by Calculated Risk on 11/21/2006 06:59:00 PM

"The housing market, as you know, it has been hit, I think, harder than most of us had expected."
Edward Lazear, Q&A Nov 21, 2006, chairman of the White House's Council of Economic Advisers

During the housing boom, there were two distinct views of the causes of the boom. The consensus view was that the boom was mostly driven by fundamentals and perhaps a little "froth" in 2005.

The minority opinion was that the housing market had become a bubble. The minority view was based on evidence of speculation: flippers, a high percentage of investment purchases, and homebuyers using excessive leverage, especially with nontraditional mortgage products.

Now that the housing bust is here, there are also two views of the bust. The consensus view is that the "worst is over". The minority view is that the bust has a ways to go.

Not surprisingly, those that felt the boom was based on fundamentals now believe the worst is over. And those that felt the boom was driven by excessive speculation believe the housing market will continue to slowdown. How one viewed the housing boom colors how one looks at the housing bust.

All the evidence so far suggests the minority view was correct. The severity of the bust has caught the majority off guard as evidenced by Lazear's comments above. Here are Lazear's comments today on housing:

Question: I was wondering if you could talk more about your outlook for the housing market. Do you expect there to be -- it to bottom in 2007? And is the worst behind us in your opinion? And what are the risks, in your mind, of a recession?

And Lazear's answer:

CHAIRMAN LAZEAR: The housing market, as you know, it has been hit, I think, harder than most of us had expected. Most forecasters were expecting a slower decline. What that probably signals is that the future will not be as negative as it otherwise would have been because we've probably had much of the decline that we're expecting to have.

Maybe. The other possibility is that Lazear and most forecasters misunderstood the housing boom, and they remain too optimistic about the housing bust. Lazear:

That said, there are -- you know, there are a number of indications that things are still not as strong as they were last year in the housing market. You know, do I see that as a problem for the economy? Obviously, we don't like to see any one industry get hit and hit hard. That affects people's jobs. The good side of that, of course, has been that non-residential construction has taken up much of the slack in that industry. So we haven't seen construction jobs fall off dramatically as a result of the housing decline.

Residential construction is off $55 Billion (SAAR), and non-residential construction is up $38 Billion from December 2005 (Census Bureau, Construction Spending). So Lazear is correct that non-residential spending has "taken up much of the slack".

But Lazear is overlooking a few facts: Even though starts have fallen off a cliff, completions are still near record levels - and when completions fall (they trail starts by about 6 months), construction spending will drop significantly. Also, non-residential investment tends to trail residential investment.

And the reason residential construction jobs haven't fallen "off dramatically as a result of the housing decline" is jobs track housing completions (for obvious reasons). I've presented these graphs before, but they fit here ...

Click on graph for larger image.
The first graph shows Starts vs. Completions.

Starts have fallen "off a cliff", but completions have just started to fall.


This graph shows starts, completions and residential construction employment. (starts are shifted 6 months into the future). Completions and residential construction employment are highly correlated, and Completions lag Starts by about 6 months.

Based on historical correlations, it is reasonable to expect Completions and residential construction employment to follow Starts "off the cliff".

More Lazear:

And I would say that as we go forward what we'd be concerned about is employment in that industry and looking to see how it transmits to the rest of the economy. I don't believe that it is going to transmit to the rest of the economy. There's been no indication that it has. Other sectors remain strong. And that would be the primary danger that I would see from the housing market, whether it's bottomed out now or whether it will take another quarter or so to bottom out I think is still up for grabs, and I wouldn't want to speculate on it.

But I would be willing to tell you that I don't think that this signifies any kind of weakness throughout the economy, in fact the reverse. The job numbers I think are probably the best indicator that the economy is very strong and in really good shape.

Lazear doesn't want "to speculate" on when the housing market will bottom out, but then says "now ... or another quarter or so". Lazear has been consistently surprised by the housing bust, and my guess is he will be surprised some more! But on the last point, job numbers do tell us the economy is decent right now, but they tell us nothing about the future.

Question: And the risk of recession, do you have a --

CHAIRMAN LAZEAR: Well, again the economy is growing. I don't even think we should be talking about going in the other direction at this point. The economy is growing. The economy is strong. The labor market is strong. You know, you see -- when you see jobs added at this rate, when you see unemployment at 4.4 percent, it's pretty hard to be thinking about things going in the other direction. I mean obviously at some time in the future things can change, but right now, as long as we keep our policies consistent with economic growth, which means keep taxes low, make sure that we don't put impediments, strong impediments to trade and business in there, I think we're on track for a strong economy.

What can I say? Oh, Lazear also revised down the White House estimates for GDP growth for Q4 and 2007.