Newly published data for the S&P Case-Schiller index for the 3rd quarter of 2010 shows that US house prices fell 1.5% year on year - Figure 1. This reverses the 2.3% increase in the 1st quarter of 2010 and the 3.8% rise in the 2nd quarter of 2010.
Figure 1
This is is a serious development which must be carefully watched. It was, of course, the decline in US house prices. through the devastation created in the balance sheets of US banks by mortgage related lending, that was the proximate cause of the international financial crisis.
At that time the downturn in US house prices was also a leading indicator of a decline in US share prices - US house prices peaked in the 1st quarter of 2006 whereas US shares continued to rise until the 4th quarter of 2007. This combination of house price decline and share price drop, a simultaneous fall in two of the largest US asset markets, produced the devastating force of the financial crisis in autumn 2008.
As was noted on this blog at the time, it was the fall in asset prices which fundamentally determined the liquidity crisis, that is the seizing up of interbank lending markets, and not a liquidity crisis which produced the fall in asset prices.
This fact was confirmed by subsequent events. Since autumn 2008 central banks have taken the strongest measures in economic history to pump liquidity into markets and reduce borrowing rates - the new round of quantitative easing by the Federal Reserve (QE2) being simply the latest step. However such unprecedented measures have been unable to raise asset prices in housing and shares back to previous levels - thereby confirming that the underlying problem is in asset prices and not liquidity. US house prices are currently 30.0% below their peak while US share prices, measured by the S&P 500, are 24.6% below their peak.
What, therefore are the implications of a new downturn in US house prices? And should it be regarded as a harbinger of a fall to come in US share prices - if both asset markets were to drop a new intense round of financial crisis, with a double dip recession, would of course be inevitable?
An immediate and relatively superficial answer is that the new fall in US house prices is as yet both small and short lived - Figure 2. The 1.5% year on year drop to the 3rd quarter of 2010 compares to an 18.9% maximum fall registered in the 1st quarter of 2009. A fall which has so far existed for only for one quarter cannot compare to the 13 consecutive quarters of falling US house prices between the 4th quarter of 2006 and the 4th quarter of 2009.
But more fundamentally there is now a contradictory dynamic driving US house and share prices. Shares represent ownership of companies which generate a profit stream, they are therefore investment in the proper sense, and are sustained by the now record level of US company profits. The large scale lay offs and downward pressure on wages in the US are raising share prices as they are boosting profits. That is the asset values underlying share prices are being increased.
However, while house construction may be categorised as investment in the US national accounts, this is in fact a confusion as regards its real dynamics. Houses, given the very high level of home ownership in the US, are in general a very long term consumer product - only a minority proportion of the US housing stock is commercially owned as a real investment in the proper sense. House prices are therefore negatively affected by the high unemployment and downward pressure on wages. The same processes raising US share prices are therefore depressing US house prices.
Figure 2
As US incomes will continue to be under pressure it is therefore quite possible that US house prices will continue a decline. But, as liquidity constraints do not exist, US share prices will be driven by company profitability - that is the determinant of the underlying value of the asset. Only if US profitability turns down should a new severe share price decline be expected.
Therefore the house price fall is likely to further undermine the political popularity of President Obama. It will be negative for certain US economic sectors - a new deterioration of banks balance sheets is possible, but a new large scale financial crisis is unlikely due to a fall in US house prices. The US population has remained essentially passive confronted with their falls in living standards. There has not been the significant social discontent seen in parts of Europe. The serious international risks to profitability lie in the threat of debt restructurings in Europe and that inflation in developing economies will lead to monetary tightening producing significant economic slowdowns in these markets.
A decline in US house prices, one of the largest asset markets in the world, is therefore a notable event requiring close monitoring. While it does not portend a new deep financial crisis it is, of course, a clear negative as regards US economic growth - an important reason that not double dip recession but continuing significantly slower than normal recovery remains the most likely perspective for the US economy.
The rise in US unemployment and falls in wages are slowly dragging US companies out of the recession through the rebound in profitability they are creating. The danger is that profitability will crack in the 'periphery' of the system - in the weaker economies in Europe and in developing markets.
Figure 2
There is an interesting debate in the blogosphere exploring the reasons for the persistent high unemployment rates in the US and elsewhere. Conservatives lay the blame on the structural skills mismatch and argue that this cannot be resolved through any stimulus spending measures. Liberals claim that the massive slump in aggregate demand from the boom, means that there are massive idling resources which can be brought to work with an appropriately structured stimulus program.
Posted by: employment genius | 22 February 2011 at 05:17