SUBMITTED BY Allan O’Brien Denchfield
America’s housing bubble still deflating

As they failed to spot the bubble, most economists seem oblivious of the threat
of further market falls to come

Dean Baker
Wednesday January 5 2011

How many economists does it take to see an $8tn housing bubble?

The answer to that question has to be many more economists than we have in the
United States. Very few economists saw or understood the growth of the $8tn
housing bubble, whose collapse wrecked the economy. This involved a degree of
inexcusable incompetence from the economists at the Treasury, the Fed
and other regulatory institutions who had the responsibility for managing the
economy and the financial system.

There really was nothing mysterious about the bubble. Nationwide house prices in
the United States had just kept even with the overall rate of inflation for 100
years from the mid 1890s to the mid 1990s. Suddenly, house prices began to
hugely outpace the overall rate of inflation. By their peak in 2006, house
prices had risen by more than 70%, after adjusting for inflation
Remarkably, virtually no US economists paid any attention to this extraordinary
movement in the largest market in the world.

Had they bothered, they would have quickly seen that there was no plausible
explanation for this jump in prices in either the supply or demand side of the
market. There were no major new restrictions on supply, with the builders
putting up homes at near record rates. Nothing on the demand side suggested that
prices should rise. The healthy income growth of the late 90s was followed by
stagnation in the last decade and population growth was relatively subdued.
Finally, there was no unusual rise in rents, which just slightly outpaced
inflation over this period.

Therefore, it should have been easy for any competent to economist to recognise
the housing bubble. Moreover, the dangers for the economy should also have been
apparent. The boom in construction (both residential and non-residential) had
raised its share of GDP by more than 3 percentage points above its long-term
average. In addition, the creation of $8tn in housing bubble wealth predictably
led to a consumption boom, as households spent on the basis of the new equity
created by the bubble.

All of this presaged disaster for the time after the bubble burst. Construction
spending was sure to plummet to below normal levels as the market recovered from
the long period of overbuilding. Consumption would also fall back as households
adjusted to the disappearance of the housing wealth that they expected to be
available to them in future years.

Yet, almost no economists saw what was clearly in front of their eyes. They
thought everything was just fine, until the house of cards eventually collapsed
in 2007-2008.

Unfortunately, the reign of error is not over.

House prices in the United States are again declining and most of the economics
profession remains clueless. The Case-Shiller 20-city house price index
for October (the data is released with a two-month lag) showed a decline of 1.3%
from September. This implied an acceleration from the prior month’s decline,
which is now reported as 1.0%. In other words, house prices are again declining
at double-digit rates. A more careful examination of the data reveals the
underlying logic. Prices are declining most rapidly in the bottom third of the
market. Prices for this bottom tier of the market were in freefall in recent
months in several cities.

The reason is that a first-time buyers’ tax credit ended in June. This credit
caused many buyers to move their purchase forward. People who might have
otherwise bought in the second half of 2010 or in 2011, instead bought in the
first half of 2010.

This tax credit had the effect of ending the plunge in house prices in 2009, and
even leading to small rise in the second half of the year. But with the credit
now expired, the price decline is resuming. It will likely spread from the
bottom tier of the market to the middle and higher end, since the sellers of
bottom-tier homes are the buyers of higher-end homes. If they must sell for much
lower prices than they had anticipated, then they will have less money to buy
these higher-end homes.

The further decline in house prices will have predictable consequences for the
economy. If house prices drop by another 15%, completing the deflation of the
housing bubble, this would imply a loss of $2.5tn in housing wealth. If
consumers spend 6 cents for every dollar of housing wealth (near the middle of
the range of estimates), this would mean a fall in consumption of roughly $150bn
or 1% of GDP. This will be a substantial drag on growth over the next two years
that will, no doubt, surprise most economists.

The other important part of this story is that many more homes will go
underwater, and there will be new losses for banks. One result of the delay in
this second round of price adjustments, though, is that trillions of dollars of
mortgages were taken out of private hands and shifted over to Fannie Mae and
Freddie Mac, the mortgage giants currently owned by the government. This means
that the losses on these mortgages will be the problem of the taxpayers, not the

Why is no one surprised?

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10 Responses

  1. Sorry – I meant:

    “Ask” 10 economists when the present economic troubles will end: and get 15 different opinions.

