Three Neglected Economic Issues and the State of the Economy

Dean Baker

July 1, 2004

1) The Housing Bubble

1) For the first time in the post-war period there has been a sustained increase in housing prices in excess of inflation. Since 1995, home sale prices have risen by more than 34.0 percent after adjusting for inflation.

2) Rents and home sale prices have always moved closely together. If fundamental factors are leading to an increased demand for housing, then they should also be pushing up rental prices. Instead, rental prices are now falling in real terms.

3) The run-up in home prices is leading construction to far outpace demand. Last year, the country added approximately 2 million new housing units. The number of vacant units increased by 750,000. This is mostly affecting the rental market at present. Eventually, it will affect the home sale market.

4) There is approximately $3.8 trillion in housing bubble wealth (@ $13,000 per person) which could disappear if home sale prices fall back in line with their historic pattern. This will almost certainly lead to a recession.

Source: BLS, BEA, OFHEO and Author's calculations.

Home prices typically track inflation - only in the last eight years have they substantially outpaced inflation.

2) The Trade Deficit and the Foreign Debt

1) The trade deficit hit yet another record in April and is now running at an annual pace of almost $600 billion.

2) Deficits of this size can only be financed by selling off an ever larger amount of U.S. financial assets to foreigners, which implies that future interest payments and profits leave the country.

3) At present, foreign central banks (primarily Japan and China) are financing the trade deficit by purchasing more than $400 billion a year in dollardenominated assets.

4) Eventually they will stop buying dollar-denominated assets. This will lead the dollar to fall until the trade deficit moves to a sustainable level (a 20 to 30 percent decline in the dollar). This will lead to higher inflation and lower living standards.


Source: BEA, Board of Governors of the Federal Reserve Board and author's calculations.

If the trade deficit remains at its current share of GDP, net foreign indebtedness will exceed the value of either corporate equities or the housing stock in less than 20 years.

3) Prescription Drug Prices

1) Prescription drug costs have been rising at a rate in excess of 10 percent annually, and are projected to continue to do so by both the Congressional Budget Office and the Centers for Medicare and Medicaid Service.

2) At this rate of growth, prescription drugs will be unaffordable for seniors, even with the new prescription drug benefit. In fact, seniors will be paying more for drugs (after adjusting for inflation) in 2006 with the benefit, than they did in 2000 without the benefit.

3) If the projected growth path for prescription drug spending proves accurate, then it would take at least $100 billion a year in excess of what is already committed under the prescription drug bill to make prescription drugs affordable to seniors.

4) If the government allows large-scale drug importation from Canada or other countries, then it will have to decide how it guides research priorities. (Drug prices will determine priorities.)


Source: Congressional Budget Office and author's calculations.

Even with the prescription drug benefit in place, drug costs will average more than $3,000 per person by 2014, if drug costs continue to rise at their projected pace.

The State of the Economy in 2004

After three years of job loss, a slump unprecedented in the post-war period, the economy is again adding jobs at a healthy pace. This recent job growth is encouraging, but it is not extraordinary compared with the recent past. Several years of such growth will be needed to make up for a long job drought.

Source: Bureau of Labor Statistics.

The current situation with wage growth is less positive. Real wages were growing at a healthy pace in the late nineties for the first time in twenty years. Wage growth gradually slowed as unemployment rose with the recession. With the upturn in inflation in recent months, real wages are now falling.