Vernon Smith: Disequilibrium in the Housing Market

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The headline of this piece refers to the housing-market disequilibrium that caused our economic troubles and not to its consequence, which is the persistence of a 9 to 10 percent unemployment rate.

Our disequilibrium course is reflected in the ratio of the median house price to median family income, steady around 4 in the 1990s, recovering to its previous high of 4.15 in 2001, and then surging to the unprecedented high of 5.2 in 2005. Economically, we borrowed massively from future income-based growth in housing demand, financing it by credit creation: from 1997 to 2010, the total market value of housing rose by $4.09 trillion, while mortgage debt rose by $4.52 trillion, a dismal sector performance. Some 23 percent of homeowners owe more than their home is worth on the market, and their demand for goods is restrained by the need to pay down debt. This is the essence of a balance-sheet recession, and is what underlies the so-called Keynesian liquidity trap.

Most postwar recessions also had origins in housing but were much less severe. All past sustained recoveries have been accompanied by a recovery in housing, hence the uncertain sustainability of the current recovery.

The flip side of homeowner negative equity is bank negative equity—to wit, insolvency. The Fed took care of that by relieving the banks of some $1.2 trillion in shaky assets in late 2008, rescuing the system from the consequences of its own decisions, not good policy but deemed by the Fed to be far better than the alternatives. When you are left with no good options, the important lesson for the future is to avoid getting into that bind in the first place and to start rethinking what you have been up to.

Meanwhile, in fiscal policy, the Bush-Obama trillion-dollar "stimulus" was a scattergun shot, not a surgical strike at the source of our distress—homeowner negative equity and the need for the relative price of homes to fall. Moreover, programs to subsidize new home buyers served to prop up home prices, not restore them to equilibrium; many people were suckered into buying too soon. And programs to lower mortgage payments by stretching loan horizons and/or lowering interest rates did not reduce negative equity by lowering mortgage principal closer to home value. Negative equity causes a lock-in; if future employment requires a move, you face the prospect of realizing a capital loss on your home and have no down payment for a new one.

There are three routes to restoring equilibrium:

• Inflate the prices of all other goods, including labor, while housing demand remains stuck in its negative equity loop. Fed policy has been consistent with this objective since 2008 with no evidence of success, as is typical in severe balance-sheet recessions.

• Allow the household deleveraging process to grind through an extended period of low GDP growth and high unemployment until we gradually recover. This option will surely succeed in due course, but not without high annual opportunity cost in terms of lost wealth creation. This was the path followed in the Depression.

• Do for households what the Fed sought for the banks: the Treasury (facilitated by Fed monetary ease and bank capital requirements) finances the banks to restate the principal on current negative-equity mortgage loans, restoring them to new mark-to-market zero-equity baselines.

The last option, in principle, seeks to reboot homeowners' damaged balance sheets in an effort to arrest a prolonged deleveraging process and more quickly restore household demand to levels no longer dominated by negative home equity. It is analogous to a mortgage "margin call" with public funding of the restored household balance sheets.

I regard the third option as far better than the stimulus, while recognizing that forgiving debt—whether bank or household debt—is never good policy. But please keep in mind that we have had no good options. (Since total negative equity is now about $700 billion, it is cheaper than was the stimulus.) This option was proposed by Hillary Clinton in September 2008 and by John McCain in his second presidential debate in October 2008. Were these the seeds of a bipartisan consensus? Hardly! It lost out to the stimulus crunch. Both Clinton and McCain recognized that their proposals went to the heart of the household and bank balance-sheet problems—Fed action directly addressed only bank insolvency.

All this is water under the bridge. But it is cause for sober reflection and learning from experience.

Smith is a professor at Chapman University and a 2002 Nobel laureate in economics.