Sunday, December 10, 2006

The great debate over the timing of the housing contraction

It is fascinating to read the wildly divergent views among academic and professional economists and analysts concerning the timing and impact of the contraction of the housing sector. Unfortunately, so many economists and commentators are falling back on passionate rhetoric and reliance on dubious "historical patterns" for their forecasts.

To wit, there are some snippets of this great debate in an article in The New York Times by Louis Uchitelle entitled "Employers Added 132,000 Jobs Last Month." It quotes "analysts at Bear Stearns Economics" as saying:

"The economy continues to absorb job losses in construction and manufacturing well. ... With the labor market tight and average hourly earnings growth continuing to rise, the gains in employment do not support the view that the Fed will be cutting rates in 2007."

The Times goes on to say:

But others disagreed, arguing that the housing market will deteriorate further, halting the steady job growth of recent months and the improving wages of millions of production workers.

They quote Ian Shepherdson, chief United States economist for High Frequency Economics as saying:

"What I am hearing from some of my colleagues is that this is as bad as housing and the economy are going to get. ... I think that is completely wrong."

No clue is given why other esteemed economists are so "completely wrong" or why it is absolutely impossible that they might be only partially wrong. It sure sounds as if quite a few people are busier grinding axes than trying to be reasonable.

The Times then goes on to tell us about the moderate views from Morgan Stanley:

“I describe what is going on as a two-tier economy,” said Richard Berner, chief United States economist for Morgan Stanley, who is more optimistic about the future than Mr. Shepherdson. “We are in the midst of a housing recession,” Mr. Berner said, but “the sharp declines in construction activity and in housing prices will soon fade

Mr. Berner argues that consumers are not as dependent as the pessimists contend on the wealth they extract from their homes to drive their spending. The more important factors today, he said, are the recent decline in energy prices and, above all, rising incomes.

I wish The Times had gotten some quotes from Stephen Roach, Mr. Berner's colleague at Morgan Stanley, who is almost always far more bearish in his economic views.

My own view is that when presented with passionate arguments at two extremes, the likely scenario is that the true is somewhere in the middle. I'm not convinced that the negative economic effects of the housing contraction are completely over, but I do not think that the worst is yet to come either. I suspect that the housing sector will be somewhat of a drag on the economy for a few more months, with the emphasis on a modest to moderate drag, but that by spring we will be seeing the beginnings of a modest recovery of housing, with the emphasis on modest.

What Mr. Shepherdson and his ilk seem to be ignoring are the simple facts that as long as demographics are growing, productivity is growing, employment is growing, income is growing, and mortgage rates remain quite low, it simply isn't within the realm of reason to argue for housing to be the sole or primary influence on the entire rest of the economy. Quite a few people have been mistakenly arguing that housing was the only "leg" propping up the economy during the past few years, and that is what drives their belief that without a strong housing sector the overall U.S. economy will crumble dramatically. Yes, housing was what was giving the economy extra strength, but the modest strength in the rest of the economy was not driven exclusively by housing. So, without housing we lose the extra strength, but the modest strength remains.

And these people are also ignoring the simple fact that productive capital seeks its most productive use, and although housing attracted a lot of that capital and may no longer be the most productive use of that capital, that capital will now simply shift to other areas (including commercial construction). That process doesn't happen overnight, but over the coming year we will see where in the U.S. economy money can be used for growth. Actually, we just saw Ford raise $18 billion in capital. I suspect that Detroit will become less of a drag over the next year and even become a source of strength in the coming years as the car companies work through their restructuring processes.

Some economists, including Charles Plosser, the new president of the Federal Reserve Bank of Philadelphia, are beginning to argue that the long-term sustainable rate of growth for the economy is going to be a bit lower in coming years as demographic growth remains modest (1%) and productivity gains become more modest (2%). Plosser suggests that something closer to 3.00% real GDP growth is more realistic in contrast to the old model of 3.50% real GDP growth.

To be conservative, I would suggest that we should start thinking of 2.5% to 3.5% as the normal range of volatility for trend growth of a stable and sustainable U.S. economy. Sure, we might see an occasional spike up to 4.00% or higher and dips to 2.00% or lower, but 3.00% should be considered "the sweet spot" and a range of 2.75% to 3.25% should be considered a "strong" U.S. economy.

-- Jack Krupansky

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