The Housing Bubble of 2008

Edward J. Dodson

[Reprinted from the Financial Times online forum
moderated by Martin Wolf, February, 2008]

The comments below were recently posted to the economists' forum of the Financial Times. As described by Martin Wolf (FT associate editor and chief economics commentator), the forum brings together "some of the world's leading economists [to] debate issues raised in FT columns by Martin Wolf, Lawrence Summers, Charles W. Eliot (University Professor at Harvard University), and occasional guest economics columnists." The forum does not normally post comments received by persons who are not professional economists. However, my input on the causes of the so-called 'housing bubble' were apparently viewed as cogent and of some value to the discussion. The subject of Martin Wolf's column was to stimulate discussion of the analysis of our current economic situation offered by Professor Nouriel Roubini of New York University's Stern School of Business, who forecasts that: "Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe." Martin Wolf asked and answered: "Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about 'decoupling'. …In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce. The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable."

My comments posted to the forum on February 21, 2008 were as follows:

A more complete understanding of the risks associated with 'housing bubbles' requires further analysis of the fundamental forces at play. Because housing is shelter and not primarily a liquid asset, the supply of housing tends to be quite elastic - with the affect that housing prices are said to be 'sticky downward'. Homeowners not forced to sell because of unemployment or other financial pressures will generally pull their property off the market and wait until a seller's market returns.

The situation for homebuilders is rather different, of course, as the homes they construct are inventory (similar to any manufacturing concern). Yet, not all builders are faced with the same degree of financial pressure related to unsold inventories. Those builders who acquired land prior to the most recent run-up in land prices have experienced above-market profit margins as land prices have skyrocketed. Conversely, these builders can continue to sell inventory at a profit even as prices have fallen. Equally important, unlike past land market cycles, few builders have engaged in large-scale speculative construction. The most at-risk type of residential construction is (as always) the multi-storied condominium building because of the significant upfront land acquisition and construction costs incurred before unit closings begin to generate cash flow.

We are clearly past the peak of the current land market cycle. A key distinction this time is that land markets (fueled by cheap and, to a significant extent, poorly underwritten credit) have become globally overheated. Rising land prices almost everywhere have stressed the profit margins of many goods producers and even service providers. As Adam Smith taught us, the wealth of a nation grows best when wages are high. The disappearance of housing savings and declines in household disposable income are clear indications that the risk of a depression-like downturn is very high in the U.S., the U.K., Australia and a long list of other nations.

******

Later that day, Martin Wolf (FT associate editor and chief economics commentator) posted this comment:

"I have little to add to what Mr Dodson says. There is a danger of a long slide in house prices in many countries, with associated freezing of the market. The full macroeconomic effects of this when households are so leveraged are unknown. But they are likely to be highly uncomfortable. Since this was a widely shared housing boom, we are obviously looking at a widely shared bust."