What Happens if it Pops?

The San Francisco Chronicle has been running some impressive housing stories lately. Though they haven't gone into minute detail, they have served as a good bubble primer for the average newspaper reader. This latest installment by Tom Abate, Chronicle Staff Writer, offers a balanced looked at the potential result of a bubble pop, including how it could harm the overall economy:

Dean Baker, a longtime housing bear with the Center for Economic and Policy Research in Washington, foresees a steeper, sharper, more catastrophic correction along the lines of the economic crash that hit Japan about a decade ago when its stock and housing markets crashed more or less together.

"I think housing prices on the average nationwide will fall 25 percent, and in some of the bubble markets, they could fall 30, 35, 40 percent," he said.

Berson, the Fannie Mae economist, echoed the concerns of those who feel that home prices have outstripped income growth to a worrisome degree. But the pattern is erratic. Some states in the middle of the country have seen little or no frothiness, while prices in the coastal markets have soared.

Two other factors worry Berson -- although he is hard-pressed to say how they will affect the macroeconomy.

The first is a rough doubling in the percentage of home and condominium purchases by investors as opposed to owner-occupants. The second is the growing percentage of loans taken out with variable rates and low or no down payments.

"What I can say is that trends that are unsustainable eventually stop,'' he said.

Of particular interest to me is this increased discussion of a "wealth effect." It's discussed briefly in this exceprt from the San Francisco Chronicle story:

Many economists also say that rising home prices create a wealth effect that encourages spending among homeowners, but the phenomenon is difficult to quantify.

Now, as interest rates start creeping up and clouds hover over home prices, there are questions whether these sources of economic stimulation will turn in the opposite direction. To a large extent, such questions hinge on where home prices are headed.