No Knight in Shining Armor

 | Oct 12, 2011 | 8:00 AM EDT
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Economists and investors feel evenly divided on whether housing will ultimately be revived and drive economic growth, as it has in past recoveries. I hate to be the one to "burst your bubble," so to speak, but this time it is different, and housing is unlikely to play its traditional role in this recovery, or in any recovery, for the next few years -- if not decades. If our authorities, mainly the Fed, believe they can reignite growth by reviving house prices and house construction activity via lower interest rates, they are sadly mistaken, and will make policy errors that will stunt the economy in the near term.

There are three simple drivers of housing demand, and none of these factors are looking favorable for housing anytime soon.

1. Supply and demand. That we overbuilt and are oversupplied is well known, but demographic changes are permanently depressing demand. The population is aging, and household formation is slowing. Families are also getting smaller, as reproduction rates approach two children per family -- and, as has happened in other developed countries, these rates may even go below that. There is simply no need for large McMansions, and aging boomers are downsizing to smaller retirement homes and condominiums. All of these forces should work against a resurgent housing boom.

2. Economics. As the housing bubble boomed in the 00s, the "affordability index" grew ever more sustainable. The income that could support the average house price far exceeded the actual median income. This imbalance is close to being fixed, but incomes are under substantial pressure, and the economy is showing no evidence of a sudden boom in average incomes. Without an ability to pay, home prices will stay down or decline further, stunting any resumption of construction growth.

3. Interest rates. Falling rates, such as what we saw in the once-in-a-generation decline of long rates since the early 1980s, do foster home affordability, and that creates demand. However, rates are now at historically low levels, and at best can stay here (if we become Japan -- a real possibility). At worse, they might rise materially as inflation increases, further hurting home affordability. Those betting on falling rates -- "how low can they really go?" -- are making an ill-informed bet, in my opinion.

These dynamics argue that economists, policy-makers and investors should look to other industries to drive the next recovery.

To illuminate the problem, I frame the question of housing prices in this way. Most people expect to sell their house for as much, or more than, they paid for it. If this ultimately happened for everyone, we would all get "free" housing, in that our only cost of housing would be maintenance, taxes and so forth -- operating costs. The problem is, how can we as a society all get "free" housing? Someone has to pay to build the housing stock. Who is this, and how do they get compensated? A society in which everyone gets "free" housing is bound to be disappointed. The bust of the bubble that we see now, and all the underwater mortgages, is the economy's way of forcing someone to pay for the housing stock. There is no such thing as a free lunch, at least for society as a whole.

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