Housing and the Great Recession: Finding the Cause -- Habitat for Humanity Int'l 1

Housing and the Great Recession: Finding the Cause

A commentary by Ted Baumann

Everyone understands that the current recession, the worst since World War II, started with transatlantic housing markets, and has in turn had a dramatic impact on them.

Housing values have collapsed, and it is extremely difficult to obtain a mortgage. The contrast with the previous decade is stark: From 1997 to 2007, housing prices rose 175 percent in the United States, 180 percent in Spain, 210 percent in Britain, and 240 percent in Ireland. By contrast, the most recent Schiller-Case index of U.S. housing prices1 shows year-on-year price declines of up to 20 percent per month in mid-2009. U.S. house prices are now at 2003 levels.

Why did housing prices rise so fast and then crash so hard?

As New York Times columnist Paul Krugman and author Robin Wells argue in a recent two-part summary of new literature in the New York Review of Books, there are four popular explanations: “the low interest rate policy of the Federal Reserve after the 2001 recession; the ‘global savings glut’; financial innovations that disguised risk; and government programs that created moral hazard.”

Krugman is a Nobel laureate for economics. Wells is the co-author, along with Krugman, of “Economics” and has taught economics at Princeton, Stanford Business School and MIT. Let’s consider their views on these theories.

Krugman and Wells acknowledge that low Federal Reserve short-term interest rates from 2001 onward might have played a role in driving up housing prices in the United States. But European prices rose even faster under much higher Euro Zone rates. In any case, the interest rates set by the Fed are short-term, which are not central to housing markets. So low short-term interest rates on their own are unlikely to be the whole explanation, they argue.

By contrast, Krugman and Wells observe that massive capital inflows to the United States and the Euro Zone from capital-surplus countries (primarily China), arising from trade imbalances, helped to push down long-term interest rates, which do influence housing markets (low long-term rates encourage rising house prices, as well as speculative investment in new housing stock).

The third explanation they consider is the “originateand-distribute” system, i.e., the separation of loan origination from risk through mortgage securitization. Krugman and Wells observe that housing prices actually rose faster in economies without sophisticated risk-distribution mechanisms (such as those in Spain). They also point out that commercial real estate values in the United States inflated just as fast as residential, without any securitization of the associated loans. So the evidence does not support this explanation, at least not in isolation.

The final explanation considered is that the U.S. Community Reinvestment Act, and the implicit government underwriting of Fannie Mae and Freddie Mac, created a moral hazard. Banks assumed that the government would bail out housing-exposed markets, which encouraged reckless lending. The problem with that theory is that the Community Reinvestment Act was passed in 1977, and the bubble only took off 20 years later. Also, “blame-the-CRA” doesn’t explain the rise in commercial real estate values or Euro Zone markets.

So which of these explanations, or which combination, do Krugman and Wells find most persuasive? Ultimately, they argue that the glut of money flowing into the transatlantic economies from China and other trade-surplus countries led to historically low long-term borrowing costs, and therefore inflated housing prices.

The resulting explosion of housing construction in turn fed the trade deficit with China, creating a self-reinforcing bubble. U.S. imports from China, of both housing materials and wage goods, rose steeply, but Chinese purchases of U.S. Treasury bonds kept the Yuan artificially weak and U.S. long-term interest rates low. Krugman and Wells accept that mortgage securitization helped it to inflate this bubble, but in the end, the main problem was insufficient oversight of the growing imbalance between housing asset prices and underlying economic fundamentals.

The U.S. Federal Reserve under Alan Greenspan knew that long-term interest rates were encouraging housing asset values that were wildly out of line with historical trends, but failed to act. By the time they did, it was too late.

The key insight of Krugman and Wells’ review of the housing bubble, however, is that the policy response to its collapse has been all wrong. A burst financial bubble damages banks by suddenly devaluing the asset side of their balance sheets, calling their solvency into question.

The transatlantic policy response has been to help the banks by capital injections and by maintaining extremely low short-term interest rates, increasing banks’ earnings spread from their lending activities, and thereby rebuilding their balance sheets (and bonuses).

But households also have “balance sheets,” and by refusing to address the post-bubble mismatch between mortgage balances and housing values, policymakers have made the recession “Great.” Households that are “underwater” on their mortgages or other asset-related debts are forced to try to deleverage by prioritizing debt reduction over consumption spending.

This has created a demand deficiency for the economy as a whole. The result: a superficial recovery with high levels of unemployment.

In effect, Krugman and Wells say, the policy choices made by transatlantic leaders, both during and after the housing bubble, have prioritized the needs of the banking sector above all else. So, while the banks have recovered, the rest of us have not.

Ted Baumann is director of international housing programs at Habitat for Humanity International.


1 “U.S. Home Prices Keep Weakening as Nine Cities Reach New Lows According to the S&P/Case-Shiller Home Price Indices”

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