Very few people – including the best informed economists – would have predicted the biggest economic events of the past year. These included the energy crisis sparked by Russia’s invasion of Ukraine and inflation fueled in part by China’s ongoing struggles with the COVID-19 pandemic. But if some economic stories are the product of unpredictable shocks, others are the result of more readable trends.
FP economics columnist Adam Tooze, on the Ones and Tooze podcast we co-host, pointed to three such trends: the US housing market downturn, changes in Japanese monetary policy, and Africa’s mounting sovereign debt struggles. What follows is an excerpt of our conversation, which focuses on US housing, edited for length and clarity.
For the full conversation, search Ones and Tooze wherever you get your podcasts.
Very few people – including the best informed economists – would have predicted the biggest economic events of the past year. These included the energy crisis sparked by Russia’s invasion of Ukraine and inflation fueled in part by China’s ongoing struggles with the COVID-19 pandemic. But if some economic stories are the product of unpredictable shocks, others are the result of more readable trends.
FP economics columnist Adam Tooze, on the Ones and Tooze podcast we co-host, pointed to three such trends: the US housing market downturn, changes in Japanese monetary policy, and Africa’s mounting sovereign debt struggles. What follows is an excerpt of our conversation, which focuses on US housing, edited for length and clarity.
For the full conversation, search Ones and Tooze wherever you get your podcasts.
Cameron Abadi: What exactly triggered the downturn in the US housing market that we’ve already seen, and how much more could the housing market fall from here?
Adam Tooze: What triggered it is pretty clear, namely that [Federal Reserve] has raised interest rates and mortgage rates have been particularly sensitive. At their peak in late November, US mortgage rates had doubled from 3.5 percent to 7 percent on a 30-year fixed-rate mortgage. They’re now slightly off those highs, all the way down to 6.25, but nonetheless it’s a big jump over a 12 month period. The only period in American history when interest rates rose more dramatically was the Volcker shock of 1979-1981 [named for Paul Volcker, who headed the U.S. Federal Reserve from 1979 to 1987]. So that’s a pretty serious discontinuity affecting one of the largest asset classes, not just in the US but around the world. US real estate accounts for about 20 percent of global real estate values, and it accounts for about 68 percent of global real estate wealth. So we’re talking about a really big shock to an asset class that accounts for about 50 percent of global real wealth.
An interesting article by Enrique Martínez-Garcia of the Dallas Fed addressed your question – how bad could this get? How much could that fall? What he’s doing is looking at how house prices have evolved over the last cycle, and it’s really dramatic.
Between 2013 and 2022, US house prices rose more than 60 percent in real terms, and a very large portion of that increase, about 40 percent, occurred between the first quarter of 2020 and the second quarter of 2022. And I think that way we get an overview of what the worst case scenario could be. If you imagine that the pandemic hype mostly dies down, you could expect a price shock of 20 percent. That would be a really, really big blow to this huge mountain of wealth. We’re talking trillions of dollars worth here.
The thing about the housing market is that it really is a very flexible supply and demand market. One of the reasons I think most analysts think we probably won’t find ourselves in the 20% scenario is that when prices are falling, people just put off the moment of selling their home. And so supply is falling fairly quickly in line with falling demand, which is being driven by rising interest rates. The market levels out. Many analysts believe that an adjustment of perhaps 5 to 10 percent is more realistic. Things could be a lot worse in the hot spots of the US housing market in places like Austin, Texas, or Phenix, Arizona, which used to be considered second-rate cities that were just super-hot, fashionable places for people to move. especially Silicon Valley, but also the east coast.
CA: What are the repercussions of this type of housing crisis on the real economy in the US? Americans are notoriously reliant on their homes as their primary investment—are some of them needing to postpone retirement, for example?
