Commentary: Housing's Roof Won't Cave In

Homeowners may well spend through the slump

With builders, lenders, and realtors slashing jobs, the housing bust is a serious drag on the economy. But there's a case to be made that despite the weakness in home prices, homeowners will keep spending enough to keep the economy on solid ground.

Here's the bullish case for the American consumer: First, people have new sources of spending money from rising wages and salaries and a booming stock market. Second, the drop in home prices so far has been small. And third, even if there is a big hit to housing wealth, research suggests that consumer spending may not drop.

Economists worry that booming house prices inflated a spending bubble that's being pricked. The game of using your house as an ATM--known as "net equity extraction"--peaked in the third quarter of 2005 at a seasonally adjusted annual rate of $864 billion in spending, according to calculations by Federal Reserve senior economist James E. Kennedy and former Fed Chairman Alan Greenspan. The rate fell to $387 billion by the last quarter of 2006.

But pay and capital gains are taking over from housing as the engines of spending growth. Wages and salaries grew about $360 billion in 2006 vs. average growth of just $275 billion in the previous two years. And stock market wealth has risen about 13% over the past year, judging by the Dow Jones Wilshire 5000 Composite Index. That more than compensates for the roughly 1% fall in housing values. Stock wealth is only a little smaller than home values. So even if housing prices were to fall, say, by an unprecedented 4% from here, the hit to net worth would be fully offset if stocks rose by just 5%.

People look at the devastation in the housing sector and are amazed that there hasn't been more damage to home prices. But that's just it: Builders have borne the brunt of the slump by cutting the supply of new homes. Their cutbacks are keeping the growing backlog of unsold houses from getting completely out of control, thus sparing homeowners from having to lower their prices much, says Karl E. Case of Wellesley College.

Even if prices do fall significantly, it may not kill consumption, judging from research on past regional price declines by Case, Robert J. Shiller of Yale University, and John M. Quigley of the University of California at Berkeley. To their surprise, they found that while more housing wealth stimulates consumption, less doesn't reduce it. "People get into a spending pattern given their level of wealth that is hard to adjust downward," speculates Case.

We aren't out of the woods. Case himself thinks there's a 50-50 chance of a recession, stemming from a steep drop in the housing sector itself and ancillary businesses. The good news for the economy is that, for a majority of consumers, the housing bust still hasn't hit home.

By Peter Coy

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