IMPACT ON CONSUMER SPENDING AND GDP |
Housing, poses enormous risk to the U.S. economy through its impact on financial markets, financial institution solvency and consumer confidence and spending. Key will be what happens to housing prices and the extent to which falling prices affect expected losses on mortgages and other linked financial instruments and the extent to which declining wealth affects consumer spending. Prospects are decidedly negative on all fronts as housing price declines continue unabated.
The linkages between housing wealth, price changes and consumer spending are imprecise and have been hotly debated. As the evidence comes in the debate is being resolved. Unfortunately, it appears increasingly that the resolution is in the direction of those who believe that housing had a substantial impact in stimulating consumer spending during the bubble phase and will have a commensurate negative impact now that the bubble is unwinding.
Part of the difficulty in tracing cause and effect is tied to transmission lags between changes in household wealth and consumer spending. These lags are long. My modeling indicates that falling housing prices will place considerable downward pressure on GDP growth during 2009 and 2010. Table 2 shows the timing and size of impacts of housing on GDP growth, which captures consumer spending, residential construction and other linked effects. Note that my Severe Recession scenario projects a -12.1% additional cumulative decline in nominal housing prices over the next two years (from 2008 Q3 through 2010 Q3), while the S&P Case-Shiller CME 10-city futures project a -14.7% decline over the same time period.
The Severe Recession GDP scenario indicates that non-housing GDP growth has been weak for several quarters. It turns negative during the fourth quarter of 2008 as recession deepens.
During 2009, the lagged impacts of cumulative declines in home prices have a very negative effect on GDP, which is offset by recovery in the rest of the economy beginning in 2010. The risk is that the recovery in the rest of the economy will be less than forecast because of negative feedbacks from housing (see Chart 1).
Table 3 includes the effect of $700 billion in additional stimulus in 2009 and 2010 on quarterly GDP forecasts. While stimulus has no effect on the housing component of GDP, it has a very favorable effect on non-housing GDP, beginning in late 2009 and gaining momentum during 2010. But, what is also clear from Table 3 is that it will take a very long time to overcome the drag on GDP of negative housing wealth effects and this will keep GDP on a slower growth trajectory for years to come.
GDP Growth Prospects Post Recession
You should note in Chart 1 that GDP growth post recession does not recover to the pre-recession level. Both of the last two recessions have been followed by prolonged periods of sub-potential GDP growth. Not only is this likely to be repeated in 2010 and 2011 but there is cause to expect sub-potential growth to be worse and extend for a longer period of time. Even the massive $700 billion in fiscal stimulus assumed in the Fiscal Stimulus scenario only manages to boost GDP growth to about 2%. I calculate that real GDP non-inflationary growth potential is currently between 2.50% and 2.75%. This is lower than in recent years due to slowing labor force growth and lower productivity gains. GDP growth is likely to remain below potential and that will add to an output gap that is already headed toward -6% to -8% by 2010 according to various estimates. Large output gaps are highly deflationary.
In past cycles aggressive monetary and fiscal policy eventually stimulated recovery, primarily through consumer spending. But there was a consequence. The saving rate resumed its secular decline and consumer debt to income ratios eventually climbed to new highs. Recovery was also assisted by expansion in household wealth.
The era of steadily rising household leverage is over. We have entered a new trend toward greater saving and less reliance on debt. By definition, a higher saving rate means that consumers will spend less out of current income. This will translate into slower GDP growth until the saving rate stabilizes. Moreover, housing wealth will not be an engine of consumer spending for a very long time. Once the housing price correction has run its course, a return to real rates of growth in housing prices of about 1.2% annually seems likely. How much this eventual return to rising real housing prices translates into consumer spending will depend importantly on the rate of inflation, which I expect to be near zero or negative (deflation) for a considerable period of time.
This is part 4 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.
Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.
*Artwork created by Iron Man Records under a Creative Commons license at Flickr.com.
