Last summer, we wrote about the property time bomb that threatened to drive the advanced capitalist economies of North America and Europe into economic recession (see The Property Time Bomb, 15 June 2005). What we said then was that there were two strong forces that were keeping world capitalism motoring along: US household spending and Chinese manufacturing production. If one of these should falter, then world capitalism would slip into slump.
The capitalist economists remain very optimistic that neither of these things will happen or that they will not make any difference. And the latest economic data coming out of the US would suggest that all is well.
As one American economist put it: "January was not only hot in the statistical sense but it was literally the hottest January on record insofar as US climatic conditions are concerned". US house builders increased their number of new housing starts by nearly 7% in one month. Sales in American shops and malls jumped 30% in January relative to December.
As a result, the economists are now forecasting the US economy will grow at a 5% annual rate in the three months to the end of March. That compares to a very poor expansion of just 1.5% in the last quarter of 2005.
But, as one sceptical American economist put it: "Which outcome is closer to the true state of the US economy – the energy-shocked, consumer-led slowdown of late 2005 or the apparent heat-seeking burst of activity in early 2006? Financial markets have voted for the latter.
“My advice is don't play with statistical fire. There may have been more truth to the weakness of the economy in late 2005 than most are willing to accept. The case for a post-housing-bubble capitulation of the American consumer remains a very real threat in 2006."
National house prices are now rising at a 12% annual rate, unheard of in all previous US housing booms. This unprecedented rise in housing wealth has enabled Americans to refinance their debt at low rates and then use the cash they've borrowed to spend, confident in the belief that when they sell their properties they will have risen so much in value that they can pay off the debt comfortably. But this is a house of cards.
Recent data on US property transactions and prices show that the downturn in the US housing market has now started. Existing house sales (roughly 80% of the market) have been edging down since last June. The number of unsold homes is now at its highest level since spring 1986.
House builders are scaling back forecasts for next year. Toll Brothers, the largest builder of luxury homes in America, recently reduced its sales projections for 2006 by 4-7%. The National Association of Home Builders index portends a further deterioration in new home starts. Mortgage applications have also drifted south since the summer.
Housing affordability, particularly in the coastal cities, is stretched to its limits. America's households are leveraged up to their eyeballs and now rely on rising house prices to supplement their incomes. Home equity withdrawal (cash generated from the rising value of homes) accounts for a record share of their disposable income.
So even just a slowdown in house price rises would hit consumption. A recent survey of homeowners in 13 areas of sharpest home price rises found that one in four would have to curb spending if house prices simply stopped rising. Now home price increases are beginning to slow from previously breakneck levels. Indeed, prices of new homes just built are falling.
All this will sound familiar to British homeowners. The collapse of the house price boom in the UK (and in Australia) last year is the future for US homeowners. House prices don't have to fall; just the increase in prices to slow down can cause a big headache for many households.
Even though the UK and Australia did not experience outright nominal house price falls; in real terms, they did. The fall in real house prices deducted something like 2-3% points from real spending growth in those economies.
Weakest rate
UK retail sales are now growing at their weakest rate for 20 years and recorded the worst figures for the January sales since 1945! The Chancellor, Gordon Brown, has been forced to halve his economic growth projections for 2006. In Australia, real retail sales are growing just 1% a year and business confidence is at a three-year low. For the first time since New Labour came into office, unemployment is steadily rising.
America has a new chairman of its central bank, the Federal Reserve. Ben Bernanke's first statement to the US Congress was to raise the question of a housing bust. Naturally, he was not too worried when he argued that "a levelling out or a modest softening in housing activity seems more likely than a sharp contraction." But a so-called soft landing in housing could still translate into a hard landing for the economy.
The house price boom in the UK, Australia and the US has been driven by an accumulation of debt. At the end of 1999, UK, Australian and US household debt levels were similar at 69-73% of GDP. Over the previous ten years, debt had risen just over 1% of GDP a year. But in the last five years, these countries accumulated debt more than five times faster.
