Sunday, June 5, 2011

Housing Prices Have Already Fallen More than During the Great Depression … How Much Lower Will They Go?

I noted in January that the housing slump is worse than during the Great Depression.
The Wall Street Journal noted Tuesday:
The folks at Capital Economics write in with this gloomy tidbit: “The further fall in house prices in the first quarter means that, on the Case-Shiller index, prices have now fallen by more than they did during the Great Depression.”
By their calculations, prices are now down 33% from their 2006 peak, compared with the 31% decline during the Depression.
The Independent agreed on Wednesday:
The ailing US housing market passed a grim milestone in the first quarter of this year, posting a further deterioration that means the fall in house prices is now greater than that suffered during the Great Depression.
The brief recovery in prices in 2009, spurred by government aid to first-time buyers, has now been entirely snuffed out, and the average American home now costs 33 per cent less than it did at the peak of the housing bubble in 2007. The peak-to-trough fall in house prices in the 1930s Depression was 31 per cent – and prices took 19 years to recover after that downturn.
How Bad Could It Get?
The above-quoted Wall Street Journal also notes:
The remarkable thing about this downturn is that even though prices have fallen by more than in the Great Depression, the bottom has yet to be reached. We think that prices will fall by at least a further 3% this year, and perhaps even further next year.
Jeff Harding recently wrote:
Another 10% decline would mean one-third of all homes would be under water. The question to ask is: is this one of those feedback loop things where the more home prices decline, the more defaults we have and the more defaults we have, the more prices decline?
When will it end? Or, a better question is: When will supply reach demand?
The answer from economics is: when buyers believe prices are no longer dropping like a rock. Not a good answer, I know, but all I can say is that at some point the affordability of housing will be attractive to buyers and the market will bottom.
The factors that will determine that point are related to: positive economic growth, rising wages, and, unfortunately, monetary-induced price inflation. I don’t see any real turnaround in the housing market for the next two years.
I pointed out in December:
[Nouriel] Roubini said that the United States “real estate market, for sure, is double dipping”, and and predicted that banks could face another $1 trillion in housing-related losses.
Now Zillow is forecasting that U.S. home values are poised to drop by more than $1.7 trillion this year.
In a real worst-case scenario, how far could housing decline?
In March, Gary Shilling predicted that housing would decline another 20%, and wouldn’t recover for 4-5 years.
I reported last year:
The co-creator of the leading house price index – Robert Shiller – says that he is worried housing prices could decline for another five years. He noted that Japan saw land prices decline for 15 consecutive years up to 2006.
Indeed, it is possible that housing prices may never return to their peak bubble levels. See this, this and this.
I noted in 2008:
In the greatest financial crash of all time – the crash of the 1340s in Italy … real estate prices fell by 50 percent by 1349 in Florence when boom became bust.
So Shilling’s prediction is within the realm of historical events: it is already worse than the Great Depression, it could get as bad as the worst depression of all time … 1349 Florence.
Moreover, while the 1349 was limited to one city-state, the current crash is more or less global. I pointed out in 2008:
The [current] bubble was not confined to the U.S. There was a worldwide bubble in real estate.
Indeed, the Economist magazine wrote in 2005 that the worldwide boom in residential real estate prices in this decade was “the biggest bubble in history”. The Economist noted that – at that time – the total value of residential property in developed countries rose by more than $30 trillion, to $70 trillion, over the past five years – an increase equal to the combined GDPs of those nations.
Housing bubbles are now bursting in China, France, Spain, Ireland, the United Kingdom, Eastern Europe, and many other regions.
Why Is This Happening … And What Can We Do to Fix It?
Government economic policy that does nothing meaningful to tackle unemployment and the failure to prosecute mortgage fraud are largely responsible for the slump in housing.
Until those policies are reversed, housing could keep declining for a long time.
As I explained last year, the government’s entire policy regarding housing is counter-productive in the long run:
When housing crashed in 2007 and 2008, the government had two choices. It could have:
(1) Tried to artificially prop up housing prices;
(2) Created sustainable jobs, broken up the big banks so that they stop driving our economy into a ditch, and restored honesty and trustworthiness to the economy and the financial system. All this would have meant that the economy would recover, and people would have enough money to afford to buy a new house. (See this).
The government opted to try to prop up prices.
Indeed, as I have repeatedly pointed out, the government’s entire strategy has been to try to artificially prop up the prices of all types of assets.
For example, I noted in March:
The leading monetary economist told the Wall Street Journal that this was not a liquidity crisis, but an insolvency crisis. She said that Bernanke is fighting the last war, and is taking the wrong approach. Nobel economist Paul Krugman and leading economist James Galbraith agree. They say that the government’s attempts to prop up the price of toxic assets no one wants is not helpful.
