President Trump’s relentless warfighting against price stability has finally paid dividends: conventional 30-year mortgage rates have breached 7% (figure above). We have been at similar levels in the aftermath of the 2020’s Bond Catastrophe, but the chart looks ugly and there is no sign of an end to policies that are designed to raise prices.
There is a fair amount of online controversy regarding the effect of interest rates on the economy, mainly due to the rise of Modern Monetary Theory (although there is also the fringe “Neo-Ricardian Heresy” within orthodox economics). However, the mechanism posited within MMT for the stimulative effects of higher interest rates is that they imply a greater fiscal deficit courtesy of interest spending. (Although neoclassical and conventional economists have kittens/ridicule the MMT position, this mechanism shows up in the orthodox “Fiscal Dominance” “theory,” which is also treated as being a Very Serious Position. Consistency is the hobgoblin of small minds, etc.)
Although I accept the greater interest spending angle, the housing market is the 200 kilogram (31 stone) gorilla in the room.
The above figure shows the 3-month moving average of private housing starts in the United States. If we look at the trend in housing starts when compared to recessions (coloured bars) we see that there is a tight link. Before the 1990s, policymakers followed fairly aggressive “stop-go” cyclical policies, and so housing markets getting whacked was fairly explicitly part of inflation control. The modern era features fairly gradual monetary tightening policies, but the early 1990s and mid-2000s recessions featured housing busts (and COVID saw a whipsaw due to private sector panic/official restrictions on activity). If we look at the mid-2000s, housing starts rolled over well ahead of the recession. (Meanwhile Wall Street economists and the equity market was unconvinced that there would be anything other than a “technical recession” in mid-2008, while the start of the recession was backdated to December 2007.)
A key exception was the recession in 2001. That was a “sectoral recession” — the tech sector blew itself up by making massive fixed investments in telecoms that outstripped the potential cash flows on the assets for some time. (The “dot-com” stocks fascinated the financial press, but they were largely a zero-sum financial trading bonanza. The capital investments in telecoms was what drove the real economy.) If you were in the tech sector, the early 2000s was a terrible time (as an ex-electrical engineer in Canada, I knew a fair amount of ex-Nortel employees). However, the effect on the broad economy was somewhat muted because the aggregate housing market continued its bull market through the tech bust.
Some commentators after the 2008 Financial Crisis tended to expect a repeat of that episode, and any signs of financial stress were taken as to be an indication of a repeat. To a limited extent, financial stress is associated with recessions — we rarely see a contraction in activity without some sector of the economy blowing up. However, it is entirely possible that the stress will be contained to a few sectors, without the solvency of the banking system being called into question. This follows from the arguments of Hyman Minsky — risk-taking within the financial sector follows patterns. The usual pattern is that risk-seeking is rewarded and thus builds up in the system as cycles pass. However, if there is a generational washout of risk-takers, risk-seeking is recalibrated to lower levels. The Great Depression was the most important example of such a recalibration (risk taking culture did not recover until the 1960s), but some lessons were learned after 2008.
Nevertheless, the housing market relies on households being willing to purchase expensive assets with relatively large amounts of leverage. Not every home purchase is highly leveraged — households who already own a home only need to finance the difference in prices between the house they buy and the house they sell. However, in the absence of circular patterns of home sales (people upgrading match people downgrading), new home buyers have to enter the chain of buyers. These new home buyers are critical to allowing chains of transactions to occur in practice — and such buyers need to finance almost the entire home purchase (since not many first-time home buyers have 100% down payments sitting in their bank accounts).
At the same time, new home building is a capital and labour-intensive activity. Which means that this activity is dependent upon the “animal spirits” of home buyers to finance the construction. Which creates a direct mechanical link between recessions and housing contractions: if people are losing their jobs, they are not in a mood to make large leveraged purchases. At the same time, if they stop making those purchases, people in construction lose jobs — ratifying fears about a weaker job market.
This also has a direct effect on profitability in the corporate sector. The Kalecki Profit Equation is an accounting identity that relates aggregate corporate profits to other macro variables (with simplifications made):
(Business Sector Profits) = (Net Investment) - (Household savings) + (Dividend payments) + (Government Fiscal Deficit) - (Net Imports).
Note that household savings subtracts from profits (and net investment adds). The usual propaganda from the financial sector is that household savings are an unalloyed good, but in the real world, they represent a drain on corporate cash flow. (Wages flow out of the corporate sector as an expense, and if they are not returned as current spending, this represents a loss.) Borrowing to buy a house is a form of negative savings, which thus adds to corporate profits in aggregate. Throttling back on housing hits business profits, which then typically causes firms to retrench (which throttles growth). A certain amount of conventional discussion of this topic refers to households “raising precautionary savings,” which is an extremely poor description of this effect. The “steady state” condition of most households is that they have extremely low current savings rates, and the changes from year-to-year are small. However, house (and car) purchases are chunky transactions that dwarf others — delaying those transactions is what matters for the national accounts.
(As an aside, when I first published my pieces on this topic, I discovered that some internet commentators view the Kalecki Profit Equation as The Kalecki Profit Opinion, and then chimed in with their own opinions on how national accounts and profits work. To repeat, the equation is an accounting identity — it is true by definition. The equation I gave is simplified and missing some smaller terms from the national accounts that would work their way into the identity. The Kalecki Profit Equation is also associated with Jerome Levy, who looked at the detailed national accounts to generate the identity. The Levy Institute has a working paper on this topic.)
Returning from theory to the current situation, I do not see the current rise in mortgage rates as being enough to cause a recession by itself. Right now, the housing market is too slow moving when compared to the ability of the White House to enact stupid policies. The obvious risk is the derailment of supply chains courtesy of global energy markets being blindsided by You Know Who. Mortgage rates rising going into a negative economic shock is just the cherry on top of the sundae.
On a final note, I historically downplayed ignored “AI” since (a) the people who care about AI tend to be loons and (b) the fixed investment was not that large in a global context. However, the second point has not been true for awhile (which I have noted) — the fixed investment is getting to be chunky numbers. That said, I am not panicking about an AI bust, as this is still largely an American phenomenon, and some of the firms involved had piles of cash that were sitting uselessly on their balance sheets anyway.
