Just as the stock market bubble artificially prolonged the U.S. economic expansion in 1999 and most of 2000, the housing bubble stimulated the American economy in 2004 and 2005. But it has now ended. The only question for 2006: soft landing or hard?
Uncharacteristically, my answer is: It all depends. O.K., having danced around the subject, I'll give you my 2006 forecast: inflation-adjusted GDP growth of 2.5%. For those who care about these things, that's really 1.5% growth because in the economic figuring, a phony number adds a percentage point. Since productivity is really rising about 1.8%, this means the unemployment rate will increase about three-tenths of a percentage point during 2006.
Now for the qualifiers. My forecast assumes (a) oil prices will come back down, (b) there will be no further misadventures in the Middle East or major coordinated worldwide terrorist attacks, (c) Ben S. Bernanke will have the same sure hand on the rudder at the Federal Reserve that Alan Greenspan has, and (d) housing prices will flatten out but not actually decline on a national average basis.
There is no longer any question that the housing bubble is history. Stories from one end of the continent to the other now tell about stable to declining prices in all previously hot markets. Major housing stocks are already down almost 50% from their August 2005 peaks. And while Maestro Greenspan's calculations show that home equity extraction has added about 1% to the real growth rate over the past five years, that gravy train is about to be derailed.
Because the bubble in housing prices did not become as distended as the bubble in high-tech stock prices did at the turn of the millennium, I don't think an actual recession is on the horizon. However, when the economy declined in 2001, until Sept. 11 the other exogenous factors were basically positive: no disasters, and no big increase in energy prices. The Bush tax cut helped then. But there will be no similar tax cut in 2006. Also, throughout 2001 the Fed reduced interest rates sharply. That's not going to happen in 2006 because of the threat of higher inflation. Indeed, it is highly likely that the Federal funds target rate, the benchmark short-term interest rate, will rise to 5% before mid-2006 -- and that's if inflation behaves itself. Otherwise, we could see the federal funds target rate spiking higher to 6%. (Eighteen months ago, it was just 1%.)
For several years -- an entire decade, according to my calculations -- consumers have been spending more than they have been earning. From 1995 to 2000, the difference was financed by capital gains on stocks. After the most recent recession from 2002 to 2005, it was financed by capital gains on houses. This capital-gains financing camouflaged the fact that the families without access to such financing were rapidly falling further and further behind. A much larger swatch of middle-income America is set to join them in 2006.
Remember, what I am giving you is the optimistic scenario. There is no guarantee that housing prices will not actually decline, at least in previously overheated areas. Already homebuyers are insisting on more stringent terms and are no longer willing to enter into bidding wars. For those people who default on their homes, or are forced by family or business situations to put their homes on the market and move in short order, it could get ugly. It doesn't take too many "forced sales" to send the whole house of cards tumbling down.
My bottom line for 2006: Expect sluggish growth -- but prepare for worse.
Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.