The Bank for International Settlements – often described as a central bank for central banks (BIS) – slammed the easy credit policy of the Fed and other central banks, the failure to regulate the shadow banking system, “the use of gimmicks and palliatives”, and said that anything other than (1) letting asset prices fall to their true market value, (2) increasing savings rates, and (3) forcing companies to write off bad debts “will only make things worse”.
David Rosenberg [former chief economist for Merrill Lynch] writes:
Our advice to the Obama team would be to create and nurture a fiscal backdrop that tackles this jobs crisis with some permanent solutions rather than recurring populist short-term fiscal goodies that are only inducing households to add to their burdensome debt loads with no long-term multiplier impacts. The problem is not that we have an insufficient number of vehicles on the road or homes on the market; the problem is that we have insufficient labour demand.
Indeed, as I pointed out in April, unemployment is so bad that 1.2 million households have “disappeared”, as people move out of their own houses and move in with friends or family.
BIS wrote in 2007:
Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.
I pointed out in March 2009:
Paul Krugman wrote a couple of weeks ago:
The truth is that the Bernanke-Geithner plan — the plan the administration keeps floating, in slightly different versions — isn’t going to fly ….
Why won’t it fly?
One reason is that economic psychologists tells us that consumer psychology has shifted for many years to come, and Americans are hunkering down and not buying anything other than the bare necessities. The Fed can try to play the part of all of the actors in the economy, but it won’t work.
Today, Edward Harrison’s must-read post explains provides additional reasons why the Geithner-Summers-Bernanke plan to prop up asset prices cannot succeed (if you don’t read the whole post, at least read the following excerpts):
The U.S. government’s efforts point in [only one direction]:
Increase asset prices. If the assets on the balance sheets of banks are falling, then why not buy them at higher prices and stop the bloodletting? This is the purpose of the TALF, Obama’s mortgage relief program and the original purpose of the TARP.
There is only one direction the government is headed: increase asset prices (or, at least keep them from falling). Read White House Economic Advisor Larry Summers’ recent prepared remarks to see what I mean. (Summers on How to Deal With a ‘Rarer Kind of Recession’ – WSJ) ….
These plans are not going to work
As aggressive as this campaign by the U.S. government is, it will have limited effectiveness because the extent of the writedowns of assets already on the books is going to be too massive. …
And Ryan Grim reported in April 2009:
Critics of Geithner, including Nobel Prize winning economist Paul Krugman, insist that the real problem is an asset collapse that led to a crisis of solvency in the banking system. In other words, Krugman argues that home values have come back to Earth, while Geithner hopes to solve the problem by pushing home values back to where they were. The conflict is a serious one because it dictates what response is appropriate.
***At a closed-door meeting with House Democrats on Monday night, according two members of Congress who were in the meeting, Geithner repeated that he believed the problem with the financial system was a lack of liquidity and that if he could get credit flowing again, the problem would right itself. Key to this analysis is the question of whether one thinks the rise of housing prices was an artificial bubble or if the collapse is reversible and we can return to those highs. Policymakers have resisted labeling it as a bubble. [head of the president's Council of Economic Advisers Christina] Romer, on Monday, came close, referring to a “run-up in housing prices that sure looks like a bubble.”…
If the crisis is understood as one of liquidity, then the appropriate response is to continue injecting capital into the banking system and fiscal stimulus into the general economy until asset prices return toward previous highs. Japanese policymakers initially understood their crisis to be one of liquidity and injected hundreds of billions during the 1990s, to little effect. But if the problem is something different — a solvency crisis brought on by essentially permanent asset-price declines — then the policy response needed is different.
So were housing prices in a bubble or not? And – if so – have housing prices now come back to earth?
Well, as liberal PhD economist Dean Baker points out:
Real [i.e. inflation-adjusted] house prices are still 15-20 percent above long-term trend.
In other words, housing was in a bubble, and still has a ways to go before it is back to normal.
As the Wall Street Journal wrote in January:
Housing economist Dean Baker, the co-director of the Center for Economic and Policy Research, laid out his case at a risk conference last week for why we still have a housing bubble. Adjusted for inflation, home prices are still 15-20% higher than they were in the mid-1990s. “There’s no plausible fundamental explanation for that,” he says.
Why? Simple, he says: Economic fundamentals are all going in the other direction. Rental apartment vacancies are reaching record highs. Many segments of the housing market are still oversupplied. And the core demographic in the country—the baby boomers—are reaching the age where they’re more likely to downsize, buying less house in the years to come.
