Commentary: Housing stabilization will lead the overall recovery
By Irwin Kellner, Sept. 2, 2008
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PORT WASHINGTON, N.Y. (MarketWatch) -- As the economy rounds the Labor Day turn, it continues to grapple with three crises.
Three years ago, the housing bubble burst. That set the stage for a pullback in new-home construction and consumer spending as home sales and prices began to fall.
When it became apparent that many home loans were not held by the banks, but turned into securities and sold, a financial crisis developed, since holders of these securities had no way of knowing their value. This led to a credit crunch, and a severe pullback in bank lending.
In an effort to ameliorate the effects of this credit squeeze, the Federal Reserve pumped loads of liquidity into the financial system, eventually producing the third crisis: inflation.
Now the question is when will these three crises end?
Investors need to know in order to time their reentry into the markets.
Policymakers have to know so that they may set the fiscal and monetary dials appropriately.
Most important, the American people would like to know because their jobs and living standards are at stake.
In my view, a series of events has to occur before we can declare these crises over and resume normal activities.
Since this whole mess started with housing becoming irrationally exuberant, it must end with a return to sanity in this key sector of our economy. And in spite of what you may have read or heard about the "unprecedented" decline in home prices, normal housing prices are still beyond the horizon.
According to the latest data from the Census Bureau and the National Association of Realtors, median home prices in July equaled 3.6 times median household incomes. This may be down from the peak of four times incomes set back in 2005, but it is still far above the 2.9 times of the 1980s -- when housing was more affordable and sales and construction grew at a steady pace.
In the halcyon days of the early 1970s, when home sales and construction were at their peaks both in absolute terms and relative to the size of the population, the ratio of home prices to incomes was less than 2.5.
To get back to the average of the 1980s, home prices would have to fall another 20%, on average. Add another 10 percentage points decline for housing to be as affordable as it was in the 1970s.
Of course, these ratios could be reached through a rise in household incomes. But this would take much longer, since incomes are growing less than 2% per year these days, owing to the drop in employment and the inability of workers to secure raises. See column.
Simply put, the first step on the road to recovery is lower housing prices. We will know when they are low enough to be affordable when sales pick up and the inventory of unsold homes begins to decline.
Once the markets see home prices stabilizing, the value of mortgage-backed securities will plumb bottom as well. In turn, this will allow the banks and other holders of these instruments to determine their market value, thus ending the recent spate of write-offs.
As this occurs, confidence should gradually return to the financial system, enabling lending to resume and the economy to grow. Then the Fed can begin withdrawing the excess liquidity now fueling inflation and all will be copasetic.
Irwin Kellner is chief economist for MarketWatch, and is Distinguished Scholar of Economics at Dowling College in Oakdale, N.Y.
