Tooze on How Low the U.S. Housing Market Could Go in 2023

High interest rates are roiling the real estate market and rippling across the world economy.

By , a deputy editor at Foreign Policy.
A cul-de-sac runs through a new housing development in Middlesex Township, Pennsylvania.
A cul-de-sac runs through a new housing development in Middlesex Township, Pennsylvania.
A cul-de-sac runs through a new housing development in Middlesex Township, Pennsylvania, on Oct. 12. Gene J. Puskar/AP

Very few people—including the most-informed economists—would have predicted the biggest economic events of this past year. They included the energy crisis set off by Russia’s invasion of Ukraine and the inflation stoked, in part, by China’s continued struggles with the COVID-19 pandemic. But if some economic stories are the product of unforeseeable shocks, others are the result of more legible trends.

FP economics columnist Adam Tooze flagged three such trends on the podcast we co-host, Ones and Tooze: the downturn in U.S. housing, shifts in Japan’s monetary policy, and Africa’s growing struggles with public debt. What follows is an excerpt of our conversation focused on U.S. housing, edited for length and clarity.

For the full conversation, look for Ones and Tooze wherever you get your podcasts.

Very few people—including the most-informed economists—would have predicted the biggest economic events of this past year. They included the energy crisis set off by Russia’s invasion of Ukraine and the inflation stoked, in part, by China’s continued struggles with the COVID-19 pandemic. But if some economic stories are the product of unforeseeable shocks, others are the result of more legible trends.

FP economics columnist Adam Tooze flagged three such trends on the podcast we co-host, Ones and Tooze: the downturn in U.S. housing, shifts in Japan’s monetary policy, and Africa’s growing struggles with public debt. What follows is an excerpt of our conversation focused on U.S. housing, edited for length and clarity.

For the full conversation, look for Ones and Tooze wherever you get your podcasts.

Cameron Abadi: What exactly has triggered the downturn in U.S. housing that we’ve already seen, and how much more could the housing market be expected to drop from here?

Adam Tooze: What’s triggered it is pretty clear, which is that the [Federal Reserve] has hiked interest rates, and mortgage rates have responded particularly sensitively. At their peak in late November, mortgage rates in the U.S. had doubled from 3.5 to 7 percent on a fixed rate 30-year mortgage. They’re slightly off those peaks now, down to a 6.25, but nevertheless, it’s a huge jump over a 12-month period. The only period in which interest rates have risen more dramatically than this in American history is during the Volcker shock between 1979 and ’81 [named for Paul Volcker, who headed the U.S. Federal Reserve from 1979 to 1987]. So this is a pretty severe discontinuity and it’s affecting one of the biggest asset classes, not just in the U.S., but in the entire world. U.S. real estate makes up about 20 percent of global real estate values, and they are about 68 percent of real assets worldwide. So we’re talking about a really major shock to what is an asset class that is about 50 percent of global real assets.

An interesting paper from Enrique Martínez-Garcia at the Dallas Fed took on precisely your question—how bad could this get? How much could this fall by? What he does is to look at the trajectory of housing prices over the recent cycle, and it’s really dramatic.

Between 2013 and 2022, U.S. house prices in real terms have risen by more than 60 percent, and a very large amount of that surge, about 40 percent, has come between the first quarter of 2020 and the second quarter of 2022. And I think that’s the way in which we get a handle on what the worst-case scenario might be. If one imagines most of the pandemic hype unraveling, you could be looking at a price shock of 20 percent. That would be a really very severe hit to this huge pile of assets. We’re talking trillions of dollars in value here.

The thing about the housing market is it really is a market with very flexible supply and demand. One of the reasons why I think most analysts think we’re unlikely to find ourselves in the 20 percent scenario is that as prices fall, what happens is that people just postpone the moment of the sale of their house. And so supply falls quite rapidly in line with falling demand driven by the rising interest rates. The market does equilibrate. So many analysts think an adjustment in the order of perhaps 5 to 10 percent is more realistic. It could be much more severe in the hotspots of the U.S. housing market in places like Austin, Texas, or Phenix, Arizona, what used to be regarded as second-tier cities which have been just super-hot, fashionable locations for people leaving, notably, Silicon Valley, but also the East Coast.

CA: What are the knock-on effects of this kind of housing downturn on the real economy in the U.S.? Americans famously rely on their houses as a primary form of investment—might some of them have to delay their retirement, for example?