Far from some rosy estimates that housing is going through a temporary, once in a lifetime downturn, and that once the market bottoms, homes will again appreciate well beyond the rate of inflation, Mr. Baker argues that home prices are far more likely to increase annually at the rate of inflation, at best.
“If anything, I expect housing to be weaker than normal rather than stronger over the next decade,” he says. “People who say this is a temporary story, there’s no real reason to believe anything like that.”
The recent burst of good housing news has been fueled by government stimulus, including the tax credit, low mortgage rates and easy financing from the Federal Housing Administration. Mr. Baker, who had been a skeptic of the tax credit, concedes that it has worked. So, too, he says, has the FHA effectively supplied credit to goose sales.
But that’s likely for the worse, he argues, taking the opposite view of policymakers at the FHA.
“As a matter of policy I can’t see that we want people to buy a house in 2009 that’s 10-20% higher than it would sell for in 2011,” he says. “In so far as the FHA was encouraging people to buy homes in bubble markets that were not deflated, that’s not good for the FHA and you didn’t help the homeowner. We didn’t do those people a favor.”
Indeed, Baker said last November that the government’s hasn’t really helped homeowners, but has really been helping out the big banks instead:
The big talk in Washington these days is “helping homeowners”. Unfortunately, what passes for help to homeowners in the capitol might look more like handing out money to banks anywhere else.
So, who benefits from “helping homeowners” in this story? Naturally the big beneficiaries are the banks. If the government pays for a mortgage modification where the homeowner is still paying more for the mortgage than they would for rent, then the bank gets a big gift from the government, but the homeowner is still coming out behind.
There are simple, low-cost ways to help homeowners who were victims of the housing bubble and lending sharks…. But this would mean hurting the banks rather than giving them taxpayer dollars, and we still don’t talk about hurting banks in Washington DC.
Similarly, Zack Carter wrote yesterday:
The Treasury Dept.’s mortgage relief program isn’t just failing, it’s actively funneling money from homeowners to bankers, and Treasury likes it that way.
Economics whiz Steve Waldman [writes]:
The program was successful in the sense that it kept the patient alive until it had begun to heal. And the patient of this metaphor was not a struggling homeowner, but the financial system, a.k.a. the banks. Policymakers openly judged HAMP to be a qualified success because it helped banks muddle through what might have been a fatal shock. I believe these policymakers conflate, in full sincerity, incumbent financial institutions with “the system,” “the economy,” and “ordinary Americans.”
Baker has also said in numerous interviews this week that the only thing the temporary tax break for first-time buyers has done is moved home purchases up by a couple of months. In other words, the credit didn’t motivate people who weren’t planning on buying a house in the near future to buy. All it did was motivate people who were already planning on buying this year to buy before the credit expired, thus creating no real boost to the housing market.
The bottom line is that home sales are plummeting because housing was in a bubble. While most assuming that Americans are being more frugal and deleveraging – so that we will soon “get thorough this” and home sales will finally bottom – that assumption might not be true.
Instead of fixing the real problems with our economy or genuinely helping struggling homeowners, the government has made everything worse by trying to artificially prop up asset prices in a way that only helps the big banks.
And as banking analyst Chris Whalen wrote last month:
An aggressive combination of reflation by the Fed and restructuring of the housing and banking sectors is the way to restore US economic growth, but you won’t hear about restructuring large banks from adherents of the neo-[i.e. faux] Keynsian faith.
Instead of embracing a permanent state of inflation, as has been the case in the US since the 1970s, we need to deflate the bubble and start again. It is not too late for President Obama and Congress to restructure the US financial system, fix the housing market and create the conditions for true economic growth.
Lest you think I am unfairly criticizing Keynesian economics, I pointed out last year:
“Deficit doves” – i.e. Keynesians like Paul Krugman – say that unless we spend much more on stimulus, we’ll slide into a depression. And yet the government isn’t spending money on the types of stimulus that will have the most bang for the buck … let alone rebuilding America’s manufacturing base. See this, this and this. [Indeed, as Steve Keen demonstrated last year, it is the American citizen who needs stimulus, not the big banks.]
Today, however, Bernanke … and the rest of the boys haven’t fixed any of the major structural defects in the economy. So even if Keynesianism were the answer, it cannot work without the implementation of structural reforms to the financial system.
A little extra water in the plumbing can’t fix pipes that have been corroded and are thoroughly rotten. The government hasn’t even tried to replace the leaking sections of pipe in our economy.
In truth and in fact, the government’s policies are not only not working to stem the rising tide of unemployment, they are making it worse.
Forget the whole “Keynesian” versus “deficit hawk” debate. The real debate is between good and bad policy.

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