May 30, 2007
Dean Baker
The Hankyoreh (South Korea), May 30, 2007
See article on original website
Back in February, former Federal Reserve Board Chairman Alan Greenspan put the odds that the U.S. economy would fall into a recession in 2007 as one in three. He may want to raise those odds.
While the stock market has been booming, this seems to be primarily the result of the sort of irrational exuberance that infects people who speculate on stock markets at regular intervals. Many investors are fishing for the next big company that will be bought out by a private equity firm, they are not looking at the prospect for long-term profits. Those who do care about future profits would probably not keep their money in the stock market. The United States Congressional Budget Office projects that, after adjusting for inflation, corporate profits will be 5 percent lower in ten years than they are today. That is not the sort of forecast that ordinarily leads to a booming stock market.
But the stock market generally has little relationship to the real economy in any case. The more important issue is what happens to growth in jobs, wages, and spending. Here the picture looks especially bleak. Since the recession in 2001, the U.S. economy has been largely sustained by an unprecedented run up in housing prices. After adjusting for inflation, house prices are more than 70 percent higher today than they were in the mid-nineties. Over the prior 100 years, house prices in the United States had just kept even with the overall rate of inflation.
This run-up in house prices spurred the economy both by boosting construction and sales of homes and also by creating a massive pool of wealth that fueled consumption. At its peak in 2005, the rate of housing construction was nearly double the rate of a decade earlier. The same was true of sales of existing homes. The growth in the housing sector between 2001 and 2006 directly added more than 1 million jobs to the economy.
However, the indirect effect on consumption was even more important. The housing bubble created $7 trillion in housing bubble wealth. This has spurred a massive wave of consumption as homeowners quickly borrowed against the new home equity created by the bubble. The explosion of consumption pushed the U.S. savings rate into negative territory for the first time since 1932-1933, the early years of the Great Depression.
However, the bubble is now starting to deflate. The boom in construction lead to a massive oversupply of housing, with inventories and vacancy rates now at record levels. House prices are now falling in many areas of the country. Consumers are rapidly losing the ability to borrow against equity in their home, as the drop in prices is eliminating much of the equity that they had. This decline in prices has also lead to a rapid rise in mortgage default rates.
The weakness in the housing sector is now spreading to the rest of the economy. Non-residential investment has been virtually flat the last two quarters and many state governments are now cutting back, since declining house prices has meant declining property tax revenue. Consumption alone has continued to grow at a healthy pace, keeping the economy moving forward in the last three quarters.
But consumption may now be slowing as well. Reported job growth has been extremely weak in the last few months, and wages have not even kept pace with inflation. Workers have been especially hard hit by a large jump in gasoline prices that has taken tens of billions of dollars out of workers pockets. The government’s data showed that retail sales declined in April, even before adjusting for inflation. With gas prices rising still further in May, it seems unlikely that there will be any rebound in consumption this month.
In short, the housing driven recovery may finally have run our of steam. No one expected the extraordinary pace of housing construction and sales of 2002-2005 to persist, but in order to sustain growth as housing weakened, there had to be some other source of demand, presumably investment or net exports, that would fill the gap. At present, these sectors are providing very little help, as both have been nearly flat in the last two quarters.
The rise in gas prices is just the final straw that is likely to push the economy into a recession this year. In the months ahead job growth is likely to stop altogether, setting the economy on the classic downward recession spiral in which declining employment leads to falling wage income, which in turn causes further declines in consumption and therefore more job loss. This recession will have the unusual feature that the weakness in the job market will likely have a direct impact on house sales and bubble inflated house prices, leading to further declines in consumption.
It is way too early to know how long this process will take to unravel and when the U.S. economy will get back on a healthy growth path. However, at this point, the immediate future of the U.S. economy does not look very good.
