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  • RecessionLoomsfortheU.S.Economyin2007

    DeanBaker

    November2006 CenterforEconomicandPolicyResearch1611ConnecticutAvenue,NW,Suite400Washington,D.C.20009Tel:2022935380Fax:2025881356www.cepr.net

  • Recession Looms for the U.S. Economy in 2007 ii

    Contents Introduction.......................................................................................................................................... 1

    Overview ............................................................................................................................................... 1

    Housing ................................................................................................................................................. 5

    Consumption ........................................................................................................................................ 9

    Investment ..........................................................................................................................................11

    Exports and Imports .........................................................................................................................12

    Government Spending ......................................................................................................................14

    Job Growth .........................................................................................................................................15

    Inflation ...............................................................................................................................................18

    Interest Rates and the Dollar............................................................................................................19

    After 2007 ...........................................................................................................................................19

    About the Author

    Dean Baker is Co-Director at the Center for Economic and Policy Research in Washington, DC.

  • Recession Looms for the U.S. Economy in 2007 1

    Introduction The recovery that began in November of 2001 is likely to come to an end in 2007. The main factor pushing the economy into recession will be weakness in the housing market. The housing market had been the primary fuel for the recovery until the last year, as there was an unprecedented run-up in house prices since 1997. With prices now headed downward, construction and home sales have dropped off by almost 20 percent against year ago levels. Even more importantly, borrowing against home equity, which had been the main factor fueling consumption growth, will plummet as many homeowners lack any further equity to borrow against. The result will be a downturn in consumption spending, which together with plunging housing investment, will likely push the economy into recession. The economy will see a substantial net loss of jobs, with nominal wage growth slowing as the labor market weakens over the course of the year.

    OverviewThis recovery has been fueled to a very large extent by a housing bubble, just as the second half of the nineties cycle was fueled by a stock bubble. Since 1997, average house prices have risen by more than 50 percent, after adjusting for inflation. Historically, house prices have moved at approximately the same pace as the overall rate of inflation.1 This unprecedented run-up has not been associated with extraordinary population or income growth, both of which have been below their average pace for the post-war years since 2000. It is also not associated with any new restrictions on supply, as housing construction was at near record levels over the period 2003-2005. The run-up in house sale prices was also not associated with any extraordinary increase in rents, which rose only slightly more rapidly than the overall rate of inflation over this period. In short, the run-up in house prices cannot be explained except as a speculative bubble.

    This bubble fueled the economy directly through its impact on the housing sector and indirectly through the impact that housing wealth had on consumption. Housing construction and sales account for more than six percent of GDP. The run-up in prices has led to a near doubling of sales of new and existing homes since the mid-nineties. It has also led to record nationwide vacancy rates for both rental and owner occupied housing. In past downturns housing investment has fallen by 30-40 percent. The sector has never seen as much overbuilding as it has experienced in the current cycle. Also, with the huge baby boom cohort now entering its retirement years, demand for housing should be shrinking relative to the size of the population in the years ahead. Based on past patterns, it is reasonable to expect a drop in output in the housing sector from its 2005 peaks of at least 40 percent. It should reach this bottom by the end of 2007 or early 2008 at the latest.

    The wealth effect created by the housing bubble fueled an extraordinary surge in consumption over the last five years, as savings actually turned negative. (The countrys demographics, with most of the baby boom cohort still in its prime saving years, is heavily tilted toward saving.) The run-up in prices

    1 Background data on the housing bubble can be found in Baker, D., 2005, The Housing Bubble Fact Sheet, Center

    for Economic and Policy Research [http://www.cepr.net/publications/housing_fact_2005_07.pdf] and Baker, D., 2006, Is the Housing Bubble Collapsing? Ten Economic Indicators to Watch Center for Economic and Policy Research [http://www.cepr.net/publications/housing_indicators_2006_06.pdf].

    http://www.cepr.net/publications/housing_fact_2005_07.pdfhttp://www.cepr.net/publications/housing_indicators_2006_06.pdf

  • Recession Looms for the U.S. Economy in 2007 2

    created $5 trillion in excess housing wealth. Conventional estimates of the size of the housing wealth effect imply that this wealth would have generated an additional $200-$300 billion of consumption (1.6-2.3 percent of GDP).

    It is plausible that the impact of this bubble wealth was actually considerably larger than the conventional estimates imply. Historically, the saving rate in the United States had averaged close to eight percent of disposable income. The savings rate began to decline sharply in the nineties, at least partially in response to the stock bubble, although other factors likely played a role. However, even assuming a baseline savings rate of just four percent, the current rate of -1 percent implies an amount of excess consumption of almost $480 billion annually, given current income levels. This higher figure is consistent with data showing that households were borrowing more than $600 billion annually against their home equity in 2005.

    This home equity-fueled consumption will be sharply curtailed in the near future. In spite of the record run-up in house prices, the ratio of homeowners equity to market value stood at a record low in the second quarter of 2006. (This is especially striking since the baby boom cohort is now ages 42-60 and would be expected to have accumulated considerable equity in their homes.) With house prices now falling, the number of homeowners who have exhausted the ability to borrow against their home will rise rapidly. A sharp run-up in credit card debt earlier this year provides evidence that this is already happening, as people who were unable to borrow against their homes likely turned to their credit cards. However, credit card borrowing cannot replace borrowing against home equity (the volume of outstanding credit card debt is less than one tenth of the volume of mortgage debt); millions of homeowners will soon be forced to curtail their consumption as home prices decline.

    Homeowners will also be hit by the resetting of more than $2 trillion in adjustable rate mortgages in 2006 and 2007. While most homeowners in the United States have generally opted for fixed rate mortgages, adjustable rate mortgages have become far more popular in the last five years. This is especially striking, since the mortgage rate available on fixed rate mortgages was at its lowest level in fifty years. Presumably, homebuyers opted for adjustable rate mortgages to take advantage of the lower starting rate. Typically, this rate is locked in for a period of three years. More than 30 percent of the mortgages issued in 2003 and 2004 had adjustable rates, which were record years for mortgage financing. The lock-in period on these mortgages is ending in 2006-07. In many cases the interest rate is resetting upward by close to two percentage points. This will be a major strain for many homeowners who were already struggling to meet mortgage payments on over-priced houses. Some homeowners will be unable to meet these higher payments and forced to sell, putting further downward pressure on the housing market.

    There also will be an increase in default rates, as many homeowners will be unable to meet mortgage payments and unable or unwilling to sell their homes. The rise in defaults will put severe strains on the portions of the financial industry that hold large amounts of mortgage debt.

    The turnaround in the housing market has already begun to affect the economy. There was a marked slowdown in consumption growth beginning in the second quarter, which has continued into the third quarter according to currently available data. At the least, it seems that the savings rate is no longer declining. It is likely to begin rising in the near future, and will almost certainly have moved into positive territory by early 2007. This means that consumption growth will be trailing income growth.