Resident Fellow Desmond Lachman

As U.S. home prices at the national level begin to decline for the first time since the Great Depression, most Wall Street analysts maintain their rosy outlook for the U.S. economy by allowing hope to triumph over experience. For while they concede that any bottom to the housing market bust is slipping ever further into the distant future, they hew to the view that the U.S. housing sector is far too small to derail the overall U.S. economy.

They arrive at this happy conclusion by blithely closing their eyes to the almost certain negative impact of falling home values on overall consumer spending. More importantly yet, they also choose to ignore the probable negative economic fallout from the seizing up of U.S. financial markets that is presently fully in train as a direct consequence of the acute problems now plaguing the sub-prime mortgage market.

Wall Street optimists minimize the bursting of the housing market bubble by emphasizing that residential construction accounts for a mere 6 percent of the overall U.S. economy. This observation leads them to contend that even were home construction to decline by 20 percent over the next year, it would not shave much more than 1 percentage point off overall U.S. economic growth. And with the rest of the U.S. economy still in fine shape, they happily conclude that there is every reason to expect that the U.S. economy will still continue to expand at a perfectly respectable 2.5 percent rate over the next twelve months.

In maintaining their rosy economic outlook, most Wall Street analysts choose to ignore Fed Chairman Ben Bernanke's recent reminder that a protracted decline in home prices could have a material impact on consumer spending. According to Mr. Bernanke's congressional testimony last week, the Federal Reserve estimates that household consumption could be negatively impacted by as much as 9 cents for every dollar that home prices decline on a sustained basis. And considering that housing wealth, which is the main source of household wealth, presently amounts to 150 percent of GDP, and that household consumption still accounts for around 70 percent of GDP, the prospect of a protracted period of declining home prices is not something one wants to cavalierly brush aside.

Contrary to what many on Wall Street would have us believe, the prospect of a protracted period of declining home prices now seems to be anything but a remote possibility. Indeed, with home prices already falling and with increased inventories of unsold homes rapidly mounting, it is difficult to see how home prices do not start falling at an accelerating rate over the next few months in order to clear a saturated market. This would seem to be all the more so the case as a tightening in mortgage lending standards and as the resetting of adjustable rate mortgages further crimp housing demand at the very same time that a marked increase in home foreclosures leads to more houses returning to an already glutted market.

Perhaps an even greater overlooked risk to the U.S. economy than slowing consumer expenditure is the prospect of a full blown "credit crunch" in the financial sector that would seriously curtail bank lending to the economy as a whole. Sadly, this prospect too now seems to becoming an ever increasing likelihood. In his congressional testimony last week, Chairman Ben Bernanke owned up to the very real possibility that the financial sector's losses from sub-prime mortgage lending could very well reach as much as U.S. $100 billion. Judging by the roughly U.S. $2.3 trillion presently outstanding in sub-prime and Alt-A mortgage lending, Mr. Bernanke's present mortgage loss estimate is all too likely to turn out to be on the low side.

Heightening the risk of a real credit crunch is the fact that mortgage lending was not the only form of reckless lending in which the U.S. financial system has been engaged over the past several years. Rather, financial institutions increasingly made risky loans to the U.S. corporate sector at ever tighter interest rate spread, while they dispensed with the usual covenants on these loans with which banks in the past had protected themselves. Now that the music has stopped, all too many financial institutions will find themselves nursing large losses that will temper their willingness to lend.

In the end, the Federal Reserve must be expected to ride to the rescue of the financial sector by substantially cutting interest rates. However, at present, the Federal Reserve sees the risk that cutting interest rates too soon might simply prolong a credit market bubble that needs to be deflated. The Federal Reserve also appears to be mindful that an unduly quick reduction in U.S. interest rates might cut the ground from under the U.S. dollar, which is already trading at a 16 year low on a trade weighted basis.

If the economy indeed slows abruptly over the next few quarters under the weight of its housing market woes, it will not be the first time that Wall Street analysts as a group missed a major turning point in the economic cycle. Rather, it will only confirm that those analysts seem to have learnt little from the bursting of the earlier dot.com bubble in 2001.

Desmond Lachman is a resident fellow at AEI.