America’s housing crisis is generally agreed to be the biggest risk for the global economy and financial markets today. This is understandable. Prospects for the US construction industry and for mortgage lenders and borrowers clearly are worse than at any other time since the early 1990s. At the same time, these risks are so widely recognised that one has to wonder whether they have been fully discounted by financial markets and largely recognised by American businesses and consumers.

I am not suggesting that the worst is over for US housing construction and employment. The decline may be only halfway through. This can be seen in my first chart, which shows that residential investment still has a long way to fall before it reaches a typical cyclical low. To judge by the present levels of housing starts and construction employment, therefore, America’s homebuilders (and perhaps their shareholders) are still in denial about their industry’s dire prospects.

But this disastrous housing outlook has to be considered from a broader macroeconomic perspective. There are, in principle, three ways that a housing collapse can affect the broader economy and financial markets:
1. Directly, through a cutback in construction activity.
2. Indirectly, through a negative wealth effect on consumer confidence and demand for credit.
3. Indirectly, through damage to bank capital and, thus, the supply of credit.

A good way to distinguish between these three separate channels of influence is to borrow Donald Rumsfeld’s famous distinction between “known” and “unknown” risks before the Iraq war.

The “known known” of the housing slump is its direct impact on GDP. This can be fairly readily quantified – a further loss of at least 1.5 per cent of GDP and probably at least half a million jobs is almost inevitable before this housing slump hits bottom in a year or so. These may sound like horrific figures, but they have to be put into the context of the huge size of the US economy and another “known known”: another part of the economy is now accelerating strongly – and for reasons directly related to the housing slump. This is the export sector, which, in terms of output and employment, is almost three times as big as housing. US exports are growing more rapidly than at any other time for 20 years, and this isn’t just a lucky coincidence. All over the world, housing cycles have been correlated with changes in net exports, because housing booms tend to suck in imports, boost exchange rates and divert resources from export industries, while housing busts do the opposite. This effect can be seen in the bottom chart, which shows the opposing – and largely offsetting – movements of housing and net exports in the US since 1960. In the present housing cycle, this process started to kick in about six months ago, with net exports contributing 1.25 percentage points to GDP growth in the past two quarters, while falling residential investment reduced GDP growth by 0.8 percentage points.

The upshot is that overall growth in the US economy seems about as likely to strengthen as to weaken in the next few quarters – provided we focus only on the direct effects of the housing slump.

The caveat in the last sentence brings me to the real worry today in the markets: whatever happens to construction activity and exports, surely the main dangers of the housing slump are in the effects on financial stability and consumer confidence.

The impact of falling house prices on consumption – the so-called negative wealth effect – is a good example of Mr Rumsfeld’s “known unknowns”. The existence of a negative wealth effect is obvious and widely acknowledged, but it is surprisingly difficult to pin down, because previous episodes of falling house prices have always coincided with rising interest rates and unemployment. Allowing for the influence of these depressing factors, most studies have concluded the residual effects of falling house prices to be quite ambiguous and weak.

All the publicity about sub-prime mortgage defaults among America’s poorest households has created the impression that this housing slump will have a bigger-than-usual impact on consumption. The reality, as suggested by recent quite surprisingly strong consumption figures, could well be the opposite. One possible reason for this is America’s extremely uneven distribution of income, as a result of which the poor consume only about one quarter as much per head as the middle class. Because the two million households at risk of losing their homes in the sub-prime crisis are mostly poor, even an extremely drastic one-third decline in their low levels of consumption would shave only 0.3 per cent off total US consumption – and only 0.2 per cent off GDP.

If the wealth effect on consumer demand – concentrated at the low end of America’s income distribution – turns out to be fairly marginal, what about the other terrifying byproduct of the US property crisis – the collapse of confidence in the banks? This can best be fairly called the “unknown unknown”, because calculations about the hundreds of billions in financial losses that inevitably will result from the sub-prime crisis depend entirely on where the risks really lie. If all the losses – estimated at anything between $100 billion (£49 billion) and $400 billion – had to be borne by the US banking system, a serious contraction in credit would be almost inevitable. If, however, the ultimate financial losses fall mostly on pension funds, insurance companies and European and Asian financial institutions (including central banks), which are believed to have been the heaviest investors in US mortgage-backed securities, then the pain of the sub-prime losses should be spread widely enough to avert a serious financial crisis, despite the widespread fears in the market today.

This raises the most worrying problem of all about the whole sub-prime crisis: nobody knows who, ultimately, will bear the losses and nobody seems to be in control. But is this “lack of visibility” really such a nightmare?

There is a story that Nikita Khrushchev, on his first visit to America, was very impressed with the supermarkets. So impressed that the first question he asked when he met Vice-President Nixon was: “Who is responsible for the supply of bread to New York City? I want to meet this brilliant man.” The fact that Nixon could not even understand the question, never mind offer an answer, revealed the market system’s greatest strength. In the capitalist system no individual is “responsible”, either for the supply of bread or for the allocation of credit. But this is a cause for relief, not despair. Markets are unpredictable and creative – which is why the next big event in the US economy is more likely to be an export-led boom than a mortgage-led bust.

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