Arnold Kling  

Housing Matters

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Vernon L. Smith and Steven Gjerstad write,


In the immediate aftermath of most recessions, housing expands more rapidly than any other component of GDP, and inflation falls. Through the first part of the expansion, housing increases and inflation remains low. In the latter part of expansions, housing ceases to respond to loose monetary policy, but inflation starts to develop. In response to developing inflation, the Fed tightens monetary policy in order to rein in inflation, housing begins a sharper decline, and the economy enters a recession. In most cases, declines in consumer durable goods expenditures begin to fall soon after the decline in housing, yet the decline in investment comes several quarters later, coincident with the start of the recession. Tightened monetary policy, and the general contraction that follows, eases inflationary pressures. As inflation subsides, the Fed returns to a looser monetary policy. At that point, housing begins a rapid resurgence, and the economy emerges from recession. As a recovery gains momentum, businesses respond to growing demand by increasing their capacity with investments in structures and equipment. This general pattern has played out in most post-war recessions, with only minor variations in the sequence of events.

I got to the paper by starting with Will Wilkinson. The authors are saying the same thing that we have been told by Ed Leamer, who they cite. From that perspective, economic fluctuations are dominated by housing, and we just had a big, bad housing crash.

It seems to follow that it will be difficult to have a recovery until we get a housing recovery. I continue to believe that it is counterproductive to try to fight foreclosures, because that keeps the housing market out of equilibrium and postpones the recovery.

Also, when James Hamilton wrote this I meant to link to it, but I forgot to publish the post. He emphasized the role of housing in the current downturn, and he also challenged the Sumnerian interpretation.

I should note that one problem with the "it was all housing" story is that much of the decline in housing construction was behind us before the bottom fell out of the economy in late 2008 and early 2009. Another problem is that an awful lot of the people who have lost their jobs were not in construction.


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COMMENTS (8 to date)
Doc Merlin writes:

Well... housing is the plurality of american savings.

Various writes:

Well I think housing is quite a large catalyst. Another component to the puzzle is that a housing decline (or in this case a crash) is often accompanied by deleveraging, which tends to be a drag on GDP. Much of the leverage in the economy eminates from the mortgage market.

MikeP writes:

So the two massive housing subsidies of interest deduction and GSE loans are even worse than the merely regressive and inefficient interventions we know them to be.

By this theory housing subsidies actively drive more untenable booms and greater busts in the larger economy.

matt mcknight writes:

To address your two problems-

The decline in the rest of the economy was perhaps delayed because degree of the banks exposure to the market was not well understood. The level of the price drop was also unanticipated and took some time to work into people's decisions on when to default.

The broader effects are easier to explain, as much of consumption was housing profit and refi. Even when it wasn't, the wealth loss, followed by the market crash meant more money had to go to savings.

fundamentalist writes:
an awful lot of the people who have lost their jobs were not in construction.

That's because housing is an effect, not a cause. It can be the canary in the coal mine, though. The cause of the housing downturn is partly a rise in interest rates but also partly a decline in capital goods industries.

azmyth writes:

"an awful lot of the people who have lost their jobs were not in construction."

Another possible explanation is the impact of Pigeou wealth effects. People were refinancing and spending their home equity increases. A 5% gain in a $300,000 house means an extra $15,000. That's a lot of money for the median household making $48,000 per year. Additionally, the Dow Jones literally dropped by more than half from late 2007 through early 2009 (over 14,100 to below 6,700). People saw their wealth evaporate overnight. It's no wonder they cut spending across the board, especially in investments and consumer durables.

Steve Sailer writes:

This is the first recession in generations in which foreclosures went up before the recession hit, not after.

Indy writes:

The conflation of mere level of construction activity with the impact of the housing bubble on AD is a common error. Here's why the bubble really mattered and had been unlike any before; Mortgage Equity Withdrawal:

http://www.calculatedriskblog.com/2010/03/q4-2009-mortgage-equity-withdrawal.html

http://2.bp.blogspot.com/_pMscxxELHEg/S5lBwomseFI/AAAAAAAAHv0/HiC3gohHcsg/s1600-h/MEWQ42009.jpg

As you can see from the chart - the amount of overall personal disposable-income consumption that was being financed by folks taking out second-mortgage home-equity loans swung from +9% to -4%, a 13% total swing, in just two years as banks quickly turned off the debt tap.

You simply don't get a 13% net drop in consumption-usable income (from spurious unrealized paper wealth) without a long term and severe decline in AD. Do we really require more complex explanations of the long-term nature of the recession than this?

Scott Sumner also makes this mistake when he talks about the "housing construction" correction being over before the real recession began - but it wasn't about construction - it was about the debt-financed consumption easy-credit home-mortgage money machine where people were able to extract (it turned out to be imaginary) "wealth" from their homes and take cruises and buy luxury cars with it. And when the music stopped, everybody stopped dancing.

In other words, it wasn't a "real economy" after all. I'm not an Austrian, but the MEW data does seem to make the story a simpler excess debt / low savings / rampant malinvestment story.

As for construction, you also can't build six million excess housing units in a decade (the cumulative number more units built than net new households formed) without a long construction industry depression.

From 1998 to 2008, the US created 11.3 million new households. We also built 17.3 million housing units. Even continuing today's depressed rates of building and levels of immigration and population growth, it will take a full decade to work off the excess.

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