now expired, the price decline is resuming. It will likely spread from the bottom tier of the market to the middle and higher end, since the sellers of bottom-tier homes are the buyers of higher-end homes. If they must sell for much lower prices than they had anticipated, then they will have less money to buy these higher-end homes.
The further decline in house prices will have predictable consequences for the economy. If house prices drop by another 15%, completing the deflation of the housing bubble, this would imply a loss of $2.5tn in housing wealth. If consumers spend 6 cents for every dollar of housing wealth (near the middle of the range of estimates), this would mean a fall in consumption of roughly $150bn or 1% of GDP. This will be a substantial drag on growth over the next two years that will, no doubt, surprise most economists.
The other important part of this story is that many more homes will go underwater, and there will be new losses for banks. One result of the delay in this second round of price adjustments, though, is that trillions of dollars of mortgages were taken out of private hands and shifted over to Fannie Mae and Freddie Mac, the mortgage giants currently owned by the government. This means that the losses on these mortgages will be the problem of the taxpayers, not the banks.
Why is no one surprised?
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5 January 2011 2:20PM
The UK will follow the US model, our economists are as useless, as are our banks and our government.
5 January 2011 2:35PM
Many US home owners have their mortgages renegotiated / reset in March.Many will find the banks will so no.Canada New Zealand's and Australia's housing markets are also wobbling.
5 January 2011 2:37PM
"This involved a degree of inexcusable incompetence from the economists at the Treasury, the Fed and other regulatory institutions who had the responsibility for managing the economy and the financial system."
No They Lied, both to the public and themselves.....but then they had 'buy to let' property and connections to wall street as well.
5 January 2011 2:55PM
What never fails to amaze me is the brass neck of many of the economists who got things so badly wrong - many of those are first in line to make portentious comments about policy are the same ones that got things so spectacularly wrong. Here in Ireland, the economics profession (with a handful of honorable exceptions) hugely underestimated the extent of the housing bubble, completely missed the inflow of billions of euro to the banks from elsewhere in the EU, and as late as 2008 were getting their forecasts almost comically wrong. Yet as recently as a few days ago in the Irish Economy blogsite, some well known economists (including one who as recently as 2005 had published a paper advocating the introduction of sub prime mortages to Ireland) had the nerve to criticise the forecasts of climate scientists and metereologist!
One thing I've noticed is that the one subsection of economists who have generally been accurate, have been economic historians, or general economists who have studied past crises in detail. This strongly suggests to me that it is at the modelling and theoretical level that economics has gone so badly wrong.
Its about time that universities started to look very closely at their economics departments to see if they measure up to standards of academic independence that would be considered normal in all science degrees and most humanities. In particular, there should be questions asked over whether it has simply become the norm for economists (including academic economists), to tailor most or all their output to various economic interests. The astonishing inability of economists to spot property bubbles must in some way be connected to the influence of the property and banking industries in supporting 'research'. I know of at least one ex bank economist who freely admitted that his primary role was as a PR person for the bank.
As for the US housing market - its important to note that the long term linkeage of prices to incomes and rents is an average - which means that for every overshoot (bubble), there can well be an equivalent undershoot. So just because house prices have gone back to pre-bubble levels doesn't mean they can't keep going down. Japanese property prices have never come remotely close to their long term values since their bubble burst in 1990.
5 January 2011 2:56PM
slackrabbit
Canada New Zealand's and Australia's housing markets are also wobbling.
And the biggie is China's huge bubble. But of course we're assured by the world of mainstream economists that there will be a soft landing.....
5 January 2011 3:05PM
This effect has caused a dearth of buyers of newly built homes at the lower end of the market, as there are a glut of homes that can be purchased from banks, mortgage companies and servicers, and HUD for 40%-70% of the cost of an otherwise identival new home down the street.
An example: We have a ten year old subdivision of homes that sold new for from $135,000 - $200,000+. The model home for that subdivision, a four bedroom, two and a half bath home in the middle of the price range but with all the options sold originally for $180,000. At the beginning of last year, the home was sold at foreclosure auction for $106.000. By the end of the year, an identical model lacking a few of the high end options was sold by a bank for $80,000.
The builder had purchased fallow farm land, put in streets and utilities, and anticipated building hundreds of new homes on the property and adjacent land over twenty years. The improvements were funded by the company and by a large bank. When the new homes stopped selling and the cash flow ended, the builder went into negative equity and was purchased by a shareholder group at a substantial discount over its previous value. They divested themselves of much of their developed land in an effort to reduce debt, and they sold the subdivision land to another developer at a loss.
The new builder built a fair number of speculative homes, hoping to capitalize on a rebounding home market with rather large but cheaply constructed homes in the same price range as the original subdivision sold at ten years ago. They were able to this because they were not burdened by the up-front costs of developing the building lots and infrastructure.
Unfortunately, the market has not yet bottomed out, and a few similar houses in the area have been unloaded by lenders for as low as $40,000, with one that needed a great deal of maintenance selling for $22,000. This has sharply reduced demand for the new homes, as the current house market in this zip code has been essentially been reduced to transfers among family members, short sales, HUD houses and foreclosures. The prices generated are far below the actual costs of the new spec homes, many of which have sat empty now for over a year.
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