Paul Krugman on the housing market

Princeton economist and New York Times columnist Paul Krugman is interviewed in the current issue of Fortune magazine. He's predicting housing price declines of 25% to 50% not based on the prices and incomes, but prices in relationship to potential rental income (which I also think is a much better barometer than incomes alone). So how bad does he think the mortgage crisis will get?

I think home prices will fall enough for us to produce about 20 million people with negative equity. That's almost a quarter of U.S. homes. If home prices are rising, or if there's positive equity, you can refinance or sell. But if you have negative equity, you can end up being foreclosed on, and then some people will just find it to their advantage to walk away...

I still think the estimates people are putting out there - $400 billion or $500 billion in losses - are too low. I think there'll be $1 trillion of losses on mortgage-backed securities showing up somewhere...

My preferred metric is the ratio of home prices to rental rates. By that measure, average home prices nationally got way too high. We'll probably basically retrace all that. So that's about a 25% decline in overall home prices. Only a fraction of that's happened so far. Of course, it varies a lot. In places like Houston or Atlanta, where home prices have not risen much compared with underlying rents, the decline will be relatively small. In places like Miami or Los Angeles, you could be looking at 40% or 50% declines...

And yet, that will still vary greatly depending on location, product type and the existing relationsihp between prices and potential rents.

People at the Fed are talking about feedback loops. At the moment, most of what they're concerned about is that falling home prices are leading to a credit crunch, which is actually driving up mortgage rates and making mortgages unavailable, which is causing home prices to fall even more. I'm not one of those people who thinks the Great Depression is coming back, but there's lots of echoes...

The financial stuff looks like a combination of 1990 and 2001, and probably bigger than both combined. You've got the financial disruption, which is probably bigger than the savings and loan crisis. And you've got the loss of wealth from the housing bust, which is bigger than the dot-com bust. So this looks fairly nasty. And then everybody who's paying attention is worrying about the Japan analogy. Japan never had a really severe recession. It just started with a recession and never really had a recovery for a whole decade. And that's the kind of thing we're afraid of...

The effective borrowing costs for a lot of people are rising, not falling, despite the Fed cuts. The rising spreads are more than offsetting it. The mortgage rates have not been falling as you might hope. And, of course, for many types of people who were able to borrow two years ago, they now can't - at any interest rate. We're looking at the classic pushing-on-a-string problem, where the Fed can cut, but it's not clear it does much for the real economy...

What Greenspan did not do was listen to warnings about subprime. The Fed had substantial regulatory and moral-suasion power. They could have done a lot to limit the excesses. It's more what he failed to do during the boom than what he did in response to the last slump...

The inflation happening right now is not being fed by expectations of inflation - there's no self-reinforcing process - it's just mostly commodity prices going through the roof. That's not pleasant, but it's not something the Fed needs to be all that worried about, as long as it stops there...

I look at the euro at $1.53 and cheer - not for this European trip I'm planning to take after classes are done. But for manufacturing plants in the Midwest, it's a very good thing. Arguably the only good thing we have going for the U.S. economy now is the weak dollar and how that helps exports...

I'm looking at the increase in interest-rate spreads, with the LIBOR (London interbank offered rate) pulling away from U.S. Treasury bills. When the spread gets that big, it suggests that banks are losing trust in each other. Various measures of panic in the markets are looking bad again. I've been thinking to myself, This is now the fourth wave. We had a first wave more than a year ago, when subprime first began to go. And everyone said that was contained. We had a second wave last August, when things started going to hell. We had a third wave late in the fall, and heroic efforts seemed to bring the problems under control. And now here we go again. This is starting to look like a much more comprehensive financial crisis...

It seems to me like every few weeks there's another $300 billion market I've never heard of that has just collapsed. And there's credit cards, auto loans - I don't know what's next. But it's clear we're going to have a commercial real estate crash not too far short of the severity of the housing crash...

If you look historically at other financial crises, they typically end up with big government bailouts. But how's that going to work in this case? We don't even know who to bail out. And part of the problem is we don't even know who owes what to whom...

How much in the end does the ability of consumers to keep spending get affected by what's going on in fairly abstruse financial markets? So I'm not quite sure how this works. Maybe that's a reason for hope. Maybe it'll turn out that all this Wall Street stuff is just less important than we think it is.