Monday, January 14, 2008

This Time It IS Different


The last two business cycles (the bubble and now the real-estate bubble) generated observations that “This time it’s different.” That is, there would be no recession despite the heady boom. In the late 1990s the New Economy advocates suggested that growing productivity guaranteed blue skies forever, and more recently some analysts have expressed faith in a soft landing because of consumer expenditures’ strength.

But the mood has turned gloomy very quickly. Yesterday’s New York Times ( ran a front-page news analysis headlined “No Quick Fix To Downturn,” and today’s Times carried a front-page ( story, “Americans Cut Back Sharply on Spending,” that explained why consumers may not rescue the economy.

Perceptions have changed because there are unique elements to the recent real-estate expansion and bust. Take a look at the following charts.

Existing-Home Sales

(Click on chart to enlarge)

Recessions shaded

New-Home Sales

(Click on chart to enlarge)

Recessions shaded

Residential real estate was not a growth industry until its 1995 – 2005 expansion, and now it will probably shrink back to its earlier size and drag the economy down with it. When this slump is over, and existing-home sales have fallen below 4 million and new-home sales are below 600 thousand, those charts will look like the python that swallowed the elephant. Wall Street mortgage securitization leveraged the Fed’s easy-money policy to enable those huge bulges in sales and building activity. This was like the 100-year flood: An event of epic propostions. Now that sales are plummeting and prices falling, it may be years before the glut of homes can be absorbed.

Historically inflation, and the Fed’s consequent tight-money (high interest rate) response to inflation, generated recession. Building activity resumed and recovery began as soon as inflation subsided and the Fed eased and interest rates fell. Residential building led the economy into and out of recession.

For example, compare inflation’s record in the chart below with the real-estate activity depicted in the charts above. Real-estate activity led the economic expansions of the 1970s, generating inflation and the Fed’s consequent high-interest-rate crackdown. As soon as recession hit and inflation slipped, the Fed eased and interest rates fell and residential building and sales bounced back.

New-Home Sales

(Click on chart to enlarge)

Recessions shaded

The Fed cracked down on inflation once-and-for-all under Paul Volcker in 1981. (The increased availability of imports and enhanced business productive capacity helped, too.) When the great residential-building boom of the 1990s began, chronic inflation was a memory. By the late 1990s existing-home and new-home sales were higher than they had ever been, yet inflation remained relatively mild.

When the bubble burst in 2001, the Fed relied on its traditional remedy to deal with recession: Lower interest rates. The bursting of the bubble had generated a slump in business investment that caused the recession. The Fed’s low interest-rate policy did little to alleviate the glut of hi-tech goods, but it did give home sales a major boost even though residential building was already strong. The Fed's easy-money policy distorted economic activity by helping where it could (i.e. residential real estate), not where it was needed (business capital expenditures). Moreover, as real-estate pushed to ever-greater records, there was no surge of inflation and consequent interest-rate run-up to choke off the boom. The Fed let the boom run, helping a strong sector get even stronger. When home sales, home building and home prices finally began to collapse in 2006, the circumstances were completely different from earlier downturns.

The 2001 – 2006 real-estate expansion was an asset bubble. Asset inflations, such as stock-market bubbles and unlike commodity-price inflations, feed on themselves because the purchaser can hold the asset for re-sale at a higher price. The asset’s use does not diminish its salability. In a speculative bubble such as 2001 – 2006, rising prices encourage – rather than discourage – demand. That led to residential real-estate’s over-building between 2001 and 2006.

In earlier booms inflation and rising interest rates quickly choked off demand, and home prices did not rise much faster than the rate of inflation. That didn’t happen this time, and the Fed refused to curtail the real-estate bubble. Now we are left with an over-priced housing stock that exceeds the nation’s ability to absorb that stock. It may take years of falling home prices and slack building activity to work off that excess capacity, and that may prolong recession more than in earlier downturns.

In the past home owners and home buyers reasonably expected home prices to quickly recover and renew their upward climb. Anyone with equity in a home expected to sell it at a gain. But today’s market is different because homeowners have little equity in their homes and they realize home prices will fall for a while. Why should someone with a $400,000 mortgage on a home whose value has fallen to $350,000 keep making payments when that person expects the home’s price to drop to $300,000? What’s the rational response? Walk away and let the bank foreclose. But that home will remain on the market (for sale or for rent) and further depress prices. In response to these conditions some homeowners may sell and some prospective buyers may postpone entering the market because they fear prices will fall even further. In other words, falling prices have may have begun to increase supply and depress demand.

This time it is different.

(The charts are taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of Economic Indicators.)

© 2008 Michael B. Lehmann

1 comment:

Seamus Furr said...

True enough. The saddest part is that this was obvious to many of us (esp. many of us renters) for years, but we were drowned out by the "buy now or be priced out forever" crowd.

Now America must pay the piper. I am so glad I'm still renting, and I'll be triple-glad if (God forbid) this coming recession kills my job.