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Why the housing market is still dragging down the recovery

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SETH PERLMAN/ASSOCIATED PRESS Very soon, supposedly, the White House will begin focusing on how to buck up the teetering economy. Infrastructure banks, trade deals, patent reform—they’re all on the rumored wish list. And now add housing. The Wall Street Journal recently reported that the Obama administration has begun brainstorming ways to bolster the housing market, which is still weak and still bogging down the recovery. “Last year,” the Journal explains, “advisers considered several housing-policy prescriptions but rejected them in favor of letting the market sort things out.” That didn’t work out, so it’s on to Plan B.

But before looking at some of the ideas kicking around for repairing the housing market, it’s worth revisiting the basic question: Just how, exactly, is the housing market dragging down the economy?

Most of the available data suggests that the housing market remains, as the Fed put it today, “depressed.” Home prices have fallen 33 percent since their peak in 2006—inevitable, since there was an unsustainable housing bubble that burst—and, according to the S&P/Case-Shiller index, prices are still stuck at levels last seen in 2003. A Morgan Stanley report estimates there are still some 2.2 million vacant homes available for sale, while 7.5 million homes are facing foreclosure. That’s why, in many areas, home prices are expected to fall still further.

So how do sputtering home prices hurt the economy? One of the biggest ways, economists argue, is the wealth effect. Housing, after all, is a form of wealth, and people who own houses can tap into that wealth to spend on goods and services. During the housing bubble, Americans were taking out home equity lines of credit to spend. Now that home values are depressed and many of those lines of credit aren’t being offered anymore, much of that spending has wilted.

To give a sense for how big a deal this is, Dean Baker of the Center on Economic and Policy Research has offered an estimate. The housing stock in the United States is worth about $8 trillion less, all told, than it was at the peak of the bubble in 2006. Studies have found that people spend somewhere between 5 to 7 cents for every dollar of housing wealth they own. That would mean the bursting of the bubble has meant about $400 billion to $560 billion less in consumption spending than at the height of the bubble years.

Instead, households are grappling with an unmanageable amount of debt. More than one in four homeowners with a mortgage, for instance, now owe more than their property’s market value. Economists like Ken Rogoff and Carmen Reinhart have discussed how the current downturn is so especially severe because there’s a large debt overhang—households are struggling to repair their balance sheets, which could take years, and, as such, they’re cutting back on spending. And the biggest contributor here is mortgage debt. Here’s a graph from Calculated Risk showing how mortgage debt (in red) has exploded in the past decade:

That’s one big consequence of the weak housing market. More directly, meanwhile, low home prices—and the glut of vacant homes on the market—means there’s not much demand for new housing. That’s kept the construction sector, where unemployment is improving but still high, stuck in the doldrums. Historically, residential investment has averaged around 4 percent of GDP, and it was more than 6 percent of GDP at the height of the housing bubble. At the moment, it’s lagging at around 2 percent and was at a record low last quarter. If residential investment was back at normal historical levels, we’d have more growth.

A weak housing market can have other adverse effects, too. Some 28 percent of homeowners with a mortgage owe more than their homes could likely fetch on the market. That’s bad for obvious reasons—those homeowners are more likely to default and be foreclosed on—but it can also hurt economic output, if it prevents people from moving to take jobs. “A homeowner who is underwater might hesitate to take an opportunity in a different location, because they’d have to move and write their bank a check at closing,” says Morris Davis, an associate professor of real estate and urban land economics at the Wisconsin School of Business—though, he cautions, this effect still isn’t entirely visible in the data.

Now, during most recessions, housing slumps usually get corrected in a relatively straightforward fashion. The recession hits, the Fed starts lowering interest rates, it becomes easier for people to get financing for a mortgage, demand for housing increases, and, so, residential investment starts growing—leading the way to recovery. “Housing has typically been the tail that wags the dog,” says Stuart Gabriel, director of UCLA’s Ziman Center for Real Estate. “When it picks up, it begins pulling other sectors with it.” For instance, new homeowners typically start buying drapes and appliances and carpeting and furniture and so forth.

But that normal course of events isn’t transpiring this time around. The housing bubble, after all, came about because of overly lax (in many cases predatory) lending practices. And, since the bubble popped, lenders have become significantly more cautious and have tightened underwriting standards. In June, Fed Chairman Ben S. Bernanke highlighted this issue, noting that even though prices and interest rates are incredibly low, “many potential homebuyers are unable to qualify for loans.” Gabriel notes that lenders are fretting that housing prices will continue to fall (making the value of the loan collateral uncertain) and are focused on stemming losses from their mortgage division. Some experts, such as Davis, argue that lenders are overreacting at this point—they’ve gone from too impetuous to too stringent. It’s also worth noting that the federal government has also moved to tighten underwriting standards since the bubble burst.

Add that all up, and a sector that typically plays a crucial part in lifting the economy out of a downturn isn’t able to play that role this time around.

So is there any way out of this trap? Some economists argue that we just have to wait until housing prices hit bottom. Only then will lenders have confidence to start lending again. Plus, normal population growth will eventually lead to an increase in housing demand and the sector will recover naturally. The problem is that that process can take years—after the 1990 housing bust in Los Angeles, home prices took a full decade to get back to their 1990 levels. If we don’t want to wait that long, then it’s time to look at policy. That’ll be a subject for a follow-up post.

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