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11/21/2010: "US housing prices fall. Why do we care?"

An article in the Financial Times reported that home prices in the US fell from July to August of 2010. This doesn't seem to be earth shattering news, so we must ask why the story was published in a London-based paper, and whether Canadians should be interested. (Click here for article 1)

From January 2002 through July 2006, housing prices in the United States increased by a total of 71%. This was due largely to the easy monetary policy implemented by the Federal Reserve. Interest rates fell as liquidity increased. Borrowing to purchase a home got easier and more people bought. The increased demand for housing caused housing prices to rise. As people began to expect prices to rise, the demand for housing increased even further. Housing prices rose because people expected them to rise. Banks in the US are generally smaller than those in Canada and typically sell the mortgages that they initiate into the secondary market. Bank liquidity increases and they are able to initiate more mortgages. The mortgages in the secondary market get packaged into mortgage-backed securities (MBSs) that allow individuals to invest in the mortgage market. Investment banks created another product known as Asset Backed Commercial Paper (ABCP) that was used to finance the creation of the MBSs.

As with all speculative bubbles, the housing bubble popped in mid 2006. Individuals without strong credit ratings and with little ability to repay mortgages were the first to get into trouble. As they started to default on their mortgages, the income of the MBSs started to fall. Foreclosures began and the number of homes offered for sales increased. From 2006 to 2010, housing prices dropped for 37 consecutive months. As banks started to realize the losses on their mortgage investments, they were forced to curtail lending in an attempt to conserve cash. The American financial system came crashing down on September 15, 2008 with the collapse of Lehman Bros., a New York based bank, the subsequent sale of Merrill Lynch to Bank of America and the government bailout of AIG, an insurance company.

A second article, from Bloomberg Businessweek explains the ongoing threat from the US housing market collapse. (Click here for article 2) While housing prices have stabilized in most markets, there is still a threat of further downward pressure due to unemployment and slow economic growth. Another downturn in housing prices could cause the crisis to spread from the subprime market to the prime market. A reduction in home prices is equivalent to a reduction in household wealth. When wealth falls, consumption falls further weakening the economy. Individuals, fearing another reduction in housing prices have begun to 'delever', paying down their existing debt. This also reduces consumption and economic growth. With the current excess supply of houses, the incentive to build new housing has disappeared. Housing is a component of investment spending and any reduction in investment reduces economic output.

In response to the credit crisis, the Federal Reserve has instituted a program of buying bonds on the secondary markets. The intent is to increase the amount of reserves in the system enabling an increase in lending and an increase in the money supply. The stated objective is to promote the pace of economic recovery. The side effect of increasing the money supply is a devaluation of the US dollar. When the US dollar falls, the price of the pound, euro, yen, yuan and the Canadian dollar all rise. This is the argument put forth in a Globe and Mail editorial. (Click here for article 3)

An appreciation of the Canadian dollar causes changes in our trade balance. As the dollar rises against its American counterpart the price of goods produced in Canada increase in the US and the price of goods produced in the US become cheaper in Canada. This tends to increase our imports and decrease our exports. Since the US is our largest trading partner, our balance of trade decreases when our dollar appreciates. As net exports decrease, so does aggregate demand and equilibrium GDP. The effect on our trade balance is explained in a Globe and Mail article. (Click here for article 4) As aggregate demand decreases unemployment rises. This is why Canadians need to worry about the decline in US housing prices.


Relevant Learning Objectives

4.2 Explain the difference between a change in aggregate quantity demanded and a change in aggregate demand, and list five shocks that change aggregate demand.

6.1 Explain the demand and supply forces that determine the value of the Canadian dollar.

6.3 Trace the impact of high and low exchange rates on real GDP and inflation.

7.4 Explain why monetary transmission can be blocked, and how quantitative easing can overcome a balance sheet recession.

Questions

1. Identify the shocks to the aggregate demand in both Canada and the United States.

2. What effect do you think that the US monetary policy has had on trade between the US and the UK? Europe? What effect has there been on the trade between Canada and the UK?

3. Quantitative easing by the Federal Reserve has caused the US dollar to depreciate. What effect, if any, would you expect this to have on the inflation rate in Canada?

4. How does the US policy of quantitative easing differ from the Bank of Canada's open market operations?

Sources

1. US house prices fall in August, Alan Rappeport, Financial Times, October 26, 2010 accessed November 8, 2010
2. Roubini sees another 'disaster' if house prices drop, Michael Cohen and Renee Bonorchis, Bloomberg Businessweek, November 8, 2010, accessed November 8, 2010
3. Quantitative easing is devaluation by another name, Globe and Mail, November 5, 2010 accessed November 8, 2010
4. Canada's record trade deficit shows impact of U.S. woes, Globe and Mail September 9, 2010, accessed November 8, 2010


Michael S. Leonard
Kwantlen Polytechnic University
Surrey, BC