EclectEcon

During the housing boom, people were happy to buy high-priced houses with no money down and interest-only mortgages because they expected to gain some equity interest in the houses as house prices appreciated. At the same time, many mortgage lenders seemed to have agreed with them that housing prices would continue to rise. The result was that, in essence, the housing loans were collateralized with the expected capital gains on the house itself: borrowers were expected to be able to pay off their loans as housing prices rose, but even if they defaulted on the mortgage, the lender expected the house to have a repo value, after costs, that would more than cover the amount of the loan.

This massive expansion of credit based on expectations of rising prices is still likely to cause serious problems for the US economy over the next several years.

1. First, there will be a downturn in housing prices. It has already begun, in fact. [Update: see this in NYTimes]
2. Second, there will be mortgage defaults as borrowers simply walk away from houses in which they have negative equity (hint: when this happens, it's boom time for U-Haul; buy now and beat the rush!).
3. Third, consumers will spend less because of their reduced ability to cash in the equity in their homes.
4. Fourth, people employed in the housing industry will have reduced incomes.

All of these effects will have come about because the US Fed let the money supply grow too rapidly, made credit too easy, and indirectly promoted this phenomenal growth in borrowing.

The only thing the Fed can do now is try to ease off. It would be a mistake to crunch the money supply too much, for if the Fed put on a big crunch, aggregate demand would plummet and we would be in for some mighty serious recessionary pressures. Instead, the Fed has to slowly try to ease the inflationary pressures (that were its own doing with past easy-credit policies) while at the same time trying to keep the housing market from crashing too severely.

Dave Altig seems to think that is where the Fed is headed — a slow, soft landing in housing prices and not much of a crunch or crisis. Calculated Risk seems to think otherwise. Nouriel Roubini also seems to think a harder landing is more likely.

My own views are similar to the predictions made over a year ago by Ed Leamer (see here); they seem considerably more pessimistic than Dave Altig's forecast, but perhaps not quite as pessimistic as Calculated Risk. I can readily imagine US GDP growth rates of less than an annualized 1% a year from now, and I just hope the Fed has enough foresight and control to keep them from turning negative.

Also be sure to check out the related material at The Big Picture.

An indirect tip of the hat is due to The Emirates Economist here, who links to an article pointing out the problems of creating an asset-pricing bubble with too-rapid credit expansion in the United Arab Emirates.