Calculated Risk has long argued that those wanting to peer into crystal ball and see the future of the US economy should look at Britain -- since Britain’s housing boom started before the US boom, and British housing prices have started to cool ahead of US prices. Consequently, the response of the British consumer to a slowing housing market is likely to help predict the response of the US consumer to a slowdown in the US housing market.
It seems like the Netherlands provides even more evidence that a stalled housing market can exert a signficant drag on the economy.
With the Dutch economy in the fifth year of a slowdown, persistently low consumer spending led the daily Volkskrant to diagnose a "new Dutch disease," and the NRC Handelsblad said the economy was "hostage to the housing market."
For the second time in two years, the economy is on the brink of recession, with gross domestic product shrinking 0.8 percent in the first quarter compared to the final quarter of 2004, when growth was flat, and the outlook gloomy.
"People don’t feel that they are automatically getting richer any more," ABN AMRO economist Charles Kalshoven said, adding Dutch welfare reforms had also created uncertainty, another reason for people consuming less and saving more.
The term "Dutch disease" refers to the 1960s, when the discovery of natural gas in the Netherlands led to a sharp rise in exports, driving up the currency and hurting export-oriented manufacturers.
But Europe’s sixth-largest economy recovered to be the envy of its neighbors with low unemployment and growth rates of 2.9 to 4.3 percent from 1994 until 2000, helped by wage restraint and booming exports.
Rising asset prices allowed Dutch pension funds to keep premiums low, and house prices, which rose by a half from 1997 until 2000, stimulated consumption further as owners borrowed --and spent -- against the higher value of their homes.
The Dutch central bank estimated in 2003 that spending on consumer goods, electronics and holidays financed by cheap mortgages boosted gross domestic product by as much as 1 percentage point in 1999 and 2000.
House prices, supported by lower interest rates, did not crash when the economy slowed in 2001, but price increases were markedly lower than during the boom years.
The ratio of savings and pension contributions to disposable income -- which had fallen to 7 percent in 2000 from more than 17 percent in 1992 -- jumped in 2001 as consumers sought to rebuild wealth and pension funds hiked premiums to compensate for equity losses.
Consumption growth slowed and eventually turned negative in 2003, when the economy dipped into recession. The Netherlands is still one of the weakest in the euro zone.
"House prices tend to stimulate consumer spending so much that just removing that stimulus tends to lead to a sharp deceleration of consumption," Fortis economist Nick Kounis said.
"For the housing market to start being a drag on consumer spending, you just need it to stop providing a boost."
Eurosclerosis might cross the Atlantic if US housing prices ever stopped rising.
Read Ted Truman’s most recent paper on current account adjustment.
He argues that even if the process of reducing the US external deficit does not reduce overall US growth, it necessarily requires some reduction in the pace of US consumption growth, or at least the ratio between the growth in consumption and the growth of income. After several years of growing faster than US income, consumption will have to grow at a slower pace than the US economy. A reduction in the external deficit, with GDP and total domestic supply unchanged, means gross domestic purchases (absorption or GDP less net exports) or total domestic demand must be reduced, the US must stop living beyond its means.
In a sense, the US has financed current consumption growth by borrowing against future consumption growth. The numbers here are not trivial: Truman estimates that reducing the US current account deficit by 3% of GDP requires reducing US gross domestic purchases by $1350 per person. Plus, the deterioration in the US terms of trade associated with the needed fall in the dollar will cut US per capita purchasing power by another $1000.
Those calculations assume that the pace of GDP growth is more or less unchanged -- all the changes is domestic demand grows more slowly than GDP for a while. But it certainly is possible that GDP growth will slow as well. Truman reminds us that during the last period of US external adjustment, from 88 to 91, the pace of real GDP growth slowed to 2.25% (it has been 4.5% during the preceding four years. During that time, domestic demand grew at an anemic 1.6% annual pace.
Real wages in some sectors -- manufacturing for example -- may rise, but overall real wages may not. Lots of real estate brokers may be out of work. As Ted Truman notes, past periods of external adjustment have coincided with a slowdown in overall real wage growth (see figure 1 of his paper).
I think external adjustment is necessary, but that does not mean that it will be pleasant. Spending more than you earn is often a lot of fun; paying off your credit card is not. That is why -- as Ted notes -- policy makers have pretty strong incentives to defer adjustment, even if delay increases the risk of a really bad outcome.
Full disclosure: Ted Truman was the director of the Fed’s international staff for a very long time, before shifting over to the Treasury, where he served as the Assistant Secretary for Int. Affairs -- in other words, he is my former boss.