Dean Baker: The Coming Housing Crash

Dean Baker is the co-director of the Center for Economic and Policy Research. He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer. He just wrote an article called The Coming Housing Crash. Here are some excerpts.

This bubble sustained the economy through the 2001 recession and provided the basis for the recovery. The housing sector directly employs more than 6 million people in construction, mortgage issuance and real estate. The indirect effect of the bubble was even larger, as people took advantage of the rapidly growing value of their homes to borrow huge amounts of money. This borrowing binge supported rapid consumption growth in a period of weak wage and job growth. It also pushed the U.S. savings rate into negative territory for the first time since the beginning of the great depression.

Right on. The economic 'recovery' coming out of the 2001 recession was built on an mountain of debt. So what happens next?

But, it was inevitable that the bubble would eventually collapse. The record run-up in housing prices led to record rates of housing construction. With population growth slowing, the country was building homes far more rapidly than the market could absorb them. At some point, excess supply will put downward pressure on prices.

The weakening of the housing market was further assisted by an entirely predictable rise in mortgage interest rates. The Federal Reserve Board deliberately pursued a low interest policy to help the economy recover from the stock crash, pushing interest rates to their lowest level in 50 years. With inflation picking up steam due to the oil price spike, higher import prices, weaker productivity growth, and a stronger labor market, interest rates are rising back to more normal levels.

So what effect will the housing bubble have on the genereal economy. So is a recession is coming?

The decline in housing prices will sharply limit the extent to which people can borrow against their home to support their consumption. This will cause savings to rebound from their current negative rates to more normal levels—at 6 to 8 percent of disposable income—but will be associated with a sharp falloff in consumption.

Together these effects virtually guarantee a recession, and probably a rather severe recession. Even worse, there is no easy route to recovery from a recession that results from a collapse of a housing bubble, just as there was no easy route to recover from the stock crash induced recession of 2001. Greenspan used the housing bubble to recover from that crash, because he saw no other mechanism. Unless Bernanke can find some other bubble to inflate, the recovery may be a long slow process. It took Japan almost 15 years to recover from the crash of its stock and housing bubbles.

The crash and post-crash world will not be pretty. Millions of people will lose their jobs and their homes. Unfortunately, the economists who led us down this path are not likely to be among the ones who suffer severe consequences.

There is growing chorus of economists and armchair pundits predicting a coming recession. A significant recession is coming in the next 12 months.