Krugman On US Housing

Paul Krugman said the housing slump in the US could take up to two years to work through, and that up to 20 million mortgages could be underwater if house prices decline by 30% between now and 2010 – which Krugman believes could well occur.

Housing is illiquid and people are reluctant to sell, factors which will prolong the pain. In contrast, stock collapses tend to be short and violent, points out Krugman. Political considerations could also draw out the process, such as freezing foreclosures, or bailing out homebuyers. It took six years for the South California housing bubble to work itself out in the early 1980s, said Krugman, who believes the national housing bubble of recent years is much worse. He noted that real estate prices in California had given up all their gains by the end of the recession. “The recession in the US could be L-shaped or U-shaped, but it won’t be V-shaped like the Asian financial crisis,” said Krugman, “because the US seems to intent on adopting some of the same strategies as Japan adopted in the 1990s.” In other words, rather than permit a savage purging of the system, the policymakers might decide to ‘buy time’ rather than solve the problem. The housing bubble inflated to historically unprecedented proportions between 2004 and 2007, aided by securitisation and collateralised debt obligation (CDO) techniques, said Krugman.

A common ratio of judging the severity of housing bubbles is the price:rent ratio, which is the average cost of ownership divided by the rental income the house would fetch as a buy-to-let property. The higher the figure, the worse the bubble. At its peak, the price-to-rent figure was 1.5 in Southern California. In the national market in 2005, it was 2.3, said Krugman. “The inevitable collapse of the housing bubble has lead to the worst outlook in the housing market since the Great Depression,” said Krugman, pointing out that housing starts have collapsed to their lowest level since 1991.

The housing market was seriously weakened by the sale of sub-standard mortgages, encouraged by securitisation and CDO techniques. Nobody knows the final bill, but Krugman guesses banks may have lost up to US$1 trillion on such products. The decline in house prices may wipe US$8 trillion off GDP, and much of that will be financed by the financial system (the lender) rather than the borrower, estimates Krugman.

Banks do not appear to be in fatal trouble, says Krugman. But stress in the system is showing up in the shadow banking system, where new institutions have adopted banking functions, such as extending credit, but away from the sharp eye of the regulator. Krugman says that auction rate securities are a good example of how the stress can appear in obscure but important parts of the financial system.

Auction rate securities, with their weekly auctions, appeared to offer liquidity and high yields to investors, but the market froze when investors panicked and headed simultaneously for the exits. As a result, the Metropolitan Museum of Art in New York and certain student loan bodies have seen the rates they are paying on their loans shoot up. Such crises have led to a wave of bankruptcies of shadow banking institutions, which Krugman described as a “stealth banking crisis”.

The only reason the US did not sink into recession last year is because of the export recovery off the back of the drastically weaker dollar, says Krugman. However, further credit bombs will be exploding for a while yet, for example in the commercial real estate market, he estimates. Krugman was sceptical that interest rate cuts will help get the economy back on track. The Federal Reserve has far less ammunition to cut rates than in previous recessions. The Fed started cutting rates when they were only 5.5% last year. In the last two economic crises, rates were around 8% before the Fed started to cut rates. “The problem is that the economic situation looks worse this time, but there is less scope for interest rates to be cut,” he comments. To cut rates by the same extent as in the last recession, estimates Krugman, rates would have to fall to zero – the same level as they were in Japan for many years after the bubble started to collapse in 1990. That leaves the Bush administration’s tax rebate checks, being posted to every citizen to stimulate the economy. But Krugman believes this cash did not go to the poorest members of society, who would be sure to spend it. Better off people will simply save it, he estimates.

Krugman believes it would have been wiser to spend the money on food stamps and more generous unemployment benefits. One option could be to carry out a huge infrastructure building programme, which would be another similarity to Japan. But if the Republican Party wins the next election with Senator John McCain becoming president, Krugman believes it is unlikely this would happen.

Recent US housing figures reported for January 2008:
-Median existing-home price was US$201,100 in January, down 4.6% from a year ago -Total housing inventory rose 5.5%
-At the end of January, existing homes available for sale were 4.19 million, a 10.3-month supply at the current sales pace (up from a 9.7-month supply in December).
-Single-family home sold at an annual rate of 4.34 million in January. This is 22.4% below January 2007.
-Existing condominium and co-op sales dropped 6.5%, and are 30.2% below the year ago levels. The median existing condo price (US$220,400) is only 1.0% lower than January 2007.
-Existing-home sales in the Northeast fell 3.6 percent to an annual rate of 810,000 in January, and are 25.7 percent below a year ago. The median price in the Northeast was US$270,800, up 3.1 percent from January 2007.

p/s Paul Robin Krugman is a liberal professor of economics and international affairs at Princeton University. He is also an author and a columnist forThe New York Times, writing a twice-weekly op-ed for the newspaper since 2000. Krugman is well known in academia for his work in trade theory, which provides a model in which firms and countries produce and trade because of economies of scale and for his textbook explanations of currency crises and New Trade Theory. He was a critic of the New Economy of the late 1990s. Krugman also criticized the fixed exchange rates of the island Asia nations and Thailand before the 1997 Asian financial crisis, and of investors such as LTCM that relied on the fixed rates just before the 1998 Russian financial crisis. Krugman is generally considered a neo-Keynesian, with his views outlined in his books such as Peddling Prosperity. His International Economics: Theory and Policy (currently in its seventh edition) is a standard textbook on international economics without calculus. In 1991 he was awarded the John Bates Clark medal by the American Economic Association. He is among the 50 best economists in the world according to IDEAS/RePEc.