This report by Dr. Robert Wescott highlights the prospects and risks for the global economy in 2006, and warns of the dangers to the U.S. economy of an overheating housing market.
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Wescott argues that four main themes are emerging:
- The Withdrawal of Policy Stimulus
- Sustained High Energy Prices
- Strong Global Productivity Growth
- International Trade is Still Expanding, but Efforts to Further Liberalize Trade are Slowing
- Moreover, Dr. Wescott finds that the housing sector has been playing a disproportionate role in America's economic expansion over the past four years.Housing contributes to economic growth through three main channels: 1) residential investment spending, 2) housing wealth effects, and 3) mortgage equity withdrawal (MEW). Between 2000 and 2005Q4, nominal U.S. GDP increased from $9,817 billion to $12,766 billion, an increase of $2,949 billion. These three factors have been responsible for surprisingly large shares of this increase.
Nominal residential investment averaged $447 billion in 2000, but increased to $791 billion by 2005Q4-an increase of $344 billion. By 2005Q4, residential investment accounted for 6.2% of total U.S. GDP-sharply higher than its 4.9% share in the 1970s, 4.4% share in the 1980s, and 4.1% share in the 1990s.
Housing Wealth Effect
The housing wealth effect describes the tendency of households to feel richer when the value of their homes increases, and for them to spend part of that increased wealth on consumer goods and services. The Federal Reserve maintains data on U.S. housing wealth in its Flow of Funds database. Net housing wealth (the value of residential housing minus mortgage debt) increased from $6,629 billion in 2000 to $10,915 billion in 2005Q3-an increase of $4,286 billion. Among a wide range of academic studies that measure the tendency of homeowners to consume part of their housing wealth, highly credible estimates range from 0.04 to 0.14, with a midpoint of about 0.07. This means that that if a house price increases by $100,000, the owner would be expected to increase his or her spending by $7,000 in the first year after the increase in value. Applying this estimate to the $4,286 billion change in housing wealth implies a contribution to consumption of $300 billion from 2000 to 2005Q3.
Mortgage Equity Withdrawal (MEW)
The combination of historically low interest rates, financial market innovation (the rapid growth of home equity loans, sharp declines in refinancing fees, the proliferation of new variable rate mortgage vehicles, etc.), and rapidly rising home prices has generated a surge in home refinancing in the 2002-05 period. Accompanying this surge has been a sharp increase in MEW and cash out refinancing. According to Federal Reserve data from 2001 through 2004, and extending the Fed's methodology through 2005, MEW going to consumption (which the Fed calls "cash outs resulting from refinancings") totaled about $1,219 billion from 2001 to 2005.
MEW provides a ready explanation for the widely noted decline of the U.S. household saving rate from 2.3% in 2000 to minus 0.5% in 2005. In order to consume at a faster pace than their incomes have increased, Americans have relied heavily on MEW during this period. The increases in MEW divided by personal income have moved basically in reverse lockstep with the declines in the household saving rate.
Together these three housing-related factors explain about $1,863 billion ($344 billion plus $300 billion plus $1,219 billion) of the total $2,949 billion increase in nominal U.S. GDP in the past four years, or 63% of this growth. That is, residential investment, which is directly responsible for just 6.2% of GDP, helped to generate nearly two thirds of all U.S. growth. This suggests that the U.S. economic expansion has not been as broad-based as generally thought. Instead, it has been heavily dependent on housing and MEW.
Directly and indirectly (through MEW), this sector, which accounts for just 6.2% of GDP, has been responsible for nearly two thirds of all U.S. growth. If the combination of rising interest rates and housing market exhaustion leads to the typical 51% reduction in housing starts, if the downturn lasts the typical 26 months, and if it takes the air out of the critical MEW process, the U.S. economy would seem at risk of heading for a soft patch or even an outright recession.