AT: It sure is a really big deal. I mean, there used to be a saying that the housing market is the business cycle in the US — that the ebb and flow of the economy is actually driving this one big market because it’s so big as an asset class and so there’s a lot of leverage stacked on it. When I think about the impact on the real economy, I think there are probably two dimensions that are kind of interesting. So one is a dimension of change where you have a relatively small percentage of all economic activity, but it fluctuates widely and through those fluctuations affects the American economy. The other dimension of this is a huge aggregate that vibrates more modestly but still has a tremendous impact due to its real size.
So the little thing that fluctuates a lot is new housing construction. One element of the story of the business cycle in the real estate market is that when the real estate market is booming, when rents are skyrocketing like they have been lately, many people decide it’s a good time to start building apartments, especially multi-family units. And that was back when America was a fast growing economy and a lot of houses were being built, a very significant element of GDP. Construction peaked at about 7 percent of GDP; now it’s only around 4 percent. But what makes it special is that it still swings like a yo-yo. It’s really one of those parts of the economy that’s bouncing up and down like crazy. So if you look at new mortgage applications in the third quarter of 2022, that’s down 47 percent year-on-year — just an absolutely gargantuan shift. Building permits for single-family homes have fallen by 30 percent compared to the previous year. The mood among home farmers is absolutely catastrophic right now. This small aggregate, which accounts for about 4 percent of GDP, varies by as much as 30 to 40 percent, adding up to a 1 percent variation in the total GDP of just this one sector. So that’s as big as any government stimulus other than the shallow emergency stimulus plans of 2020.
Now take the other component you alluded to, the so-called wealth effect. Housing is the most important store of wealth for the vast majority of households. And as the value fluctuates, it affects sentiment and people’s willingness to spend. The vast majority of spending is, of course, influenced by income rather than wealth. But on the fringes, there’s some wealth-effect induced spending, and that’s a huge sum. So that’s not 4 percent of GDP; that’s 75 percent of GDP—personal consumption spending is about $17.8 trillion a year. So when the Dallas Fed tells us that it thinks a major shock to the housing market could cut personal spending by 0.5 to 0.7 percent, you might shrug and think, well, that’s not very much , except that it’s a fraction of the $17.8 trillion. In fact, the damage amounts to another 100 to 150 billion dollars. So numbers like this are really bad news.
CA: Exactly what broader role does US residential real estate play in international financial markets? Here, internationally, what are the broader implications of a downturn in the US housing market?
AT: Yes, housing is critical to finance, because for the vast majority of people, it’s the only readily available form of collateral on which to borrow – and they can borrow substantial amounts, three times their income. That’s a lot of leverage to amass, so it’s very important. In the case of the US, we are talking about $13 trillion in outstanding mortgages. So that’s more than all corporate debt. If you add up all the bonds — not the stocks, but the bonds — issued by American companies, the real estate mortgage sector is even bigger. And it’s made up of millions of small creditors who have borrowed. So it’s a huge part of the financial system. And if it’s true that real estate has been or is the business cycle, it’s also true that real estate has been at the heart of most major financial crises.
And in the current situation this year, when the volume of mortgage applications is down 47 percent, as you can imagine, the companies that make money from mortgage origination have taken a complete slump in business. And these are the non-bank mortgage lenders who are really an important part of the modern American mortgage system. We have already seen a number of bankruptcies in this sector this year.
But the prevailing consensus right now, after we’ve kind of done a gut check and done our brains and considered all the risks, is that this doesn’t feel like 2006 or 2007. Why is it different? Because private label mortgage securities, which have been at the center of the crisis in the past, are a mere shadow of what they once were. Mortgage lending by foreign banks that were directly involved in the US mortgage system before 2000 has declined sharply.
Also, there has been a huge and somewhat dramatic shift – very under the radar and somewhat amazing – essentially there has been a nationalization of the US mortgage market. By this I mean that government-backed mortgage backstops Fannie Mae and Freddie Mac have taken an even larger share of the US mortgage market than before. So before the crisis, they had about 40 percent of the market for mortgages that are packaged into securities and then reissued. And currently they have about 67 percent of the outstanding mortgage volume in the United States. And that gives the system a kind of security underpinning that it’s never had to this extent.
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