U.S. Housing Bubble has Finally Burst

After the longest and most gravity-defying run-up in US house prices in history, the bubble has finally burst.

In the three months to September 2006 residential investment declined at an annual rate of 17 %, a weighty blow to overall output.

House prices have fallen across the U.S. in the past 6 months. We may even experience the first calendar-year decline in the median national house price since accurate records began half a century ago. Since it was housing that was propping up the economy for the past five years, it is said, the outlook is bleak.

The problem in the story is this. Construction and housing-related economic activity were supposed to be only one, relatively small, part of the effect of the deflation of the housing bubble on demand. The much bigger drag on growth was expected to come not from the direct effect of a reduction in activity by builders but in a reduction in the estimated housing wealth of tens of millions of Americans. The decline in prices was supposed to chill consumers, who would rush to redress their balance sheets by increasing savings and reducing consumption.

The pessimists argue that the worst is yet to come, that the housing market will continue to weaken and, after a suitable time lag, the consumption effect will be deep and powerful. But the direction of house prices, and their effect on consumption, is highly uncertain.

While other markets certainly tend to overshoot when they correct, housing is different. As prices fall, householders simply opt not to sell and stay longer where they were, keeping prices sticky. And though the recent residential slump is far from over, the latest data on such indicators as mortgage applications suggest at least that the pace of decline is slowing sharply.

In any case, what the consumer has lost from the fall in the price of his house, he has probably gained from a fortunate confluence of economic events (oil or stocks).