Keynesian economics at work: Housing bubble bursts (again)

Victor Joecks

A key tenet of Keynesian economic philosophy is that government must take an active role during downturns in the business cycle (otherwise known as depressions or recessions). Keynesians believe that government policies must encourage more spending and greater employment in the short term. This additional spending, or “stimulus,” will bring the economy out of its downturn and lead to economic growth.

This was the rationale given for the $787 billion stimulus pushed by President Obama and Sen. Harry Reid last year. And now, more than a year later, the results are in and the stimulus was and is an epic failure. Especially for Nevada.

Included in the federal stimulus was another example of the failed Keynesian way of thinking – an $8,000 tax credit for new homeowners that was supposed to expire in November 2009. Before it expired, though, Congress passed an extension through April 2010 and also extended a $6,500 tax credit to some current homeowners.

This tax credit was going to provide a “stimulus” to the struggling housing market that would allow it to recover. Did that happen?

No. All it did was push up the timeline for buyers who were going to buy anyway in the near future. It also cost taxpayers a lot of money. And now that the tax credit has expired, mortgage applications have fallen by 42 percent, and since home sales follow mortgage applications by a couple months, the housing market has hit a record low for new home sales. Total home sales are about to take a big hit, and those numbers are likely going to fall even further in the near future.

Mortgage applications tend to lead home sales by a couple of months. Move mortgage applications over two months and the potential drop-off in sales is going to be enormous.

Head over to Bloomberg for the full interactive chart. How bad will it get?

[F]inancing requests for home purchases plunged 42 percent from late April through early June, to levels last seen at the start of 1997. The decline reversed a 48 percent surge in the two months leading up to an April 30 contract-signing deadline to qualify for the home-buyers’ tax credit. …

Existing home sales, which are tallied when transactions close, will rise 6 percent to a 6.1 million annual rate in May, economists surveyed by Bloomberg News forecast before today’s report from the National Association of Realtors. Purchases may hold up in June because buyers still had time to make the June 30 closing date to qualify for the credit. Then, beginning in July, sales will tumble, Shepherdson said.

“The summer is going to be dreadful because the tax credit pulled activity from the summer into the spring,” Shepherdson, the chief U.S. economist at the Valhalla, New York-based research group, said in a telephone interview last week. “New lows do seem entirely possible,” he wrote in a note to clients. [Emphasis added]

This shouldn’t surprise anyone, since the government’s other stimulus program, “Cash for Clunkers,” had the exact same effect.

What’s especially ironic in all of this is that Keynesians, like Paul Krugman, wanted the government to create a housing bubble in 2002 in order to offset the NASDAQ bubble. As we all know, especially in Nevada, we got one – thanks to the Federal Reserve setting artificially low interest rates and irresponsible mortgages from Fannie and Freddie based on political pressure.

What do our politicians need to do? The same thing they needed to do 16 months ago. Let the economy retract in the short term in order for individuals to move assets from low-value industries to more productive sectors of the economy.

During recessions, in a free-market system, the economy moves money and jobs from low-performing areas to higher-performing ones. And when I say “the economy,” I mean millions of individuals acting in their own self-interest. The economy isn’t a giant organism that has a mind of its own.

This reset is necessary and healthy, because resources (natural resources, products and people) are scarce. Keeping limited resources in low-value sectors of the economy and not allowing them to move to high-value sectors limits economic growth.

To use an analogy, it’s like pruning a tree. In the short term, the tree is smaller, because you’ve cut back in some areas. But those cut backs are necessary to stimulate growth in the long term. Without those cuts, the tree won’t grow as large and may even die.

Let’s also use automobiles as a historical example. Before cars, people still needed transportation. They just used horses and buggies. As cars replaced the horse and buggy, the horse and buggy manufactures were hurt. Consumers no longer needed their product (at least not on such a large scale). Employees lost jobs. Large businesses closed or were forced to retool. This is the kind of economic reordering that happens everyday in the free market. And for consumers, it’s good that this happens.

Unfortunately, the government often prevents the necessary corrections from happening.

While it’s good for consumers in the long run for recessions and corrections to happen, economic downturns can be painful in the present. And politicians, citing misguided economic theories, are eager to look like they’re doing something to help. Politicians offer bailouts and stimulus packages that they claim will jumpstart the economy and decrease unemployment.

While stimulus packages, bailouts and creating bubble markets may work in the short term, they do not create sustainable economic growth. This is because scarce resources are not transferred from low-value products to high-value ones, as explained above.

Politicians or the Federal Reserve guided by Keynesian economics, pay little attention to the idea of long-term consequences. Unfortunately, for politicians this often makes sense for selfish reasons. Politicians want to get re-elected. By the time long-term consequences hit, it is likely a different politician will have to take the unpopular steps to deal with the mess they have created. Ironically, the politicians who actually created the mess may be remembered fondly for the good times they oversaw. The Federal Reserve faces political pressure to make sure the economy keeps going strong.

Because politicians and the Federal Reserve bowed to the political pressure in 2002 to improve things in the short run, we are now suffering the long-run economic consequences.

The stimulus bill and bailouts are simply a doubling down on our past mistakes. We must let individuals in the market shift scarce resources from low-value products to high-value ones, or our long-term economic growth will continue to be stunted.