U.S.: There's No Place Like Home--for Economic Growth
Housing is an American obsession. A whole cable network is devoted to caring for home and garden, shelter magazines populate the newsstands, and the Internet is peppered with do-it-yourself Web sites. Housing captures the limelight in the economy as well. And while its performance in 2002 may not be as stellar as in recent years, worries about housing bubbles and construction stalling out the recovery are overblown.
To be sure, housing is a major economic sector. Home construction has added to real growth of gross domestic product in each of the past three years. Plus, housing influences consumer demand for everything from carpeting to appliances to dinnerware. In the first quarter, such spending jumped at a 17% annual rate. Homebuilding and spending on home goods together account for 8.7% of the U.S. economy. In comparison, business investment in information-processing equipment accounts for 6.1%, and federal spending on goods and services is 6.2%.
Equally important is housing's wealth effect. A substantial portion of consumer net worth comes from rising home values. What makes this crucial to the outlook is that tapping into home equity in the form of refinancing or lines of credit has funded a big chunk of recent consumer purchases, and that spending has fueled the recovery.
THAT'S WHY the back-to-back drops in residential building set off worries about housing and the economy in general. If home demand or prices were to collapse, a consumer pullback could drag down the recovery.
However, economic fundamentals strongly argue that won't happen. Three supports will keep housing aloft this year. First, mortgage rates are low (chart). Second, the economy is already in recovery. And third, labor markets are starting to turn around. Rather than being a big drag on real GDP growth, housing may still have some room to grow in the second half.
Such optimism about housing may seem misplaced, considering that housing starts fell 8.1% in March and 5.4% more in April. Construction began the second quarter sharply below its first-quarter level. But the slide in starts says more about weather patterns so far in 2002 than about the economy's health.
A mild winter across most of the country boosted starts in both January and February. The nearly balmy temperatures also allowed more buyer traffic and sales, which pulled forward sales activity from the spring. That's why starts are falling--and why sales of both new and existing homes also will likely look weak this quarter.
But that doesn't mean home demand is flagging. So far in May, the monthly average of mortgage applications to buy a home was at the highest rate ever (chart). As these loans are processed, home sales will begin to rise again. Plus, demographics indicate there's room for further growth. Overall homeownership stood at a near-record 67.8% of households in the first quarter; but for those 35 or younger, the prime home-buying group, the rate is only 41%.
Increased home buying indicates that consumers are upbeat about the economy's future. That optimism was also borne out in the gain in the University of Michigan's consumer sentiment index for early May. Consumers are seeing a nascent turnaround in the labor markets, where in April, private companies added workers for the first time in almost a year. In addition, for most workers, pay raises are outpacing inflation, giving a boost to buying power.
Home buyers will also get a lift from relatively cheap mortgages. Although mortgage rates fell sharply in the aftermath of September 11, they have recovered to a point below 7%. Because inflation is expected to stay tame, and because the Federal Reserve is unlikely to raise short-term interest rates soon, mortgage rates will stay near 7% for a while. That will make home buying affordable this year just as better job growth gives more consumers the financial stability to buy a home.
IS THERE A DARK LINING in housing's silver cloud? Some would say yes, arguing that the unwavering rise in home buying, even in the face of recession and terrorism, means that buyers have become irrational, and that prices have bubbled up to unsustainable highs.
Certainly, some areas have seen real estate prices fall. After the crash of the tech industry, home prices in Silicon Valley slipped. High-end apartments in Manhattan have also gotten cheaper. But for the U.S. as a whole, housing is simply not in a bubble.
Keep in mind what a bubble is: It's when the price of an asset is bid up rapidly to a level unjustified by fundamentals. Think tulip mania of the 1600s or dot-com stocks in the 1990s. Housing has not seen an unsustainable price jump when you include rising land costs but hold the size and quality of the building constant. Since 1980, the price of such a new house rose, on average, 3.5% a year, based on a Commerce Dept. index.
From 2000 to the first quarter of 2002 alone, the annual gain was 5.1%. The recent runup can be explained by falling mortgage rates, which let people pay more for a house while keeping their monthly payments down, the record participation rate in the labor markets, and the rising purchasing power of workers' wages, spurred by high productivity and low inflation.
EVEN SO, is the pickup in the growth rate worrisome? BusinessWeek calculates that if the rise in new-home prices had followed the 3.5% long-run trend, the average house would cost $6,000, or about 4%, less than what the house actually sold for in the first quarter. Considering the give-and-take of real estate bargaining, that gap is hardly large enough to suggest that U.S. homes are overvalued (chart).
Fed Chairman Alan Greenspan presented a similar conclusion in an April speech. He downplayed the idea that housing was approaching a bubble like that of the Nasdaq stock index of the late 1990s. He pointed out that home sales carry high transaction costs and that "when most homes are sold, the seller must physically move out. Doing so entails significant financial and emotional costs, and is an obvious impediment to stimulating a bubble through speculative trading in homes."
Could anything cause a nationwide crash of home values? One danger would be a sudden and sharp jump in mortgage rates. But again, given the benign outlook for inflation, that's not likely.
Instead, after some volatility in the spring, building activity and home sales should resume a modest growth rate come this summer. Add in the continued boost to household budgets coming from home-equity lines of credit, and it's easy to see that the entire housing sector will contribute to economic growth in the second half. Beyond a description of happy domesticity, "home sweet home" is also a maxim for economic growth.
By James C. Cooper & Kathleen Madigan