The Hill, August 25, 2010
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A young person following the news for the first time would probably think that an economist is someone who gets on television to say how surprised he is by the economy. Yesterday, the economists were out in force telling us how surprised they were by the 27 percent drop in existing home sales in July. This was the sharpest one-month drop in sales ever recorded and left monthly sales at their lowest levels since 1999.
Of course there was no excuse for the surprise. Every week the Mortgage Bankers Association does a weekly survey of its members on mortgage applications. This survey showed purchase applications plunging in May. By the end of the month, applications were more than 40 percent lower than they were at the end of April.
If people don’t take out mortgages then they are not buying homes. This is why people who understand the economy were not surprised by the plunge in sales reported yesterday. They knew this was going to happen.
In fact, the plunge was predictable even before we had the data on mortgage applications. There had been a surge in sales in May and June. The reason was the homebuyers tax credit, which initially only applied to sales that were closed by the end of June. (The deadline on closing was later extended, but only for homes that were contracted by April 30th.)
The tax credit gave people up to $8,000 to buy a home. While it is unlikely that many people who had not intended to buy a home would do so because of this credit, the money would certainly be an incentive for people to move their purchases forward. In other words, people who had been thinking of buying a home in the second half of 2010 or even 2011 would likely try to buy a home earlier to take advantage of the credit.
In other words, the main effect of the credit was to get people to buy homes sooner than they would otherwise, not to buy more homes. It is not clear why anyone thought this would be a good idea. The credit did temporarily increase demand in the housing market and even caused a modest increase in prices in the second half of 2009.
However, the boost to the market was guaranteed to be temporary. The whole story of our recession is the bursting of a huge housing bubble. House prices had gotten out of line with fundamentals. At this point the bubble is roughly two-thirds deflated, meaning that as a nationwide average prices are still about 15 percent above their trend levels. The remaining bubble is considerably larger in the most inflated areas.
Trying to sustain an over-valued housing market is like an agricultural price support program, but it makes considerably less economic sense. There remains an enormous glut of housing, as shown by the record housing vacancy rates, which will be a powerful force putting downward pressure on house prices.
The data released yesterday showed a 12.5 month inventory of unsold homes. This will likely put serious downward pressure on prices for the second half of 2010 and into 2011. Look for the bubble to finish deflating with a further drop in prices of 15-20 percent.
This is not good news for the economy. Growth was already faltering. The relatively good growth of the second half of the 2009 and the first quarter of 2010 was driven by an inventory cycle as firms sought to rebuild their inventories following their initial selloff at the beginning of the recession.
If we pull out inventories, final demand grew at an average rate of just 1.2 percent over the last four quarters. Now that the inventory cycle is competed, we should expect GDP growth to be pretty much equal to final demand growth.
And, it is more likely that final demand growth will be weaker going forward rather than stronger. State and local governments will be cutting back spending in response to their budget shortfalls. The stimulus from the federal government will be winding down in the 4th quarter and even more in 2011, another source of contraction.
And now we have a plunge in home sales. This directly slows growth, since the realtor fees and other costs associated with house sales are a part of GDP. The indirect effect could be even larger, since plunging house prices will destroy more home equity, thereby further weakening consumption.
Whether or not this leads to the fabled double-dip is really beside the point. The growth that we can anticipate will be too slow to generate jobs, and certainly too slow to keep the unemployment rate from rising. In other words, we can expect the unemployment to rise in August and most of the rest of the year, whether or not the recession has a second dip.
This story should have people outraged. This is an entirely preventable disaster. It never would have happened if we had competent people managing the economy. Unfortunately, we will never recover from this downturn until we stop trusting our fate to people who are continually surprised by the state of the economy.