HOW MANY ECONOMISTS DOES IT TAKE TO SCREW IN A LIGHT BULB?

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
guardian.co.uk

http://www.guardian.co.uk/commentisfree/cifamerica/2011/jan/03/useconomy-economics

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
[http://www.prospect.org/csnc/blogs/beat_the_press_archive?base_name=_treasury_officials_who_missed&month=03&year=2009]
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
[http://www.aflcio.org/mediacenter/speakout/dean_baker_recession.cfm].
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
[http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff–p-us—-]
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
banks.

Why is no one surprised?

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