[Column] The bursting of the U.S. housing bubble: does it spell recession?

Dean Baker, co-director of the Center for Economic and Policy Research

The evidence is mounting that the U.S. housing boom is turning into a bust. In the last week, the National Association of Realtors released data showing that house sale prices are down from last year's levels in 26 major metropolitan areas; the Commerce Department reported that housing prices are down by more than 15 percent from their bubble peaks; and the Mortgage Bankers Association reported that applications for home purchase mortgages have dropped by more than 20 percent from their levels one year ago. In addition, a new poll of builders showed industry confidence at the lowest level since the middle of the 1990-1991 recession.

The end of the housing boom is likely to lead to the end of U.S. economic recovery. The housing sector has been hugely important to the U.S. economy since the last recession. The unprecedented run up in house prices led to a record boom in housing construction and sales. In 2005, new home construction was nearly 50 percent higher than its level a decade earlier, even though population had risen by just 10 percent. Sales of existing homes in 2005 were nearly twice the 1995 rate. The surge in both construction and sales led a boom in employment in these sectors, which together account for almost 5 million jobs.

In addition to the direct employment in housing related sectors, the housing boom also spurred the economy through the wealth created by the jump in house prices. Historically, house prices have moved in step with other prices, keeping just about even with the overall rate of inflation. In the last decade, house prices suddenly exploded, increasing by more than 50 percent, after adjusting for inflation. This created more than $5 trillion in housing bubble wealth.

Consumers have borrowed against this new wealth at a feverish pace, pulling more than $600 billion out of their homes in the last year. This borrowing fueled the consumption boom of the last five years, pushing the savings rate into negative territory for the first time since the beginning of the depression in the 1930s.

Of course, just like the stock bubble, the housing bubble was not sustainable. The stock bubble collapsed because the supply of new issues of tech stocks eventually exceeded the demand from speculators. Similarly, the record levels of housing construction inevitably led to a glut of housing on the market. For a long time, real estate speculators were willing to buy up excess housing, but there is a limit to how much property speculators can buy. Once they reached this limit, inventories began to grow (they now are at record levels), and the price boom came to an end.

There are desperate sellers in many of the areas where the housing market was booming just a year ago. In many cases, sellers are offering large concessions to unload their homes, such as paying buyers' closing costs, covering a year of condo fees, or offering lower than market mortgage rates. Since these concessions, which lower the true sale price, don't show up in the house price indexes used by economists, the decline in housing prices so far is actually considerably larger than most analysts recognize.

How far and fast prices will fall is difficult to know at this point, but a few things are predictable. Housing construction and sales will drop back toward natural market trend levels. Housing construction is already down by 15 percent from its peak. It is likely to fall at least twice that much before stabilizing. Sales of existing homes, which are the lifeblood of the real estate industry, are also likely to fall by 30-40 percent from peak levels. There is no reason to expect the rate of housing turnover to be higher today than in the past, especially now that the country has a considerably older, more stable population.

In addition, the borrowing spree of the last five years is likely to come to an abrupt end as stagnant or declining home prices cut off this important source of credit. There is evidence that we are already seeing the effects of this credit squeeze, as credit card debt has begun to soar in the last few months. Families who can't get the money they need by borrowing against their homes will turn to credit cards as the best available alternative.

All of this is very bad news for the U.S. economy. If housing construction and sales fall back to trend levels, it would mean a loss of more than 2 million jobs. The decline in consumption that will result because people can no longer borrow against their homes will have an even more dramatic impact on the economy. The financial system will also be shaken by an unprecedented wave of mortgage defaults, as millions of people will face difficulty in sustaining their mortgage payments.

There is no obvious way to prevent the collapse of the housing bubble from leading to full-fledged recession, and quite likely a severe recession. Over the longer term, the U.S. economy will eventually be lifted by a reversal of its trade deficit, although this will require a sharp fall in the dollar, which will in turn lead to more inflation and lower living standards. The reversal of the trade deficit will also lead to a loss of an important source of demand for major U.S. trading partners. This will spread the fallout from the collapse of the housing bubble around the world if effective policies are not pursued to sustain demand elsewhere.

It was an enormous mistake for the United States to allow a housing bubble to grow to such dangerous proportions. It is unfortunate that the Federal Reserve Board and others in policy making positions ignored warnings when this crisis still could have been averted.