By Martin Feldstein

The risk of a downward spiral of house prices is the primary danger facing the American economy. Because of the structure of securitised mortgage finance, this risk has the potential to cause a global financial crisis. Both of these problems will remain until a new policy brings stability to house prices.

The current decline of house prices is the natural result of the bubble that by 2006 had raised house prices to 60 per cent above their long-term trend. The sharp decline since then means that today’s prices are about 15 per cent above the trend level. But while a further 15 per cent decline may be inevitable, there is nothing to stop prices declining even further.

House prices that could overshoot by 60 per cent on the way up could also overshoot substantially on the way down. During the past 12 months, house prices across the nation fell by an average of 16 per cent. The large overhang of unsold homes continues to create pressure for further price declines. The record level of defaults and foreclosures continues to add to the stock of unsold homes. Potential house buyers who foresee continued foreclosures are reluctant to buy now because they anticipate future price declines.

A policy is needed that will permit the appropriate 15 per cent additional decline in house prices but end the risk of a further downward spiral. No such policy is now in place or on the legislative drawing board. The fear of continued mortgage defaults and house price declines is depressing the prices of mortgage-backed securities and of the derivative products based on them. This fall, in turn, is causing large losses at commercial banks and other financial institutions.

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August 27, 2008 2:22pm in Credit squeeze | Comment