The Bursting of the Housing Bubble and the Coming Recession

August 17, 2006

Dean Baker
Truthout, August 17, 2006

See article on original website

Every day presents new evidence that the housing boom is turning into a housing bust. In the last week we have seen data showing that house sale prices are down from last year’s levels in 26 major metropolitan areas, housing starts are down more than 15 percent from their bubble peaks, and applications for home purchase mortgages have dropped by more than 20 percent. A new poll of builders showed industry confidence at the lowest level since the middle of 1990-1991 recession.

At this point there is little doubt that the housing market is headed downward. The question is how low will it go and what will be the impact on the economy. If housing construction and sales prices revert to long-term trends, the decline will be severe, as will be the impact on the economy.

Over most of the post-World War II era, house prices have moved largely in step with other prices, keeping just about even with the overall rate of inflation. In the last decade, house prices suddenly exploded, increasing by more than 50 percent, after adjusting for inflation. This unprecedented run-up in house prices led to record levels of housing construction. The number of homes built in 2005 was almost 50 percent higher than it had been a decade earlier. This huge construction boom was a key factor in pulling the economy out of the recession.

The wealth created by the housing bubble also played a central role in propelling the economy. The run-up in housing prices has created more than $5 trillion in bubble wealth. Consumers have borrowed against this new wealth at a feverish pace, pulling more than $600 billion out of their homes in the last year. This borrowing fueled the consumption boom of the last five years, pushing savings into negative territory for the first time since the beginning of the depression.

Of course, just like the stock bubble, the housing bubble could not be sustained. In the stock bubble, the supply of new issues of tech stocks eventually exceeded the demand from speculators. Similarly, the record levels of housing construction inevitably led to a glut of housing on the market. For a long time, speculators were willing to buy up anything that was built, but eventually the supply of speculators, or the supply of money to the speculators, reached a limit. Once they stopped buying, inventories began to grow, and the price boom came to an end.

There are desperate sellers in many of the areas where the housing market was booming just a year ago. In many cases, sellers are offering large concessions to unload their homes, such as paying buyers’ closing costs, covering a year of condo fees, or offering lower than market mortgage rates. Since these concessions (which lower the real sale price) don’t show up in the house price indexes used by economists, the decline in housing prices so far is actually considerably larger than most analysts recognize.

How far and fast prices will fall is difficult to know at this point, but a few things are predictable. Housing construction and sales will drop back toward trend level. Housing construction is already down by 15 percent from its peak. It is likely to fall at least this much more before stabilizing. Sales of existing homes, which are the life-blood of the real estate industry, are also likely to fall by 30-40 percent from peak levels.

In addition, the borrowing spree of the last five years is likely to come to an abrupt end as stagnant or declining home prices cut off this important source of credit. There is evidence that we are already seeing the effects of this credit squeeze, as credit card debt has begun to soar in the last few months. Families who can’t get the money they need by borrowing against their homes will turn to credit cards as the best available alternative.

This does not paint a pretty picture for the economy. If housing construction and sales fall back to trend levels, it would mean a loss of more than 2 million jobs. The decline in consumption that will result because people can no longer borrow against their homes will have an even more dramatic impact on the economy. The financial system will also be shaken by an unprecedented wave of mortgage defaults.

Unfortunately, at this point there is no obvious way to avoid this scenario. The real problem was letting the housing bubble grow to such dangerous levels in the first place. The Federal Reserve Board, along with the economics profession, deserves to pay a serious price for such a momentous mistake.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer. He also has a blog, “Beat the Press,” where he discusses the media’s coverage of economic issues. You can find it at the American Prospect’s web site.

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