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Home Publications Blogs Beat the Press Real Estate Prices Have to Fall So That They Can Then Rise and Boost the Economy

Real Estate Prices Have to Fall So That They Can Then Rise and Boost the Economy

Friday, 05 November 2010 05:20

That seems to be the argument in a Washington Post column by David M. Smirk. I'm not kidding, here is the essence of the argument laid out in the 3rd and 4th paragraph of the piece:

"A more compelling theory [than inadequate stimulus] is that global assets remain overvalued. Specifically, the price of real estate debt and sovereign debt on bank balance sheets, propped up by government actions, remains too high. The economy can't gain traction until these prices reflect realistic valuations.

Asset prices are important because America has never had a recovery without residential housing leading the way. Real estate values are still high by historic standards. The value of all real estate is roughly $18 trillion, with mortgage debt about $10 trillion. The ratio of mortgage debt to GDP value is 56 percent. In the 1960s and 1970s, the ratio was 29 percent. In the late 1990s it was only 38 percent."

Smirk is right that real estate is still over-valued, but it is hard to understand how a decline in real estate prices will boost the economy. What matters for a residential housing lead recovery is the need for residential housing. This results from excess demand for housing. We have record levels of vacant housing in the country right now. We will have to see quite a drop in housing prices in order to fully absorb the existing supply.

This gets back to the mortgage debt part of the story which has nothing to do with current real estate values, but rather with their past values. Of course the mortgage debt to GDP ratio is too high, that is what happens when you have a housing bubble. People borrow against inflated housing values. Unfortunately, the Washington Post did not have room for columns from people making this point in the years from 2002-2006 when the housing bubble was growing.

It is not clear how Smirk thinks that a drop in housing prices helps this picture. This will worsen the debt burden of homeowners, leaving them with less wealth thereby further reducing consumption. The decline in house prices must happen (we can't sustain bubble-inflated prices indefinitely), but it makes the immediate economic situation worse, not better.

In the real world, this recovery cannot be led by housing construction because this is not the traditional sort of recession. The normal recession comes about because the Fed raises interest rates to slow the economy. This leads to a plunge in housing construction creating pent-up demand. When the Fed decides to take its foot off the brakes and get the economy going again it just lowers interest rates, triggers the pent-up demand for housing and the economy takes off.

This recession was the result of the collapse of a housing bubble which led to a huge excess supply of housing. Interest rates are also just about as low as they can possibly be, taking away the option of further declines by simple Fed actions.

Apparently Smirk and the Post failed to notice the difference between this recession and prior downturns. Therefore we get this attack on Obama and Paul Krugman that is incoherent in just about every way.

Comments (8)Add Comment
the green tea revolution
written by frankenduf, November 05, 2010 8:22
or, just pick up a history book to figure the way out of the great recession- massive government demand to create jobs to kickstart a middle-class backed recovery- obama even ran on this policy, the 'green jobs revolution', where the win-win of a massive federal jobs stimulus is recovery and advancing our green infrastructure/technology which will pay dividends for future generations- the dems deserved to lose, as they betrayed their voters by not following thru, and giving us a likely Japan style 10y recession, unless the ubercorrupt repubs give us a 12y one
written by coriolis, November 05, 2010 8:48
Dr. Baker,
There is a typo. The stenographer's name is David M. Smick. The typo makes it look as if you are resorting to name calling, which is beneath a man of your standing. Besides, David Smirk is David Brooks nickname.
written by skeptonomist, November 05, 2010 9:03
The last two recessions, 1991 and 2001, were not the result of the Fed raising interest rates and choking housing, they were the result of financial overreach, and so was the Great Depression. True, the Fed probably did cause recessions in the 70's and 80's when it tried and failed to stop inflation, but this may not be a good way to define "normal". Somehow the economy got along pretty well from WW II to the late 60's when the Fed generally refrained from fooling around with interest rates - there was actually a substantial housing boom after the war which did not result in a huge bubble.
written by Matt, November 05, 2010 9:52
Actually, a drop in RE (land) prices presumably would help the economy. That "wealth" doesn't exist anyways, as we all know the properties are over-valued. When the prices fall, people will be able to get housing for less, and businesses will be able to get office space for less.

