Falling Housing Market is Not Bad News

The drop in housing prices in October has almost uniformly been interpreted as a bad sign for the economy in 2011.  I’d like to offer an alternative viewpoint: I think the drop in housing prices may be a tough but necessary step in the healing process.

Consider this. The false boom of the 2000′s was built on rising home values. Americans borrowed against those high home values, which enabled them to maintain a higher standard of living than they could really afford.  The borrowing flowed into mortgage-backed securities, which were in turn bought by overseas investors, effectively lending America the money to finance the trade deficit.  On a country level, we maintained a higher living standard than we could afford.

We’re still doing it, though now housing, consumption and imports are being propped up by federal government borrowing.  We still haven’t made the big jump to investing in our future–knowledge capital and productive physical capital.

From this perspective, a rise in housing prices is a signal that the “bad money pump” has started again. It means we are falling back into the same bad habits of borrowing money from overseas to finance housing, which in turn is used as collateral for debt to buy imports. We don’t want that!

I’d welcome anyone who would explain to me why  housing prices  are a good signal of the underlying long-term strength of the U.S. economy.

Less support for housing?

In a new column entitled “Time to Let Home Prices Fall?”, Tom Petruno of the LA Times writes:

Leave housing to market forces, let prices fall until buyers are motivated to come in, and hope that the economy can stand one final cathartic wave to clear the excesses of the bubble.

He also notes that

a new decline in home values also could force the banking system, and the government, to finally deal realistically with a root cause of the economy’s woes: the gigantic debt load consumers took on over the last two decades.

As measured by the Federal Reserve, the household sector is  reducing its debt, but at a very slow rate. And because domestic hedge funds and nonprofits are folded into the stats for the household sector,  we have no idea whether actual American households are reducing their debt at all.

The question is whether a sharp fall in housing prices would be bracing or destructive.