How falling home prices imperil the U.S. economy

Some argue government should do more to stop a negative feedback loop in the housing market.

from the February 22, 2008 edition

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Some want more government intervention

Some policymakers argue that government should do more. One idea, backed by Democratic presidential candidate Hillary Rodham Clinton, is to impose a temporary moratorium on foreclosures. Others have floated an idea modeled on the mortgage rescue undertaken during the Great Depression. The government could become a buyer of mortgage securities – large pools of now-sagging mortgages – and then move forward with loan modifications that ease the terms for borrowers.

Behind all these plans, whether modest or ambitious, is the notion that the vicious cycle must be broken.

A negative feedback loop in housing is one of the greatest risks to the economy now, say economists. During the boom years, a positive loop was at work: Home prices rose, buoying the availability of credit and making it unlikely that home buyers would default on their loans.

Now the loop is operating in reverse. The more home prices fall, the more owners find that their best financial option is to simply walk away. Because many recent buyers put little money down, they lose little – except their credit score – by handing in the keys on a purchase that is losing its value.

"While many have fretted over the ... resets of adjustable-rate mortgages, falling home prices are a much more important concern," Scott Brown, an economist at the investment firm Raymond James, writes in a note to clients.

"Home price declines threaten to turn many recent homebuyers upside down – that is, owing more than the home is worth," he adds. "Falling home prices and tighter mortgage credit in turn lead to even weaker housing conditions, further home price declines and even tighter mortgage credit, and so on."

But economists see limits to what government can do to help marketplace participants regain confidence.

Efforts to intervene could have unintended consequences, some experts note.

A bailout of mortgages would probably be "a transfer [of tax dollars] from renter to owner ... and from poor to rich," says Morris Davis, a University of Wisconsin economist.

Housing's negative feedback loop, for now, is daunting. The positive element is that markets tend to rebalance eventually. Buyers will bid when prices become attractive enough. And most banks will face losses but not outright failure, analysts say.

"I don't think we're going to see a depression," says Dean Baker, an economist at the liberal Center for Economic and Policy Research in Washington. But he says that at the current rate, $3.2 trillion a year in housing wealth is being destroyed by falling prices – a hard blow to the economy.

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