Krugman warns of lasting housing downturn

House prices could fall by 30% between now and 2010, destroying $8 trillion of wealth, says the Princeton economist.
It has become a tradition for extremely intelligent people to say very depressing things at CLSAÆs benchmark Asian conferences. The latest example, with economist Paul Krugman addressing institutional investors and company managers in Tokyo, did not break with convention.

Krugman said the housing slump in the US could take up to two years to work through, and that up to 20 million mortgages could be underwater if house prices decline by 30% between now and 2010 û which Krugman believes could well occur.

Housing is illiquid and people are reluctant to sell, factors which will prolong the pain. In contrast, stock collapses tend to be short and violent, points out Krugman. Political considerations could also draw out the process, such as freezing foreclosures, or bailing out homebuyers. It took six years for the South California housing bubble to work itself out in the early 1980s, said Krugman, who believes the national housing bubble of recent years is much worse. He noted that real estate prices in California had given up all their gains by the end of the recession.

ôThe recession in the US could be L-shaped or U-shaped, but it wonÆt be V-shaped like the Asian financial crisis,ö said Krugman, ôbecause the US seems to intent on adopting some of the same strategies as Japan adopted in the 1990s.ö In other words, rather than permit a savage purging of the system, the policymakers might decide to æbuy timeÆ rather than solve the problem.

The housing bubble inflated to historically unprecedented proportions between 2004 and 2007, aided by securitisation and collateralised debt obligation (CDO) techniques, said Krugman. A common ratio of judging the severity of housing bubbles is the price:rent ratio, which is the average cost of ownership divided by the rental income the house would fetch as a buy-to-let property. The higher the figure, the worse the bubble. At its peak, the price-to-rent figure was 1.5 in Southern California. In the national market in 2005, it was 2.3, said Krugman.

ôThe inevitable collapse of the housing bubble has lead to the worst outlook in the housing market since the Great Depression,ö said Krugman, pointing out that housing starts have collapsed to their lowest level since 1991.

The housing market was seriously weakened by the sale of sub-standard mortgages, encouraged by securitisation and CDO techniques. Nobody knows the final bill, but Krugman guesses banks may have lost up to $1 trillion on such products. The decline in house prices may wipe $8 trillion off GDP, and much of that will be financed by the financial system (the lender) rather than the borrower, estimates Krugman.

Banks do not appear to be in fatal trouble, says Krugman. But stress in the system is showing up in the shadow banking system, where new institutions have adopted banking functions, such as extending credit, but away from the sharp eye of the regulator. Krugman says that auction rate securities are a good example of how the stress can appear in obscure but important parts of the financial system.
Auction rate securities, with their weekly auctions, appeared to offer liquidity and high yields to investors, but the market froze when investors panicked and headed simultaneously for the exits. As a result, the Metropolitan Museum of Art in New York and certain student loan bodies have seen the rates they are paying on their loans shoot up. Such crises have led to a wave of bankruptcies of shadow banking institutions, which Krugman described as a ôstealth banking crisisö.
The only reason the US did not sink into recession last year is because of the export recovery off the back of the drastically weaker dollar, says Krugman. However, further credit bombs will be exploding for a while yet, for example in the commercial real estate market, he estimates.

Krugman was sceptical that interest rate cuts will help get the economy back on track. The Federal Reserve has far less ammunition to cut rates than in previous recessions. The Fed started cutting rates when they were only 5.5% last year. In the last two economic crises, rates were around 8% before the Fed started to cut rates. ôThe problem is that the economic situation looks worse this time, but there is less scope for interest rates to be cut,ö he comments. To cut rates by the same extent as in the last recession, estimates Krugman, rates would have to fall to zero û the same level as they were in Japan for many years after the bubble started to collapse in 1990.

That leaves the Bush administrationÆs tax rebate checks, being posted to every citizen to stimulate the economy. But Krugman believes this cash did not go to the poorest members of society, who would be sure to spend it. Better off people will simply save it, he estimates. Krugman believes it would have been wiser to spend the money on food stamps and more generous unemployment benefits.

One option could be to carry out a huge infrastructure building programme, which would be another similarity to Japan. But if the Republican Party wins the next election with Senator John McCain becoming president, Krugman believes it is unlikely this would happen.

Some members of the audience asked questions about the threat of inflation in the wake of the interest rate cuts and the weaker dollar. Krugman answered that with the financial system in such trouble, and the real economy also likely to slow, the Fed has decided that inflation is less of a threat than a Japanese-style deflationary spiral. ôThe Fed is right to disregard inflation. The threat of a deflationary mindset is very serious,ö said Krugman.

It was an excellent presentation and did CLSA's tradition of conference doom and gloom proud.
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