Surging house prices were a dominant feature of the economic expansion and housing boom several years ago, and falling house prices have been a dominant feature of the subsequent collapse of the housing sector and descent of the economy into the Great Recession.

the housing market and the housing finance system but also the balance sheet of the household sector. This damage, in turn, has prompted a major cutback in consumer spending along with resurgence of the personal saving rate.

House prices still are in retreat in many places, there’s risk of overshoot on the downside, and government efforts to stem the tide have been inadequate for the task. Achievement of the widely anticipated economic recovery may very well require more decisive policies to halt the destructive downward spiral in house prices.

Household Balance Sheet

The boom/bust house-price cycle has had dramatic effects on the balance sheet of the household sector. During the boom, surging prices bestowed huge wealth gains on homeowners; indeed, holding gains came to $6.7 trillion for the 2003–2006 period. These gains, in turn, supported huge increases in home mortgage debt as many households refinanced into larger first mortgages and tapped home equity credit lines.

Housing equity grew substantially during the boom despite the debt expansion, reaching a record $12.5 trillion by early 2006. This amount was equivalent to a lofty 58.5 percent of the market value of household real estate (leaving 41.5 percent mortgaged) and came to more than one-fifth of total household net worth. The housing boom spurred the net worth of the housing sector to record levels, in both absolute terms and relative to disposable personal income.

The bust in home prices has provoked major deterioration of the household balance sheet. Homeowners have lost about $5 trillion of market value since 2006 (through the first quarter of this year). Furthermore, owners’ equity has shrunk by more than 40 percent and the ratio of housing equity to the market value of homes has slipped to only 41.4 percent (leaving 58.6 percent mortgaged). The housing share of total household net worth also has shrunk, despite the recent collapse of the stock market, amounting to only 15 percent at the end of the first quarter.

Consumer Spending

The price-driven growth in housing wealth fueled consumer spending during the boom, and the subsequent price reversals have taken a heavy toll on this dominant component of spending in the U.S. economy. In this regard, it’s noteworthy that changes in housing wealth have more powerful impacts on consumer spending, saving, and borrowing decisions than equivalent changes in equity wealth produced by swings in the stock market.

The surge in housing wealth generated more than a percentage point of real GDP growth in both 2004 and 2005 as household borrowing surged and the personal saving rate fell to historic lows. The contraction in housing wealth has generated similar-sized reductions in GDP growth since mid-2007 and the saving rate has shot up in the process—approaching 7 percent by May of this year. Further increases certainly would jeopardize the gradual recovery in GDP that we expect to begin in the latter part of this year.

Policy Implications

A variety of government policies have been enacted to help rebalance housing demand and supply and support house prices, but there’s still work to be done. The government should strengthen temporary measures to stimulate demand, pull out the stops on foreclosure prevention, and support appraisal practices that do not reinforce the downward spiral in prices.