Wrong Then, Wrong Again

May 13, 2008

Dean Baker
The Guardian Unlimited, May 12, 2008

See article on original website

The same economists who failed to spot this year’s financial meltdown are now predicting that everything will soon be fine.

The economists are telling us that everything is going to be fine. It seems that the worst is behind us. The credit crunch is over, the tax rebate cheques are in the mail, the dollar will stop falling, and the economy is now expected to pick up in the second half of the year. That is what most economists have been saying.

Of course all the economists saying this completely missed the $8tn housing bubble and most of them probably missed the $10tn stock bubble also. In other words, knowledge of the economy is not the strong suit of the expert economists who are telling us that the economy will be fine.

Here is why they are wrong, yet again. The housing market is currently in a free fall. The latest data from the Case-Shiller 20 city house price index show real prices falling at an almost 30% annual rate. This rate of price decline implies a loss of almost $6tn of housing wealth by the end of the year – that’s $80,000 for every homeowner in the country.

This stunning loss of wealth has two important implications for the near-term course of the US economy. First, consumption is certain to decline. For the vast majority of families, their house is their main source of wealth. Tens of millions of baby boomers are approaching retirement without a traditional pension and very little money accumulated in personal savings or a defined contribution pension. The one source of wealth that these people had been counting on in retirement, in addition to their Social Security, was the equity in their home.

This wealth is now disappearing with the collapse of the housing bubble. As baby boomers see the price of their homes drop from $400,000 to $300,000, a typical decline in many areas, they will suddenly find themselves with little or no equity. If they hope to have anything other than Social Security to sustain them in retirement, they will have to hugely increase their savings during their remaining working years.

In many cases the loss of equity will more directly lead to an increase in savings because it will prevent homeowners from borrowing any further against their home. At the peak of the bubble in 2006, homeowners withdrew more than $700bn in equity from their homes. As house prices plunge, tens of millions of homeowners will no longer have any equity against which to borrow. This will leave them no choice except cutting back their consumption.

Standard measures of the size of the wealth effect from housing imply that a loss of $6tn in wealth will reduce annual consumption by between $240bn to $360bn a year, between 2%-3% of GDP. This sort of plunge in consumption would imply a severe recession.

The other important effect of plunging house prices is an inevitable surge in default rates. For some bizarre reason, many economists continue to think that the mortgage crisis was caused by adjustable rate mortgages resetting to higher interest rates. While a reset could often be a trigger event forcing families to default, the underlying problem was that house prices had fallen so that people no longer had any equity in their homes.

Homeowners don’t default on homes in which they have equity. They will either borrow against the equity to make their payments or they will sell the home and put money in their pocket. As house prices continue to fall, the number of homeowners with no equity will soar.

Even more importantly, many homeowners will find themselves deeper underwater making default a much more attractive mortgage. If you like your home, it may be worth paying off a $400,000 mortgage on a house that is currently worth $380,000. This sounds like a much worse deal if the mortgage is $400,000, but the home is worth $250,000, as will be the case in many of the former bubble markets.

This means that the default rates will surely be heading upward in the months ahead as will the write-off that banks will take on these mortgages. The $250bn or so that has already been written off by the banks is just a down-payment, the big hits are yet to come.

Of course, the economists who most of the media rely upon to inform the public don’t see any of these problems ahead, just as they didn’t see any problems ahead at this time last year. But those of us who learned our grade school arithmetic know that we can look forward to serious economic and financial troubles ahead.


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 (www.conservativenannystate.org). 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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