Dean, you seem to be making the all-too-common mistake of considering only the property owner's perspective, and not the potential property user's. Property owners may lose "wealth" but others will gain it.
Smick's Overpriced Assets - Supply Always Creates Demand
written by izzatzo, November 05, 2010 10:42
Smirk (sic) is right that real estate is still over-valued, but it is hard to understand how a decline in real estate prices will boost the economy.

While Baker and Smick agree even down to the point that government should allow house prices to fall further to market value, the difference is how they treat wealth. Baker says it drove down aggregate demand into a recession, while Smick claims that the same current overvalued assets will restore aggregate demand by virtue of their falling prices.

Smick argues in effect that the past high price of houses was like the high price of oil, which "caused" the recession and the only cure is a corresponding price reduction. This eliminates the wealth effect from the housing bubble at the outset, by setting up overpriced housing with any other asset, like oil, as simply overpriced independent of wealth, i.e., overpriced oil was not considered an "asset bubble".

The overhang of excess debt in the housing sector is not necessary for Smick's argument - that overpriced assets must come down for economic recovery. It's included in order to blame the government for not allowing lower house prices to extract from underwater homeowners, their full due amount of book value loaned to lenders. In other words, lenders are fully shielded from all systemic risks which are shifted onto borrowers.

For Smick, it's not about current collapsed aggregate demand due to wealth reduction. Instead, it's about artificial "pulled forward demand" during the bubble, which now must be dealt with by restoring optimal levels of relative demand via lower selectedasset prices, the only kind of "deflation" acknowledged by Smick et al.

That's how Smick means a fall in real estate prices will "boost" the economy. Full employment aggregate demand is "already there" ... there's just too much of it in one place and not enough in the other due to relative price distortion ... all because of government interference in a "free market".

Just remember to start with the axiom that supply creates its own demand to always get the right answer.
written by skeptonomist, November 05, 2010 12:33
Smick's attitude seems to be that of most economists before 1929, epitomized in the remark by Treasury Secretary Mellon that the solution was to "liquidate" everything. This is basically what happened after 1929, so if you think that the course of the economy 1929-1933 was the ideal, this approach is justified. A surprising number of economists do seem to think so.
written by Joe, November 05, 2010 2:58
"the debt is a reason domestic demand remains weak."

He talks about private debt to gdp but fails to realize that debt to gdp gets worse when gdp falls, not just when debt rises.

Private debt to gdp ratio improves when the public sector takes on debt to improve gdp. That's what has happened and that is what should continue to happen.

The talk about the deficit is because there is talk of a tax hike on the table and because the democrats controlled the money. Once the tax hike is off the table the deficit talk will be on the back burner as it was when between 2001-2007.
written by Joe, November 05, 2010 5:15
Today, Republicans risk making the same mistake if they offer simplistic bromides and fail to take a cold, hard look at the nature of America's economic predicament. They should begin with this analysis, calculated by economist Niall Ferguson: Had Americans not been able to take out cheap home equity loans during the George W. Bush administration, the economy would have grown annually by an average of only 1 percent.

From the end of World War II until the year 2000, our economy grew at an average annual rate of 3.2 percent. Yet since 2000, annual growth has averaged only 2.4 percent. That modest 0.8 percentage point difference is a large part of the reason so many Americans are unemployed or underemployed. Sadly, the U.S. economy is plagued with structural problems, including impediments to the lending process, inadequate training of our human capital, an internationally noncompetitive business tax system and a general fixation with trading financial paper rather than making things. These are likely to defy quick-fix remedies from either party.

Notice in the list of "structural problems" there is no mention of growing income inequality which is really the only reason economic growth would have been 1% without a credit bubble.

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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.