Jan162015

Lingering debt from the housing bust weakened the economy

Excessive debt created during the housing bubble is preserved on banker’s and homeowner’s balance sheets providing a deflationary overhang to the US economy.

debt_never_diesThe US economy is generally very resilient. There are always bearish prognosticators concocting doomsday scenarios that never come to pass. Most of the time, these people are ignored as tin-hat wearing crackpots, but occasionally a real economic crisis hits that makes these people look prescient.

When I was first trying to understand the housing bubble, I used to frequent the housing bubble blogs back in 2005 and 2006. When the bears on those blogs argued the case for a near depression for the US economy, I told them I thought they were too bearish: housing would crater, but the economy would endure. I was wrong, and later I came to embrace their view.

When I wrote the Great Housing Bubble in 2007 and 2008, I made the following observation:

As with any illness, the recovery is often plagued by symptoms of the disease and unwanted side effects. The recovery from the Great Housing Bubble will be no exception. The main problems will be experienced by those who bought at peak prices and did not go through the cleansing foreclosure process. As painful as foreclosure is to those who must endure it, foreclosure is the cure to the disease of the market. After foreclosure, a borrower is no longer burdened by high housing payments, and is free to move to find new work and spend income on consumer goods.

Consumer spending has been weak since 2008 because the bad debt and onerous debt-service payments were preserved.

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Houses will become America’s new debtor’s prisons. By the end of 2008, anyone who purchased between 2004 and 2007 will be underwater. Everyone who is underwater and making crushing home payments will be stuck in their homes until values climb back above their purchase price. … People trapped in their homes cannot move to accept promotions or advancements in their careers, and people who are making large debt service payments have less discretionary income to spend. In an economy heavily dependent upon consumer spending, the impact of this loss of spending power will serve as a drag on economic growth.

I also predicted in many posts that the economy would not improve due to improvements in the real estate markets. Much government policy over the last several years has been designed to stimulate housing in hopes it would stimulate the economy. It was never going to have that effect, and even when house prices bottomed in 2012, it had little impact on the overall economy.

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The economy was never going to improve on the back of real estate or housing construction. For the economy to get stronger, some other sector of the economy needed to improve and take housing along for the ride. The International Monetary Fund noticed the same thing.

A Housing Crisis Can Cripple A Nation’s Economy For Years

Tomas Hirst, Jan. 12, 2015, 10:59debt_star_2

A property-price crash can cripple a nation’s economy for years to come, according to a new paper by the International Monetary Fund.

Although most people understand that the crisis of 2007-2008 led to a housing-price collapse and the Great Recession that followed, the new paper describes exactly why it is that a housing bubble also manages to trigger unemployment, revenue decline at corporations, and lower gross domestic product. …

So what happens when the housing market goes bust?

Firstly, falling house prices lowered demand both during and after the crisis. This is because lower prices reduce the amount of borrowing that households can raise against their property. Less access to credit tends to mean less spending, generally.

In other words, all Ponzi schemes collapse.jesus_Bernanke_saves

Substantial falls in the value of housing assets could have implications for the sustainability of people’s finances in retirement and force precautionary saving (people holding on to more of their income rather than spending it) to compensate for this perceived shortfall.

People wisely start saving more.

the housing bust also affected demand by curtailing investment both directly and by restricting small business investment, which is overwhelmingly secured against property. This has the short-term impact of reducing the amount being spent in an economy, but it also has longer-term costs as it holds back creation of new businesses and prevents investment to expand existing small businesses.

children_debtor_prisonLenders have been sitting of mountains of cash in their vaults unwilling to lend over the last several years.

“High private-sector indebtedness could be one factor behind weak domestic demand, as (i) both the peak level of debt and the increase in debt during the boom were much higher in the current episodes than during past episodes and (ii) a number of studies (e.g., IMF, 2012; Mian and Sufi, 2014) find that debt overhang tends to weigh heavily on growth following financial crises.”

Debt service prevents people from spending on other goods and services.

The only cure for these woes is time. Keynesians will undoubtedly claim their stimulus made the difference, and it may have made the last six years less painful, but efforts to save the banks by preserving bad debt also held the economy back over the same period.

In my opinion, we are finally reaching the light at the end of the tunnel. Make sure you read on Monday as I detail my reasons for believing the economy is finally getting better.

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