No-one can deny that the weakness of the housing market remains at the heart of the economic crisis in the US. In fact, it is the American equivalent of the sovereign debt crisis in the eurozone. The overhang of housing debt is forcing US households to run large financial surpluses in order to pay down their liabilities, just as the the overhang of sovereign debt in the eurozone is forcing governments to improve their financial balances. And that is resulting in weak economic activity on both sides of the Atlantic. The question of what should be done about it is now coming to the centre of the economic debate in the US. Diagnosing the problem is relatively straightforward. Solving it is not.
The story of the American housing bubble, told in the graph below, is by now a very familiar one. During the boom years up to 2006, the build up in mortgage debt was more than matched by the rise in house prices, so net worth in housing rose dramatically, by more than $8 trillion in less than a decade. (This is equal to 60 per cent of US GDP in 2006.) However, when house prices started to fall, this process was even more rapidly reversed. Net worth in housing has plummeted by $7.3 trillion in the last five years. This has left 22 per cent of US households holding outstanding mortgage debt which exceeds the value of their homes.
There is no end in sight to this problem. House prices appeared to stabilise in 2010, but now seem to be falling again, as the rising number of repossessions increases the overhang of unsold homes on the market. Although households are trying to pay down mortgage debt, this process is inevitably very slow, relative to the potential speed at which house prices could fall. Fears are mounting that the housing market is beginning to spiral downwards again.
What can be done about this? The politics are not easy, because people who have not incurred excessive housing debt are hostile to the notion of bailing out those who have been more “reckless”, in their eyes at least. Efforts by the Obama administration to alleviate the problem have been half-hearted and have met with little success. But now there are many schemes being proposed to forgive part of the debt for households in negative net worth, or to enable them to refinance their mortgages at the lower rates now available in the market.
Martin Feldstein yesterday suggested an intelligent version of these schemes, under which the value of all mortgages would be reduced to a maximum of 110 per cent of the value of the home. Half of the costs of this debt relief would be incurred by the government, and half by the banks, in the form of loan write-offs.
The economics of this are worth thinking about. If we accept that housing is the core problem holding back the economy, we are implicitly also accepting that the US is constrained by a shortage of demand, not of supply. Some economists talk as if a housing recession, or a balance sheet recession, is something new and different. This is true, in the sense that it is particularly intractable and long lasting. But in deeper analytical terms, it is not clear that a focus on housing adds anything very novel to the theoretical debate about the economy. A chronic demand shortage at a time when interest rates are at their zero bound has been very well analysed, notably in this paper by Gauti Eggertsson and Paul Krugman, which is destined to become a macroeconomics classic.
The key question is whether measures to address the housing problem directly are more effective than alternative ways of alleviating the shortage of demand. These alternatives, of course, include QE by the Fed, and fiscal easing via infrastructure spending or the President’s jobs plan. I have not seen any work which clearly establishes that direct action to address the overhang of housing debt is more cost effective than these alternative measures, but there are some reasons for believing that it might score quite well on these grounds.
Some ways of helping the housing market can be implemented simply through regulation, rather than through budgetary expenditure. For example, regulatory or legal changes could make it easier for households in negative equity to refinance their mortgages at lower rates. These measures would have a large bang for the buck.
Other measures to relieve mortgage debt directly would certainly incur a larger initial cost, and only a relatively small part of this would be translated into extra expenditure in the first year by the households which would benefit. It is quite likely that other forms of fiscal easing, like infrastructure spending, would score better on cost effectiveness in the first year or two.
But debt relief would probably have longer-lasting effects on spending, because the net worth of the households affected would be permanently improved. Furthermore, since these households are likely to be the ones which are the most liquidity-constrained in the entire economy, they are particularly likely to translate any financial help they receive into extra expenditure.
Finally, there would be an unquantifiable benefit from the removal of downside risk from the housing market. As things stand, there is a significant risk that the market will go into a further downward spiral, taking household wealth and consumer spending down with it. It is significant that some conservative economists like Martin Feldstein have supported direct action to underpin housing on exactly these grounds.
They are right.