    Ah yes: the dismal science. (Victorian economist Thomas Carlyle’s response to the Reverend Thomas Robert Malthus. No matter what you think, it was actually Lord Keynes who said “in the long run we are all dead”.

  2. cubed2k, Jan van Eck, and Ian are immigrant lovers. They don’t understand that lots of Mexicans come across the border into Arizona a kill lots of ranchers.

    Jared Loughner is clearly Mexican – and clearly only recently arrived from across the border.

  3. A problem, always unspoken is that there is an aging demographic in many states, those that were hit by inflated appraisals during the “bubble”… do they eat cat food on toast or pay their still inflated property taxes. Have worked with many people of this age bracket, paid off homes, that can no longer hang on. What about that sector of our society, what happens to them, all they did was live a life of hard work and within their means, and kaboom!

  4. As 10 economists when the present troubles will end: and get 15 different opinions.

  5. Jan van Eck,
    I’ve actually given a lot of thought to the immigrant thing (which is a diversion “issue” actually used to spur conflict amongst the populous like DADT) and honestly we could gain more if we are helping eachother and to make an effort in attempting to create an issue out of it or try to solve one would limit an opportunity to use to our benefit and would waste time an energy. Think about it, yeah our lives suck, but so do theirs. If we just discount this then we’re no better than those who hold us in chains. As long as we stay divided we’ll never become large enough to make the necessary changes. If we actually worked out some kind of negotiation with them as a whole like cutting the naturalization time in half for helping us remove everyone in the Government and restructure it so we’re all more involved as a whole in its developement and operations, then we would be able to accomplish so much more and so much faster.

  6. these incompetent economist never ever use their knowledge and expertise . instead they followed the FED on what they have been told. if FED tell them that depletion is not good for the economy and inflation is good to create jobs, then these incompetent economist will said so. if FED said we have to lower interest rates and increase interest rates, the incompetent economist will say so. the question is; whom we have to trust now?

  7. cubed2k- I made this point repeatedly a year or so ago, that the media keeps saying “the banks, the banks, the banks”. The banks had been made whole at that point. And then some. They lost nothing, they kept the investors’ cash and wrote loans while putting up 2% of each loan. Another topic I brought up is that all the for sale signs on foreclosed properties say “bank owned” or “lender owned” and we all know that that isn’t true either. But it continues the lie when joe sixpack sees the sign on the house next to his- this is actually false and misleading advertising under the FTC, the signs should read: “Owned by OneWestBankfsb, as successor by assignment from IndymacBankfsb,in accordance with the PSA from SPLAT2003-Q1,FDIC as receiver, with MERS as straw man,buy at your own peril” Maybe r.e. agents could fit this on a 4×8 sheet of plywood.

  8. cubed2k,

    Yeah — but not the MBS either — they have been paid. It is whoever the servicer is currently servicing for — itself – or unidentified party.

  9. “The other important part of this story is that many more homes will go
    underwater, and there will be new losses for banks.”

    They keep saying the BANKS – it’s the MBS & ABS – damn. Banks are just servicers at this point in the game. These journalists keep saying Banks. They keep saying it on TV, the internet, etc. They never tell the real story.

  10. Another insidious reason housing prices are going to continually deflate is the politics of immigration, or more concisely, alien expulsion. The argument is advanced that there are 11,000,000 Hispanics living in the US without documents, the mis-named “illegal aliens.” There are probably another !6,000,000 undocumented Canadians that are ignored, at least so far. But these millions also consume housing units, either homes or apartments. When they get expelled, then millions of housing units are vacant and thrown on the market. The hosing market is peculiar in that pricing is tightly bound to small variations in demand; when supply cascades, the ability to sell any one unit becomes very difficult, and all prices fall substantially. Since there is no evidence that the national mood is going to swing in favor of enlarged immigration, it would be prudent to expect continued, and continual, emptying of housing units by emigration and vacancy over-supply.

    The Hispanics involved in construction will be first to leave; the over-supply will collapse new building, leaving no jobs for them.

    Also missing from most analyses is that roughly 30% of perfectly legal and documented immigrants never attempt to apply for, and are not interested in, “citizenship,” and end up returning to their native countries. This pattern has been true for two centuries. Currently, the internal birthrate is insufficient to sustain the population, so natural population contraction will continue absent fresh immigration. Over time, this continues to leave vacant housing.

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