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The current economic recession is far from over and might last a long time, said Erik Hurst, V. Duane Rath Professor of Economics and Neubauer Family Faculty Fellow. “It’s going to be nowhere near close to the Great Depression,” Hurst said. “It will be deep, but policy might be able to mitigate how deep the recession is.”
One of the causes of the current recession was the misperception of housing price dynamics by financial institutions, he told the alumni Entrepreneurial Roundtable during “Working With Private Equity Groups” at Gleacher Center on February 7. In particular, banks failed to recognize that long-range annual housing appreciation averages about 1.1 to 1.2 percent both nationally and globally, Hurst said.
Analyzing data from U.S. cities, Hurst showed that housing booms — or increases in real housing prices of 15 percent or more over a three-year period – are always followed by substantial housing busts which eroded most of those housing gains. “I gave a lecture very similar to this talk to the U.S. Federal Reserve Board in 2004,” Hurst said. “I gave the same lecture to the Chicago Federal Reserve Board in 2005 and again in 2006. After the 2006 lecture they said, ‘The prices have yet to come down.’ I said, ‘Just wait. I may not be able to predict the timing, but this is how housing markets have to work.’”
When housing prices get too high in one area, buyers move elsewhere or developers are induced to build in other areas, he said. “Demand for housing goes up and drives up the price for housing, because supply is fixed in the short run,” Hurst said. “Eventually supply adjusts. As supply adjusts, it pulls the prices back down toward an equilibrium level. The areas that have the biggest busts are the ones that have the most supply expansion, just as theory would say.”
During the national housing boom in the late 1990s and 2000s, lenders incorrectly assumed housing prices would remain high and thus loaned to people with high probabilities of default, he said. When housing prices finally dipped, lenders were left with housing assets worth far less than the loans they issued for those houses, Hurst said.
According to bank prospectuses from Lehman Brothers and Citigroup in 2005, neither lender understood the history of local housing price dynamics, he said. Although the United States had not experienced a decline in national housing prices in nominal terms since 1972, it had also never experienced such a boom as from 1998-2005, Hurst said.
“In the Citi report, after U.S. housing prices had increased well above trend for basically eight years, they said, ‘The risk of a national decline in house prices appears remote,’” Hurst said. “Lehman Brothers put 5 percent weight on the probability that
housing prices would fall by 5 percent over the next three years. As a result, they lent to a whole bunch of people at the wrong interest rates and are taking huge losses because of their errors in forecasting housing prices.”
Because macro economic policy makers try to promote economic stability, economic growth, and fairness, these goals often conflict with each other, he said. The drawbacks to current stimulus proposals are that government spending is typically inefficient and the money must be borrowed, increasing deficits and the cost of borrowing, Hurst said.
“If there is pressure to get the money in quickly to stabilize the economy, it might come at the cost of doing inefficient things, such as building bridges to nowhere,” he said. “If it’s not being used efficiently, it could be used somewhere else and will be a drain on the economy going forward.”
Economists must carefully debate the prospects of maximizing long-range growth with minimizing the impact of a recession now, Hurst said. “One option is stopping a big recession from happening – that is, creating 0 percent growth – by injecting the stimulus package today, while the increased deficit today could reduces U.S. GDP growth to 2 percent a year from 2011 to 2020. Or we can have a big recession today — like a 2 or 3 percent decline in U.S. GDP in 2009 or 2010 — but we grow at a normal, long-range trend of about 3 percent a year through 2020.” He stressed that large efforts to stimulate the economy today could hinder U.S. growth going forward.
— Phil Rockrohr