News that the Twin Cities area housing market cooled in October is no surprise. Sale prices for existing homes had increased sharply for two years. New construction had boomed. Neither trend was sustainable over the long run.
The most important economic law is that if things cannot go on forever, they won’t. The housing boom has to end, and apparently is starting to do so. The only question is whether it will end with a bang or a whimper.
A bang would see house prices falling 20 percent or more, many households defaulting on mortgages and construction coming to a virtual standstill. It would take five years or more to sort out and might be the foremost economic problem on most people’s minds during that period. Personal bankruptcies would rise, mortgage companies would write off large losses and many builders would go belly up.
A whimper would see stagnation in prices. Some houses would appreciate a few percent a year while prices of others fell by similar proportions. Overall, prices would remain essentially flat for three to five years as incomes and the general price level caught up to housing. Turnover and refinancing would drop dramatically as people hunkered down in their homes. Mortgage defaults might increase, but would not reach epidemic proportions.
Builders would experience a few slow seasons, but few would go broke. Development of new subdivisions would slow but not stop. Somewhere down the line — say by 2010 — home prices and construction would slowly return to historic trend levels.
Which is more likely? Real estate experts seem to think that a slow, hissing deflation of a balloon is much more likely than a dramatic pop. They are probably right.
While some localized dramatic busts occurred in the 1990s – Southern California being the most dramatic – neither the Twin Cities nor the nation as a whole has experienced a real estate crash in decades.
But markets can bust. The value of the Nasdaq stock index fell 75 percent from February 2000 to September 2002. Many Minnesota farms lost two-thirds of their market value between 1980 and 1984. After increasing by a factor of 22 from 1970 to 1980, the price of gold fell 67 percent in the next 20 years. (In recent months gold has risen to the highest levels in 25 years.)
There are key differences between gold or high-tech stocks and houses. People cannot live in a share of stock or a gold ingot. While houses may be the most important assets most households own, they are even more important as shelter. People are happy when their house increases in value but they don’t sell it just because it drops.
So it is unclear whether October’s slump is the beginning of a precipitous drop or of a gentle slide. One of the nice things about economics is that time resolves most uncertainty. In a few years we will know for sure what happened to the housing market in 2006. Meanwhile, watching it will be interesting.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.