AT: It’s a really big deal, for sure. I mean, there used to be a saying that the real estate market is the business cycle in the U.S.—that what drives the ups and downs of the economy is in fact this one big market, because it’s so large as an asset class and so much leverage is piled on it. To think about the effects on the real economy, I think there are probably two dimensions of this that are sort of interesting. So one is a dimension of change, where you have a relatively small component of overall economic activity, but that swings wildly and by means of those swings exerts an impact on the American economy. The other dimension of this is a huge aggregate, which swings more modestly, but, nevertheless, given its real size, has a huge impact.

So the small thing that fluctuates wildly is new construction of housing. One element of the story of the business cycle from the real estate market is that when the real estate market is booming, when rents are rocketing ahead, as they have recently, a lot of people decide it’s a good time to build housing, notably multifamily units. And this is what was, once upon a time when America was a rapidly growing economy and used to build a lot of houses, a very significant element of GDP. Construction peaked at about 7 percent of GDP; it’s now down to around 4 percent. But the thing about it is, it still swings like a yo-yo. It’s really one of the bits of the economy that just bounces up and down like crazy. So if you look at new mortgage applications in the third quarter of 2022, that’s down 47 percent year on year—just an absolutely gigantic shift. Single-family-home building permits are down 30 percent year on year. The mood among homebuilders is absolutely catastrophic right now. This small aggregate, which is like 4 percent of GDP, is swinging by as much as 30 to 40 percent, which adds up to like a 1 percent swing in overall GDP from just this one sector. So that’s as big as any government stimulus program other than the flat-out emergency stimulus programs of 2020.

Now, take the other component, which is the one that you were alluding to, which is the so-called wealth effect. Housing is, for the vast majority of households, their principal store of wealth. And as that fluctuates in value, it affects people’s moods and their willingness to spend. The vast majority of spending is, of course, affected by incomes rather than wealth. But at the margin, there is some spending that will be induced by wealth effects, and this is a huge aggregate. So this isn’t 4 percent of GDP; this is 75 percent of GDP—personal consumption expenditure accounts for about $17.8 trillion per year. So when the Dallas Fed tells us that it thinks a severe shock to the real estate market could reduce personal consumption expenditure between 0.5 and 0.7 percent, you might shrug and think, well, that’s not very much, except that it’s a share of the $17.8 trillion. In fact, it amounts to another $100 to $150 billion hit. So these kind of numbers are really bad news.

CA: What broader role, exactly, do U.S. housing assets play in international financial markets? What are the broader implications here, internationally, of a downturn in U.S. housing?

AT: Yeah, housing is crucial to finance because, for the vast majority of people, it’s the only readily available form of collateral on the basis of which they can borrow—and they can borrow significant amounts, three times their income. That’s a lot of leverage you can pile on, so it’s very significant. In the U.S. case, we’re talking about $13 trillion of mortgages outstanding. So that’s more than all corporate debt. If you add up all of the bonds—not the shares, but the bonds—issued by corporate America, the housing mortgage sector is larger than that. And it’s made up of millions of small creditors who’ve borrowed. So it’s a huge piece of the financial system. And if it’s true that real estate was or is the business cycle, it’s also true that real estate is pivotal to most major financial crises.

And in the current situation this year, as the volume of mortgage applications has fallen by 47 percent, as you’d imagine, the businesses that make money from issuing mortgages have suffered a complete collapse in business. And those are the non-bank mortgage lenders, which are really a major part of the modern American mortgage system. We’ve already seen a couple of bankruptcies in that sector this year.

But the prevalent consensus right now, having done a kind of gut-check and patted ourselves down and thought about all of the risks, is that this doesn’t feel like 2006 or 2007. Why is it different? Because private-label mortgage-backed securities, which were at the center of the crisis in the past, are a shadow of what they used to be. Mortgage lending by foreign banks that were directly involved in the American mortgage system before 2000 is much reduced.

Plus, there has been a huge and sort of dramatic shift—very much under the radar and kind of astonishing—essentially, there’s been a nationalization of the American mortgage market. By which I mean that the government-backed mortgage backstops Fannie Mae and Freddie Mac have taken on an even larger share of the American mortgage market than they did before. So before the crisis, they had about 40 percent of the market of mortgages that are packaged into securities and then reissued. And currently they have about 67 percent of the outstanding volume of mortgages in the United States. And that gives a kind of underlay of security to the system, which it has never had to this extent.

Cameron Abadi is a deputy editor at Foreign Policy. Twitter: @CameronAbadi

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