Baker: Don't Expect a Housing-Led Recovery

Dean Baker, an economist for the Center for Economic and Policy Research, has published a challenge to the conventional wisdom, arguing that an improved housing market could not lead the U.S. out of the recession.

Baker, known for calling the housing bubble early, notes that a fully-recovered housing market would simply not generate enough consumption by homeowners to replace the current shortfall in demand, because housing is not going to return to its pre-recession heights (nor should it). Despite having fallen sharply over the past few years, housing prices are currently close to the long-term trend, as Baker's chart shows:

Baker does some back-of-the-envelope arithmetic to make his point clear:

...what is the story of how rescuing underwater homeowners would have saved the economy? There are some economists who argue that the consumption of underwater homeowners has a hugely disproportionate impact on the economy. That seems a bit hard to imagine.

Let's try some simple numbers. The total amount of underwater equity is estimated at around $700 billion. Suppose that we wiped that out tomorrow. If our underwater homeowners spent 15 percent of their equity each year, more than twice as large as the wealth effect more generally, this new equity would generate $105 billion a year in additional consumption, about 0.7 percent of GDP. That's helpful, but not close to enough to get us back to full employment.

The takeaway is that the kind of demand created by the housing bubble won't come back even if the housing market does. Baker suggests that the government has to replace the lost demand in the short run, and in the long run exports have to fill in the gap. Whether he's right or wrong about the possible solutions to the problem, his analysis of the housing market is helpful for thinking about the size and nature of the problems besetting the U.S economy right now.