Another gem from Stephen Roach

Five and a half years ago the equity bubble popped. Within six months, the US economy went into mild recession, and the global economy was quick to follow. Today, America’s housing bubble is finally bursting. Is the die cast for another bubble-induced downturn in the US and global economy?

All asset bubbles are alike. Sure, there are obvious differences between equities -- a financial asset -- and homes -- a tangible asset. But to me, the Shiller definition says it all: A bubble is an outgrowth of powerful amplification mechanisms -- both real and psychological -- which create an unsustainable condition whereby “… price increases beget further price increases” (see Robert Shiller’s Irrational Exuberance, second edition, Princeton University Press, 2005). The rise and fall of the US housing market fits the Shiller script to a tee. House price appreciation surged to a 27-year high in 2005, and as of the first quarter of 2006, prices were still rising by 20% or higher in 53 metropolitan areas across the United States. Both pricing and demand were feeding on each other through classic Shiller-like amplification mechanisms.

As always, the upside of a speculative bubble lasts for longer than you think. But when it finally goes, it invariably unwinds with greater force than widely expected. That seems to be the way the chips are now falling in the US housing market. Demand for homes is falling like a stone and inventories of unsold dwellings are ballooning -- up 40% for existing homes and 22% for new homes in the 12 months ending July. These are the classic quantity adjustments that set the stage for price destruction -- the endgame of any asset bubble. So far, home values just seem to be leveling off at still lofty price points. As the bid-offer gap widens in an excess inventory and rising interest rate climate, price declines will come as they always do. This bubble is not different.

Construction activity is the last shoe to fall in a housing downturn. Due to sunk fixed costs of land and property acquisition by developers, homebuilding typically continues into the inventory overhang phase of the cycle. Such is the case today -- with residential construction activity still holding at relatively high levels through mid-2006. However, once this last gasp of project completions runs its course, the construction downturn should gather force. Given the magnitude of the current inventory overhang, the downside of the building cycle could be both deep and prolonged -- lasting possibly a couple of years and entailing peak-to-trough declines of at least 25%. For a sector that boosted US real GDP growth by about 0.5 percentage point per annum over the past three years, it is now poised to subtract about one percentage point per annum over the next couple of years -- a swing of 1.5 percentage points off the overall US growth rate.

Of course, the construction impact is only part of the story. There is also the wealth effect from the housing bubble to consider. Since the dawn of the Asset Economy in 1995, growth in real disposable personal income accounted for only about 85% of the cumulative growth in personal consumption expenditures. The balance came from wealth effects of a seemingly endless string of asset bubbles -- first equities, then property. The property-based wealth effect became especially important in driving consumer demand in recent years. Over the 2004-05 period, real personal consumption grew at a 3.7% average annual rate -- more than 50% faster than the 2.4% average annual gains in real disposable personal income over the same period. The gap between household incomes and spending is traceable to the extraction of equity from an increasingly frothy housing market. According to Federal Reserve estimates, mortgage equity withdrawal exceeded $700 billion (annualized) in the first half of 2006 -- more than enough to provide an “extra” stimulus to consumer demand as well as to provide a substitute for income-based saving. In the frothy house price climate of the past five years, the property-based wealth effect probably boosted growth in total consumer demand by at least 0.5 percentage point per year. In a stable to falling home price climate, that impetus could fade quickly to zero -- and possibly go into negative territory if saving-strapped American households elect to start saving out of labor income again.

All in all, a post-housing bubble shakeout could entail a haircut of at least two percentage points off the overall US GDP growth rate -- 1.5 percentage points via the construction effect and another 0.5 percentage point from the wealth effect. The overall impact could even be larger if households elect to rebuild income-based saving balances -- hardly unusual in light of the looming retirement of some 77 million baby-boomers. The repercussions of multiplier effects through construction-related hiring shortfalls could also compound the problem. For a US economy that has been growing at a 3.2% average annual rate over the past three years, a two percentage point haircut does not guarantee a recession. But it certainly could end up being a close-enough call that might trigger a recession scare in financial markets. The hope, of course, is for the exquisitely well-timed handoff -- a seamless transition from asset-dependent consumption to other sectors, such as capex and net exports. I remain suspicious of such claims of built-in resilience. If the US consumer slows, the demand expectations that typically drive capital spending will also weaken. So, too, will the growth dynamic of America’s export-led trading partners -- thereby undermining support for US exports, as well. In short, for a wealth-dependent US economy, the bursting of another major asset bubble is likely to be a very big deal.

It is also likely to be a big deal for an unbalanced global economy. In 2000, when the equity bubble burst, the gap between current account surpluses and deficits was less than 4% of world GDP. This year, as the housing bubble bursts, that same gap is likely to be around 6% of world GDP. The disparity between current account surpluses and deficits -- and the added point that the US accounts for about 70% of all the deficits in the world -- underscores the increased dependence of the rest of the world on the US. For that reason, alone, a bursting of the property bubble poses equally serious risks for America’s key trading partners and for the rest of an increasingly integrated global economy.

Ironically, at just the moment when it has become evident that the US housing bubble has burst, the key architects of this sad state of affairs -- America's central bankers -- are cavorting at their annual retreat in Jackson Hole, Wyoming. Denial has long been deep at this Fed love-fest. A year ago at this same conference, considerable adulation was heaped on the post-bubble legacy of the Greenspan Fed -- namely, that the US central bank was correct in dealing with the equity bubble after the fact (see Alan Blinder and Ricardo Reis, “Understanding the Greenspan Standard” available at www.kc.frb.org). This, of course, is consistent with Greenspan’s own self-professed verdict of vindication for the Fed’s post-bubble clean-up strategy (see his January 3, 2004 speech, “Risk and Uncertainty in Monetary Policy”) as well as a similar argument presented at an earlier Jackson Hole gathering by then Princeton professor Ben Bernanke (see the 1999 paper by Ben Bernanke and Mark Gertler, “Monetary Policy and Asset Price Volatility”). Missing in this self-serving depiction is an assessment of the consequences of aggressive post-bubble monetary easing tactics. The injection of excess liquidity is key in that regard -- sufficient in the current instance for one bubble to beget the next. In that important respect, the housing bubble was a direct outgrowth of the Fed's post-equity bubble defense strategy. And now the US, as well as a US-centric world economy, must come to grips with what its central bank has wrought -- yet another post-bubble shakeout.