Amazingly, on many measures, Americans would suffer more from a housing bust than Australians or Brits. Household debt to GDP may be higher in Australia and the UK, but only 30% of Australian homeowners have any mortgage at all, while 45% of Americans do. And when mortgage debt is measured against assets, Australians have only 21% of the home value mortgaged, while Americans have double that. As a result, it costs Americans around 18% of their household disposable income to service their housing debt, but just 12% for Australians and 10% in the UK.
Moreover, the US financial system has become heavily linked to property. Commercial banks have more than half their assets in real estate.
While property prices rose, households felt confident to borrow even more at favourable interest rates. And banks were happy to provide credit since the risk was spread against the consumer's main asset, which was rising in value.
Have no doubt. The US economy depends on this low interest-rate housing boom like no other. The big US banks have made huge profits in the last few years from lending on real estate. Now 45% of all the profits made by the top 500 companies in the US come from the financial sector.
If the housing market collapses, that will make a huge hit on the profits of big business. Even more serious, most US mortgages are sold on by the banks to semi-government agencies, called Fannie Mae and Freddie Mac. Because they are backed by the US government, it is assumed these agencies cannot go bankrupt. But they have been engaged in many financial contracts; using the mortgages they hold as collateral. If Americans start defaulting on their mortgages in a big way, it could mean that mortgage agencies will be in trouble and require taxpayers to bail them out. That will slow the economy even more. Worse, the trouble could spread through the financial sector like a disease, bringing down a swathe of banks.
At the moment, residential mortgage delinquencies are near record lows at just over 4% of total loans, but should house price rises stop, defaults will become more commonplace.
At their peak, UK and Australian citizens sucked out the equivalent of 8% of household disposable income in borrowing on the rising value of their homes. In a recent report, erstwhile Fed Chairman Alan Greenspan calculated that US households had extracted much the same amount from their homes in 2004. This extra boost to incomes was key in driving the consumer-led boom in the UK, Australia and the US.
The end of the UK and Australian housing boom occurred when the BoE and RBA raised interest rates. That caused house prices to stop rising and there was an abrupt drop in equity extraction. This provided a big shock to consumer income in those countries. While mortgage rates in the UK and Australia are directly linked to the movement of short-term rates set by their central banks, this is not the case in the US. They do not determine mortgage rates. Indeed, only one-third of all US mortgages are financed on variable rates, while over 70% are in the UK and Australia. Even so, in the last few months there have been signs of an upturn in mortgage rates.
It won't take much of a rise in mortgage rates to kill off the current US house price boom. That's because, according to the National Association of Realtors (NAR), US house prices are at their highest relative to average income for 15 years. So just a small rise in mortgage rates would make most US homes 'unaffordable' and home prices would have to fall. As US mortgage rates rise, mortgage equity withdrawal in the US will fall, just as it did in the UK and Australia.
US property bubble
In the last two years, the US property bubble has meant that housing and related sectors have contributed 1.5% points to average real GDP growth of 3.75%. Similarly, housing-related job growth has been twice as fast as other sectors of the economy and has contributed nearly one-quarter of all net new jobs in the last two years.
If annual house prices only slow to half the current rate of 12%, housing's contribution to private consumption growth will disappear. So the US real growth rate would fall towards recession levels.
Most important, unlike the other “Anglo-Saxon” economies, a property bust in the States would have a significant impact on the world capitalist economy. Should the current US house price growth of 12% year on year in the third quarter of 2005 halve in 2006, that would cut global output growth by 1% point at least.
The dynamic impact of a housing slowdown on the US economy is likely to be much worse. Foreign investors won't recycle their capital into the US fixed income assets at current yields if US growth slumps. This will force up US interest rates. Rising mortgage rates will then compound the misery for households and encourage them to save more and spend less.
So, by the end of this year, one of the legs holding up the world capitalist economy may have well and truly buckled.
February 2006
See also:
- The perfect circle of success by Michael Roberts (February 10, 2006)
- Oil price shock by Michael Roberts (October 12, 2005)
- The life blood of capitalism by Michael Roberts (September 7, 2005)
- The Property Time Bomb by Michael Roberts (June 15, 2005)
- Britain's House of Cards Wobbles by Phil Mitchinson (June 8, 2005)