After the fall
Jun 16th 2005
From The Economist print edition
Soaring house prices have given a huge boost to the world economy. What
happens when they drop?
PERHAPS the best evidence that America's house prices have reached dangerous
levels is the fact that house-buying mania has been plastered on the front
of virtually every American newspaper and magazine over the past month. Such
bubble-talk hardly comes as a surprise to our readers. We have been warning
for some time that the price of housing was rising at an alarming rate all
around the globe, including in America. Now that others have noticed as
well, the day of reckoning is closer at hand. It is not going to be pretty.
How the current housing boom ends could decide the course of the entire
world economy over the next few years.
This boom is unprecedented in terms of both the number of countries involved
and the record size of house-price gains. Measured by the increase in asset
values over the past five years, the global housing boom is the biggest
financial bubble in history. The bigger the boom, the bigger the eventual
Throughout history, financial bubbles-whether in houses, equities or tulip
bulbs-have continued to inflate for longer than rational folk believed
possible. In many countries around the globe, house prices are already at
record levels in relation to rents and incomes. But, as demonstrated by
dotcom shares at the end of the 1990s, some prices could yet rise even
higher. It is impossible to predict when prices will turn. Yet turn they
will. Prices are already sliding in Australia and Britain. America's housing
market may be a year or so behind.
Many people protest that house prices are less vulnerable to a meltdown.
Houses, they argue, are not paper wealth like shares; you can live in them.
Houses cannot be sold as quickly as shares, making a price crash less
likely. It is true that house prices do not plummet like a brick. They tend
to drift downwards, more like a brick with a parachute attached. But when
they land, it still hurts. And there is a troubling similarity between the
house-price boom and the dotcom bubble: investors have been buying houses
even though rents will not cover their interest payments, purely in the
expectation of large capital gains-just as investors bought shares in
profitless firms in the late 1990s, simply because prices were rising.
Homes as cash machines
One other big difference between houses and shares is more cause for concern
than comfort: people are much more likely to borrow to buy a house than to
buy shares. In most countries, the recent surge in house prices has gone
hand-in-hand with a much larger jump in household debt than in previous
booms. Not only are new buyers taking out bigger mortgages, but existing
owners have increased their mortgages to turn capital gains into cash which
they can spend. As a result of such borrowing, housing booms tend to be more
dangerous than stockmarket bubbles, and are often followed by periods of
prolonged economic weakness. A study by the IMF found that output losses
after house-price busts in rich countries have, on average, been twice as
large as those after stockmarket crashes, and usually result in a recession.
The economic damage this time could be worse than in the past because house
prices are more likely to fall in nominal, not just real terms. Not only do
houses in many countries look more overvalued than at previous peaks, but
with inflation so low, prices would have to stay flat for at least a decade
to bring real prices back to long-run average values. Most important of all,
in many countries this house-price boom has been driven far more by
investors than in the past, and if prices start to dip, they are more likely
to sell than owner-occupiers. In America this could mean the first fall in
average house prices since the Great Depression. Owners who have been using
their home like an ATM to extract cash, or who were relying on rising house
prices to provide them with a comfortable pension, will suddenly realise
that they need to start saving the old-fashioned way-by spending less of
The Fed frets
The lesson from recent experience in Australia, Britain and the Netherlands
is that, contrary to conventional wisdom, a big rise in interest rates is
not necessary to make house prices falter. This is bad news for America.
Even if prices there initially just flatten rather than fall, this will hurt
consumer spending as the impulse to borrow against capital gains disappears.
It is by encouraging such borrowing that rising house prices have given a
bigger boost to America's economy than elsewhere. Two-fifths of all American
jobs created since 2001 have been in housing-related sectors such as
construction, real-estate lending and broking. If house prices actually
fall, this boost will turn into a substantial drag.
No wonder that the Federal Reserve is starting, belatedly, to fret about
house prices. By holding interest rates low for so long after equities
crashed, the Fed helped to inflate house prices. This prevented a deep
recession, but it may have merely delayed the needed economic adjustments.
Ideally, the Fed should have tried to cool the housing boom by raising
interest rates sooner and by giving clear verbal warnings to buyers, as
Britain's and Australia's central banks have done. Even now some stern words
from Alan Greenspan, the Fed's chairman, could restrain more house-price
Of course, by the time American prices begin to fall, probably sometime next
year, they will not be Mr Greenspan's headache. He will have retired and
someone else will be in his job. If weaker house prices push the economy
towards recession, the awkward truth is that America's policymakers will
have much less room to manoeuvre than they did after the stockmarket bubble
burst. Short-term interest rates of only 3% leave less scope for cuts. In
2000, America had a budget surplus. Today it has a large deficit, ruling out
big tax cuts.
The whole world economy is at risk. The IMF has warned that, just as the
upswing in house prices has been a global phenomenon, so any downturn is
likely to be synchronised, and thus the effects of it will be shared widely.
The housing boom was fun while it lasted, but the biggest increase in wealth
in history was largely an illusion.