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Home Publications Blogs Beat the Press Housing and the Downturn: It's Really Not That Complicated

Housing and the Downturn: It's Really Not That Complicated

Tuesday, 01 July 2014 09:34

Neil Irwin has a piece noting housing's importance in the downturn, which gets things half right. First, housing is typically important in economic cycles, as he says, but the picture is quite different than Irwin implies.

In a typical recession housing construction falls because it is very sensitive to interest rates. Most recessions are brought on by the Fed raising interest rates to slow the economy. In these cases the decline in housing is a deliberate outcome of Fed policy, not an accidental outcome to be avoided.

In contrast, the most recent downturn was brought on by a collapse of a housing bubble. This made it qualitatively different from most prior downturns (the 2001 recession was also bubble induced) in several different ways.

First, construction was proceeding at an extraordinary rate of more than 6.0 percent of GDP before the collapse, compared to an average rate of just over 4.0 percent of GDP. This meant that housing contracted far more than it would in a typical downturn. Furthermore, because of the overbuilding of the bubble years, housing fell further than normal, hitting levels just above 2.0 percent of GDP. And, because the downturn was not brought on by a rise of interest rates it could not be reversed by a drop in interest rates.

There really should not have been much mystery about housing being in a bubble. There was a huge unprecedented run-up in house prices that broke with a century long trend in which nationwide house prices had just kept pace with the overall rate of inflation. There was no plausible basis in the fundamentals of the housing market for this run-up, with income and population growth both relatively weak. And, rent just kept pace with inflation during the bubble years.

The effect of the bubble on consumption was also predictable. The bubble created trillions of dollars of ephemeral housing wealth. This led to a surge in consumption due to the housing wealth effect, pushing the savings rate to record lows. When the bubble burst, consumption fell as the housing wealth disappeared, but the saving rate is in fact still relatively low, contrary to what is often asserted in the media. There is no reason that we should expect people to be consuming a larger share of their income than is currently the case. The only mystery about the current state of the economy is why anyone would see any mystery






Comments (6)Add Comment
private debt
written by joe, July 01, 2014 12:27
The private sector was spending more than its income, running up debt. That went in reverse in 2008. Yes, there was a bubble, yes a surge in consumption. But it's a deleveraging story, a story of private debt accelerating for decades. The housing bubble is just the proximate cause.
private debt
written by Squeezed Turnip, July 01, 2014 1:16
joe, private debt was high in the 80's followed by a deleveraging to about normal levels. The next wave went from the 1990s to the bubble pop, and was funded mostly by home equity loans (also a culprit in the 1980's). But it not just a deleveraging story, though principally so. It was also a story of liberalization of finance and the privitization of governance. We all know corporate governance is in need of reform, as most decisions are now made where workers, and their public representatives, have no say in the decision making process (which is what I hate most about the Hobby Lobby ruling).

The point
written by Squeezed Turnip, July 01, 2014 1:22
The housing bubble allowed people to take out home equity loans above their pay grade, so yes the housing bubble is fore and center, since it made possible the the escalation in private debt.
Who Could Have Known? What Could Rental Prices Possibly Have to Do With It?
written by Last Mover, July 01, 2014 1:58
And, rent just kept pace with inflation during the bubble years.

This was key, clear evidence the bubble existed early on, casually ignored by the mainstream.

It is an axiom of economics that present value of an asset rented must equal present value of the same asset sold, ceteris paribus. If not, forward prices in the markets are diverging that violate the axiom.

Why would owners of houses deprive themselves of higher rental income consistent with higher sale prices? They wouldn't unless there was a bubble. If rental prices went up owners would pay more to own them and collect the higher rent.

With a bubble owners knew they could sell houses to other owners at higher prices without raising the rent. Given overbuilt houses and high vacancy rates owners kept the rent down to keep them occupied.

The bubble could not reflect itself in the rental market because there were too many houses chasing too few renters. Owners of otherwise vacant houses knew they would remain vacant unless they met the competitive rental rate - a rate that excluded the bubble value of the house.

But most economists, the FIRE sector and key policy makers like Greenspan never pointed to the violated axiom otherwise held sacred in all transactions between buyers and sellers involving assets that can be rented.

And to rub it in, note how rental rates are increasing now, especially in areas where the very predators who fueled the bubble bought blighted houses en masse to refurbish, rent them and cash out to sell them to new owners who will continue the high rents.

Who could have known rental rates were out of sync with selling prices that drove the bubble? Of course it could not have been the same ones who know exactly the value of rising rental rates and sale prices today.

Otherwise one would have to conclude the same players who evolved through a period of gross incompetence as economic winners ... have evolved further into all-knowing economic geniuses as winners as well.
Where's the outrage
written by Dave, July 01, 2014 11:35
Yes, personal savings dropped, but somehow the level of savings in deposit accounts skyrocketed. Who was depositing this money? Investors that were keyed into the scam coordinated with German banks! Where's the outrage?

But I disagree that the bust wasn't brought on by a rise in interest rates. It was. Bernanke raised rates very quickly, which started the bust cycle. The underlying cause of collapse was the inherent instability of the derivative markets, but the pin prick was a rise in rates.
Revolving home equity loans and private debt
written by Squeezed Turnip, July 02, 2014 9:48
I present the following evidence as an addendum to my remarks concerning the fueling of private debt by inflated home values.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.