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Can Housing Stay Solid?

The stock market is deep in bear territory, the manufacturing sector is in a recession, capital spending has fallen off a cliff, and exports are slowing sharply. Only the housing market seems to be escaping the weakness that is sapping overall economic activity.

"Housing has acted as the economy's bulletproof vest," says economist Mark M. Zandi of Inc. Counting direct spending on construction, remodeling, and furnishings, plus the indirect impact of rising home prices, he estimates that the sector accounted for 25% of the nation's growth in 1998 and 1999 and 15% in 2000. "If the housing market falters," warns economist Ian Morris of HBSC Securities Inc., "we're looking at a full-fledged recession."

As of now, that's not happening. Housing starts, which slowed modestly to a 1.53 million-unit pace in the second half of last year, have recently rebounded to nearly a 1.63 million rate. And sales of both new and existing homes are running close to the record paces of recent years. "The national housing market has remained strong," says Stuart Miller, CEO of Lennar Corp. (LEN), the nation's largest homebuilder.

Home prices, too, remain robust. The Office of Federal Housing Enterprise Oversight reports that home-resale prices a few months ago were running 8.1% above year-earlier levels, and in many major metropolitan population centers, the gains were closer to 16% (chart). Although prices in a few areas have reportedly leveled off recently, they're still up sharply since last year.

The hefty decline in mortgage rates over the past year has clearly helped bolster housing--and pushed measures of housing affordability close to the record levels reached back in the 1960s. But industry observers are still puzzled by housing's buoyancy in the face of soaring layoffs, falling consumer confidence, and the stock market debacle.

While many experts attributed housing's unusual strength in the late 1990s to the huge rise in stock market wealth, it now appears that this effect may have been exaggerated and that housing's current strength has partly offset the impact of stock market declines on consumer spending. The fact is that the stock market swoon has mainly affected the 10% of households that account for the vast majority of stock holdings. By far, the principal asset of the two-thirds of households that are homeowners is their homes.

Thus, the real wealth effect for many people has come from rising home prices--which may help explain why consumption has held up relatively well. Indeed, Zandi speculates that some people who have soured on the market are shifting their investment dollars to home purchases, which offer the added inducement of tax-free capital gains.

All of this points to the crucial role of the housing market in the months ahead. While Alan Greenspan's Fed is hoping to inject even more life into housing--or at least keep it from weakening--both Zandi and Morris have doubts that it will succeed. Stay tuned. Sometime in the next year or two, Congress is likely to sharply reduce or eliminate the federal estate tax for most of the 2% of households that have to pay it. A new study by Wojciech Kopczuk and Joel Slemrod of the University of Michigan suggests that this will not only make a lot of potential heirs happy, but could modestly lengthen the lives of some of those whose estates will benefit from the tax cut.

Past research provides evidence that tax changes can affect many forms of behavior, from work effort, saving, and investment to the timing of transactions such as capital gains or events such as marriages, births, and divorces. Since studies indicate that death rates among adherents of different faiths decline during holidays such as Passover, Ramadan, and the Chinese Harvest Moon festival and then peak after they end, Kopczuk and Slemrod wondered if deaths of people affected by estate-tax reforms might possibly show a similar timing effect.

To find out, they examined death rates of those affected by 13 estate-tax changes from 1917 to 1984. Somewhat to their surprise, they found that in cases where tax rates were raised, death rates tended to be higher in the weeks before the rise went into effect. And in cases where tax rates were cut, death rates were higher in the weeks following the cut.

The researchers estimate that a $10,000 tax saving seems to boost the probability of someone dying just before a tax increase by 1%, while the same saving increases the probability of dying just after a tax cut by almost 2.5%. "Evidently," says Slemrod, "some people are able to will themselves to survive a bit longer if it will enrich their heirs." Although their projections have been revised downward, most forecasters still see modest real growth ahead for the economy on the scale of 1% or 1.5% for another quarter or so. The problem, note economists David H. Resler and Carol A. Stone of Nomura Securities International Inc., is that real (inflation-adjusted) growth isn't what it used to be. That's because it now reflects quality adjustments made in the measure of inflation over the past decade plus those resulting from continuing improvements in high-tech capital goods.

Thus, many companies, such as computer makers, may be posting positive real sales growth while actually selling fewer machines (albeit with more computing power) and watching revenues stagnate.

Under these circumstances, say Resler and Stone, a better guide to the true state of the economy may be its nominal growth rate. And that rate, as the chart shows, has already fallen below its average level during past recessions.

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