I will build on my conclusions from the first two parts of this series to analyze where the economy is headed. In the first part I discussed why interest rates are heading higher. As a consequence, in the second part of this series I argued that the housing market will experience falling prices. If my predictions turn out to be correct, the economy will suffer a recession that would be even more painful than that of 2001.
The 2001 recession was relatively short and mild compared to those in the past. As the economy contracted, President Bush provided stimulus by introducing legislation that cut taxes while simultaneously increasing spending on social programs and defense.
The economy also received a boost when the Federal Reserve rushed to cut rates to an unprecedented level of 1%. At the same time China entered the WTO and U.S.-China trade exploded. Since China wanted to maintain the yuan’s peg to the dollar, they were forced to use their surplus dollars to buy U.S. investments, in particular bonds which caused both short and long-term rates to fall.
Historically low rates spurred consumers to take on record debt which was used to buy things like plasma TV’s, SUV’s, stocks, and especially houses. As the demand for housing outstripped supply, prices started to rise at an unusually high rate. When the value of peoples homes increased it caused their wealth to also increase even though their wages saw no improvement during the same period. This wealth effect contributed to further consumption and home equity extraction.
The Housing Effect
Since 2001, manufacturing has been replaced by housing as the main engine for economic growth. As the following graphic shows, the booming housing market’s impact on the economy cannot be overstated.
However, as I concluded in the previous part of this series housing is overvalued and prices will decline over the coming few years. Such a scenario would devastate the economy. Dean Baker estimates that a contraction in housing activity could shave 3 to 4 percent off GDP.
Housing construction is equal to approximately 5 percent of GDP. Construction of new homes has been going on at a near-record pace over the last few years, in response to the run-up in housing prices. Home construction could easily fall back 40 percent (this was the drop off in the 1981-82 recession), which would imply a direct loss in demand equal to 2 percentage points of GDP.
In addition, the large wealth effect associated with the housing bubble, which has spurred a consumption boom in the last few years, will go into reverse as housing prices plummet. Research from the Federal Reserve Board shows that a dollar in additional housing wealth leads to 4 to 6 cents of annual consumption. This implies that a loss of $5 trillion in housing wealth would lead to a decline in annual consumption of between $200 billion and $300 billion. This loss in consumption is equivalent to 1.6 to 2.5 percentage points of GDP.
Combining the 2 percentage point drop in demand due to a falloff in housing construction with the 1.6 to 2.5 percentage point drop in demand due to the reversal of the housing bubble’s wealth effect leads to a falloff in demand of between 3.6 and 4.5 percentage points of GDP. If employment fell in the same proportion, this would imply the loss of between 5.0 million and 6.3 million jobs.
Since recent data is indicating a hard landing for housing, I am expecting that we will see a recession in 2007. This time Fed rate cuts will not save the economy since foreigners will put upward pressure on long rates. In addition, the government will be handcuffed to provide fiscal stimulus since it is already running unsustainable budget deficits. Therefore, the upcoming recession should be far more painful than the last economic contraction and it could turn out to be as bad as Japan’s recent experience.