U.S. housing crisis

General credit gridlock means housing is not the whole story, but it’s the center of the maelstrom. Speaking at the Kansas City Fed’s annual shindig at Jackson Hole, Wyoming in late August, Fed Governor Frederic Mishkin looks at the current housing problem in the U.S. as throwing sand in the transmission of money supply as a determinant of economic activity. Mishkin even titled his paper “Housing and the Monetary Transmission Mechanism.” Mishkin said the effect of a monetary shock on housing is not well understood. Even though residential investment accounts for only 5 percent of GDP, Fed modeling indicates the housing sector is three times more responsive to monetary policy in the short run than is overall spending. In fact, “exceptionally unfavorable conditions in the housing sector have the potential to create instability in the financial system — instability that could magnify problems for the overall economy…. A breakdown in financial stability occurs when shocks to the financial system cause disruptions to the credit intermediaries that are so severe that the system can no longer channel funds fluidly to creditworthy households and businesses with productive investment opportunities. Without access to financing, individuals and firms must cut their spending, which will have consequences for overall economic activity.”

Any asset price collapse can create financial market instability, and that is exactly what the sub-prime problem may be doing in the U.S., where real estate is worth about $20 trillion. A 20-percent drop in its face value would be some $5 trillion, which in turn is almost a third of U.S. GDP. This kind of phrasing is to mix a stock (housing) with a flow (GDP), but never mind — the potential disruption is huge.

Mishkin warns that we have a lot of uncertainty about how house price declines affect consumer behavior and the overall economy, but once a bubble has burst, monetary policy is less effective in restoring an economy to health. Mishkin thinks the argument for the central bank to respond to a housing bubble being burst is weaker than for other asset prices, but once a bubble is seen to be bursting, the central bank has to act fast.

In Japan’s case, the Bank of Japan (BOJ) failed to ease monetary policy fast enough and by a big enough amount, and the government acted too slowly to bail out the banking sector. Mishkin says “The lesson that should be drawn from Japan’s experience is that the task for a central bank confronting a bubble is not to stop it but rather to respond quickly after it has burst. As long as the monetary authorities watch carefully for harmful effects stemming from the bursting bubble and respond to them in a timely fashion, then the harmful effects can probably be kept to a manageable level.”

Mishkin didn’t mention deflation in the speech, and in fact argues for central banks to respond to other factors (such as falling production) rather than house prices directly. But to anyone familiar with monetarist theories, the implication is there — like Japan, the U.S. could be vulnerable to deflation if falling house prices cause the consumer to withdraw into his shell.