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View related content: Monetary Economics
Resident Fellow Desmond Lachman
On observing Federal Reserve Chairman Ben Bernanke minimize the likely economic impact of today’s deepening housing market problems, one has to wonder what, if anything, might the Federal Reserve have learnt from the bursting of the dot-com bubble in 2001. At that time, too, the Fed downplayed the economic consequences of a collapsing asset market. And it did so only to find itself, a few months later, in the awkward position of having to aggressively cut interest rates to prevent the dot-com crash from precipitating a deep economic recession.
Drawing parallels between the earlier dot-com meltdown and today’s unfolding problems in the housing market would seem appropriate given the very strong run-up in home prices over the past six years. As Robert Shiller, the renowned Yale University expert on the U.S. housing market, has correctly observed, between 2000 and 2006, home prices, adjusted for inflation, increased by a staggering 80 percent. That remarkable increase in home prices, which has no precedent in the United States over the past hundred years, increased household wealth by around 50 percent of GDP, or by an amount not dissimilar to that created by the earlier run-up in dot-com equity prices.
Among the more important factors fueling the housing market boom in recent years was the maintenance of abnormally low interest rates by the Fed in the wake of the bursting of the dot-com bubble. Not only did the Fed cut interest rates to as low as 1 percent by 2003, but it was also very slow in restoring interest rates to more normal levels over the next four years. No wonder, then, that speculative home purchases became increasingly rampant as the housing boom gathered pace.
Adding fuel to the housing market boom was an unprecedented relaxation of mortgage-lending standards and the introduction of a vast array of new lending instruments specifically designed to make it easier for the least creditworthy borrowers to buy homes. No longer were borrowers required to verify their income or to provide a credit record to qualify for a mortgage loan. And no longer did they need to pay high interest rates or amortization payments in the early stages of their loan, as adjustable rate mortgages and interest-only loans became the norm.
The trouble with today’s housing market is that the chickens are now coming home to roost as the period of easy home credit has run its course. Fearful of igniting inflation, the Fed has restored interest rates to 5.25 percent and it shows no sign of dropping its inflation guard any time soon. At the same time, an alarming rise in defaults at the subprime, or the weak credit end, of the home market has led to the folding of many subprime mortgage lenders, which last year accounted for as much as 20 percent of total mortgage lending. Rising defaults have also prompted the regulators, who were pretty much asleep while the party was in full swing, to now take it upon themselves to shut the easy mortgage credit door long after the horse has bolted.
As the easy credit cycle has run its course, home prices at the national level, which were increasing at a 15 percent annual rate as recently as last year, have already begun to level off. Looking ahead, it is difficult to see why nationwide home prices do not fall at an accelerating pace in response to the housing market’s rapidly deteriorating fundamentals. Not only do we have a large inventory of unsold homes overhanging the market and the unwinding of excessive speculative positions, but we are faced with the prospect that potential demand for those houses gets choked off by tightening credit standards and by the resetting of adjustable rate mortgages at appreciably higher interest rates. As if that were not enough, the housing market will also have to absorb an estimated 500,000 houses that will come back on the market as a result of foreclosures on defaulted loans.
Optimists argue that the prospective debacle in the housing market is not of the greatest importance for the whole of the U.S. economy, since residential construction only accounts for 6 percent of U.S. GDP. That line of reasoning, however, overlooks the very depth of the housing market recession as suggested by a decline in housing starts of over 30 percent over the past year. It also overlooks the likely spillover effect of a housing market recession on the many industries that provide furnishing or appliances to newly constructed homes.
More important still, the soft pedaling of the housing-market bust overlooks the very high probability that declining home values will almost certainly impact household spending decisions as households see their main source of wealth decline with falling home prices. As a result, we could very well see the housing market decline shaving off anywhere between 2 and 3 percentage points from GDP growth in 2007, which could take the U.S. economy close to recession.
It is all very well for Chairman Bernanke to act as a cheerleader at this very difficult time for the U.S. home market. It would be a grave mistake, however, for him to allow his wishful thinking to influence his interest rate decisions in the months ahead. If the Fed’s past experience with the bursting of the dot-com bubble is any guide, being tardy in cutting interest rates will only exacerbate the negative impact of the housing market on the overall economy and lead to an unnecessary degree of pain.
Desmond Lachman is a resident fellow at AEI.
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