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No Day at the Spa: Rejuvenating the Economy Won’t be Easy

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Some financial market gurus suggest that policymakers should let the economy go into a recession, and they may be about to see their wish fulfilled in the wake of today’s release of consumer spending in the critical holiday month of December. Data released today by the U.S. Commerce Department show that last month, consumer spending slipped by 0.4 percent, with spending growth for the year declining to 4.2 percent, the lowest growth since 2002 and down sharply from 5.9 percent growth in 2006.

A sharp economic correction, the rationale goes, would clear all those bad loans off the books, bring house prices in line, and give financial markets and the economy a fresh start. It almost sounds like a spa treatment for the economy. Some back-of-the-envelope calculations, though, suggest that the recession necessary to bring things back in line will be anything but rejuvenative. The economy could spend months in a kickboxing gym instead of a day at a spa.

Leaving the current situation to Wall Street financiers, policymakers in the Bush administration, and regulatory officials at the Federal Reserve, all of whom got us into this mess in the first place, seems like only a prescription to prolong the pain. Policymakers should instead step in now, not just to provide an economic stimulus, but, more importantly, to put the economy on track to a much healthier future with a major economic makeover.

How much worse can the trouble in the housing market get? A lot, if the past is any indication. Take the last two housing downturns as benchmarks. One way to identify swings in the housing market is by comparing house prices to rents. After all, they both measure the same good—a roof over one’s head. When it reached its peak in early 1979, this ratio was 9 percent above its long run average and by its next peak in the middle of 1987 it was 3 percent higher than the long-term average.

In comparison, the last peak in 2006 was 43 percent larger than the long-run average ratio of house prices to rents. Right there, anybody should know that the present is nothing like the past. But let’s stay with the past for a little longer. It took 22 quarters before the ratio of house prices to rents bottomed out following the peak in 1979. It was again another 22 quarters before house prices regained some ground after the peak in the late 1980s. Thus, one may conclude that we are three quarters into a 22-quarter cycle—another four and a half years to go.

This would likely still leave a substantial overvaluation in the housing market. Remember, though, that the recession is meant to correct all imbalances. To reach the long-run balance between house prices and rents would take another nine years given the adjustment pace of the past three quarters. At the speed of adjustment after 1979 it would take another 17 years before the two prices are in balance and at the adjustment pace after 1987 it would be another 27 years before house prices and rents are in sync.

No quick and easy fix here.

These time periods may prove to be a best-case scenario. Homeowners, prospective buyers, builders, and investors will likely want to know when house prices may start to grow faster than inflation again. If the correction of the late 1970s is the benchmark, it would take a little over 49 years before the overvaluation is corrected and house prices relative to other non-housing prices would grow again. In comparison, it would take 167 years at the rate of adjustment of the late 1980s to get to the same point.
The implications of these rough calculations are clear. The troubles in the housing market could get much worse for much longer. Economic growth and job growth could also be harmed much more than in previous recessions since the spillover effect from the housing mess to the credit markets is likely larger than in the past. Families have amassed a lot more debt, financial institutions are less regulated, and market participants are still sorting through the implications of the fallout from the widespread use of sophisticated yet poorly understood financial instruments.

I admit that I don’t know if there will be a recession. I do know, though, that the answer to the current bout of economic instability has to be a fundamental overhaul of the U.S. economy to ensure strong and stable growth that is equitably shared. Anything short of such a major intervention that promotes innovation, regulatory soundness, and a tighter link between economic growth and income gains will only help to prolong the economic pain.

To speak with our experts on this topic, please contact:

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