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Profound crisis in real estate would have major effect, although not catastrophic, on economy as a whole

  For some time the real estate sector has been one of the main components of household wealth. Moreover, its recently acquired importance in developed countries has turned the sector into one of the main players in the economy. Therefore, when bad news arise from the real state sector, all the alarms turn on, especially when the country involved is the US.

  In order to see how the real estate sector spearheaded US growth it is enough to observe the strong residential investment. This has been continuously growing as a percentage of GDP during the past 15 years (see graph above) and especially as of 2002, coinciding with a period of very low interest rates. The other important factor to bear in mind is the historic rise in housing prices, which have been growing systematically above the CPI and they doubled in the past 10 years (see graph below). As a consequence, many US households felt that their wealth was soaring, leading them to increase their consumption significantly. Moreover, housing is the main collateral for credit available to most households, hence, the increase in prices allows them to increase their borrowing, which in most cases is used to consume even more. This new form of financing, which was very rare at the beginning of the Nineties, has become nearly 6% of the disposable income.

  Following such a lengthy period of expansion in the real estate sector, what everybody thought that was impossible, is beginning to happen. The price of new housing, which in the past decade has been growing at an annual average rate of 5.7%, fell by 10.9% in the first three quarters of 2006 while the price of existing housing has become stagnant. The rate of activity in residential construction has dropped sharply and new housing starts, after 15 years of growth at an annual average rate of 5.6%, dropped by 23% in the first three quarters of 2006 (see graph below). This cascade of negative figures is raising the fear of a slowdown in the US economy. Not only because of the drop in residential investment but especially for the effects that it could have on consumption, the big US growth engine. It seems that the building-blocks of housing are beginning to make the pillars of the economy shake. Will they turn out to be earthquake-proof?

  Nevertheless, if there is one economy in the world that is efficient and capable of adjusting rapidly, it is the US economy. A good sign of it is the rapid correction that has shown up in new housing starts, where production is traditionally inelastic over the short-term (see previous graph). This is the point of view that has been taken in our main forecast scenario. In this scenario, we expect a moderation of private consumption growth and a drop in fixed-asset residential investment so that, in overall terms, it is expected that the US economy will still grow by 2.6% in 2007.

  Be as it may, in order to discern the transmission channels of a shock in the real estate sector and the extent of its possible effects, it is very illustrative to consider a scenario of major, though not catastrophic, adjustment. In this alternative scenario, on the one hand, we consider a further drop of 10% in prices, in line with the drop that has taken place in the first three quarters of 2006 (although prices have somewhat recovered in recent weeks). On the other hand, we consider that residential investment as a proportion of the GDP returns to the levels seen in the Nineties (which would mean a drop of 15%). The drop in investment would mainly affect the construction and manufacturing sectors which would take off 0.4 points from GDP growth in terms of the main scenario (see accompanying table). In addition, the drop in prices would generate a negative wealth effect on consumption (and to a lesser degree on imports), which would grow below expected and take off another 0.6 points from GDP growth. The US economy thus seems to be sufficiently flexible to withstand a harsh blow from the real estate sector and would end up growing by 1.6%. This, of course, would leave it exposed to possible future eventualities.

  It would thus be hit, but not knocked out, and with a reduced margin for manoeuvre to face up to possible adverse situations. Inflationary pressures still persist and will limit the capacity of the Federal Reserve to revive the economy through reductions in the price of money. Furthermore, fiscal policy is also limited by the high fiscal deficit. In any case, we should point out that prospects on inflation have held stable and the drop in oil prices may provide a breath of fresh air which would be welcomed by the Fed.

  The US economy seems to be moving down and what is bringing about this drop is the very pillar that has sustained the powerful engine of the economy. In any case, the efficiency with which the construction sector is responding should make a soft landing possible, so long as there are no last-minute surprises.

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