What Will Housing Market Slide Do to the Economy?

Alan Greenspan said he was puzzled about why the bad credit mortgage mess hadn’t had a greater impact on the economy. That was last month.

The latest economic data show that indeed the crunch of higher home mortgage payments and higher energy prices are sapping economic growth.

Clearly, the home loan mess impacts all homeowners, even indirectly. If the house down the block is sold at a foreclosure auction, how much is your home worth?

That thought is chilling for millions of Americans who count their home as their most important asset - both financially and psychologically.

How far can home prices fall? It depends on which economist you ask. Months ago, Robert Aliber, retired University of Chicago economics professor, has said home prices may drop as much as 30 percent.

The latest gloomy housing market forecast - backed up by compelling data - comes from Gary Shilling, frequently bearish, but even more frequently correct.

To be blunt, Shilling is forecasting a drop of 40-50 percent in home prices in the more overpriced areas such as California and Florida, and ordinary homeowners could see a decline of 10-15 percent in the value of a suburban home.

Shilling’s forecast is based on the historic value of homes, adjusted for what he calls the “McMansion effect” of today’s larger homes being worth more. Using historical data compiled by Robert Shiller, he says home prices would have to drop 45 percent to reach historically normal levels.

Existing-home prices peaked in October 2005, and are down about 4 percent on a national basis through March 2007.

But Shilling says the worst is yet to come, because he estimates it takes about 18 months from when home prices first start to slide for homeowners to recognize that this is not a fleeting blip.

Now that “interval of denial” is about over, and homeowners start realizing that if they want to sell, they’ll have to cut prices, Shilling says.

Even worse, he says there is no way this problem can be confined to the bad credit mortgage loan or housing markets. He estimated that overbuilding has resulted in at least two million “excess” homes - a factor that depresses not only home building, but related industries in the coming years.

Already, housing starts have fallen 33 percent from their peak of 2.265 million in January 2006 to 1.518 million in March. Shilling predicts an additional 25 percent decline in housing starts, and says there is no way capital spending by businesses can pick up the slack in builder confidence.

THE OPTIMIST’S VIEW

It’s a good thing there’s a contrary opinion on this subject, because if there weren’t, the level of home mortgage panic instilled in America right now would be out of control.

Economist Brian Wesbury takes an opposite viewpoint, pointing out that the housing industry has fallen victim to the Fed’s 17 consecutive rate hikes.

Wesbury contends that “absurdly low mortgage interest rates” in 2002-2004 pushed housing activity beyond fundamental levels, and created incentives for buyers to make purchase decisions that seem irrational now.

Today, rates have moved “closer to normal,” causing a housing crunch.

But Wesbury says that since mortgage rates are not excessively high today, there should be little impact on other sectors of the economy.

While acknowledging the pain of the real estate slump, Wesbury says that overall low unemployment and strong manufacturing indexes demonstrate an accelerating economy, despite continued woes in housing.

Says Wesbury:

“After the shock of rate hike works its way through the system, the ample liquidity of an easy monetary policy will reassert itself” resulting in renewed growth.

The stock market seems to agree with Wesbury.

Shilling predicts “an American recession to commence later this year, and to extend globally in 2008.” Time will tell.

SOURCE: Chicago Sun-Times