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.

Why We Struggle: Too Much Housing, Too Little Information Technology

Here’s a chart that to me sums up the past decade.  This was supposed to be the Information Revolution…but what we mostly did was build homes.

Private fixed assets are things like machinery, computers, factories, power plants, housing–all the privately-owned productive assets of the country.  From 1999 to 2009, the real net stock of private fixed assets grew by 26%, the slowest 10-year increase in the post-war period, according to data from the Bureau of Economic Analysis.

That slow growth in real private fixed assets is bad enough.  What’s worse, housing accounted for the majority, 53%,  of the real increase in private fixed assets. By comparison, information technology equipment and software–computers, software, and communications equipment–only accounted for 14% of the increase in productive assets. If we toss in spending by on ‘communications structures’, that gets us up to 16%.

In any case, the net real increase in housing fixed assets was more than triple the net real increase in IT fixed assets.  That may help explain why we are in such dire straits now—plenty of new homes, not enough investment in IT.

That’s why I’m not terribly concerned about the slow pace of recovery in the housing market.  I’d rather see money go to more productive uses.

Some caveats: This analysis does not include government assets or consumer durables.

Housing and Jobs

I’ve never been a big  fan of home construction as a driver of economic growth.  Way back in 2005 I wrote a piece for BusinessWeek entitled “The Cost of All Those McMansions” :

whether prices level out, crash, or even keep going up, the housing boom is already having pernicious economic effects. The real problem: the incredible amount of resources — workers, materials, and money — being sucked into home construction and renovation….Residential investment has become a black hole, absorbing a staggering 5.8% of gross domestic product….. housing-driven growth, while creating jobs and lifting wealth, is also distorting the economy, benefiting low-tech commodity sectors rather than the high-tech industries at the heart of America’s competitive strength.

(I know it’s chintzy to self-quote, but please forgive me for now).

Housing construction, although it counts as investment in government statistics, has much less positive impact on long-term growth than other types of investment.

However,   spending on home construction does have one virtue–most of the money goes to domestically-produced goods and services. A calculation by two BLS economists, Carl Chentrens and Arthur Andreassen  (in  a  paper they presented at the 2009 Federal Forecasters Conference) suggests that only 7% of spending on residential investment ‘leaks’ into imports. By contrast, they find that about 21% of nonresidential investment leaks overseas (that makes sense, since so much business investment goes for IT and transportation equipment, much of which has a heavy import component).

That makes new home construction a much better generator of domestic jobs, in the short-run, than other types of spending.   For example, American consumers went shopping for more clothing in the first quarter of 2010. But that uptick of consumer activity sure as shooting didn’t create many clothing production jobs in the U.S.

So if we want job growth–and we do, we do–it’s  going to be tough to get a job recovery without at least some improvement in the housing market.