GLOBAL financial markets are being buffeted by concerns about the sustainability of economic recovery in the developed economies. Central to these concerns are renewed fear about the US housing market and the possibility of default on government debt in the euro zone, especially in Greece.

The crisis that rocked global financial markets in 2008 had its origins in booming house prices. A chart from The Economist shows that, from 1997 to 2006, house prices soared in most developed economies, except for Japan. They more than doubled in the US, New Zealand, Denmark, Belgium, Sweden, Australia and France. They rose more than two-and-a-half times in Spain, almost trebled in the UK and increased three-and-a-half times in Ireland.

Construction boomed on the back of new housing developments. In Ireland, employment in construction rose 10% a year from 2000 to 2006. In Spain, construction’s share of gross domestic product rose from 7% to 11% between 2000 and 2006.

Rising house prices encouraged households to increase debt to fund higher consumption. In the US, average household debt rose from 80% of after-tax income in the mid1980s to 140% in 2007. Merrill Lynch calculated that half the economic growth in the US in the first six months of 2005 could be attributed to unusually high levels of residential investment and the effect on household wealth of booming house prices. When US house prices fell about 30% in 2007-08, banks’ resultant losses plunged the banking sector into crisis, culminating in the sharpest contraction in global economic activity since the Second World War.

Despite attempts to stimulate economic activity through low interest rates, quantitative monetary easing and large budget deficits, economic recovery in the richest nations remains sluggish because households are trying to reduce their high debt by cutting consumption spending. Housing markets remain under pressure from large quantities of unsold stock and construction remains very weak as a consequence.

In the US, new house prices are still about 20% below their 2007 peak and the number of monthly new homes sold is 25% of previous levels. According to one report, US banks have almost 1-million unsold repossessed houses on their books. House prices in Spain have fallen by 15%, but in the areas dominated by holiday homes, prices have fallen 40%. There are a million homes for sale in Spain, of which 700000 have not been occupied and which could take years to unwind.

In a number of countries (Ireland, Spain, Greece, the UK) the problems of weak domestic consumption now risk being worsened by attempts to reduce high government deficits. This is happening in response to investor unwillingness to fund what are perceived to be unsustainably high levels of government debt. But reducing government spending and raising taxes while consumer spending is weak risks pushing these economies back into recession.

Sound banking practices ensured SA’s banking system was spared any fallout from the global financial crisis. Nonetheless, recovery in local economic activity is also being restrained by a weak housing market and consumer debt reduction.

In The Economist chart, by far the highest increase was in SA, where house prices rose four-and-a-half times.

According to Absa, the price of a middlesized house in SA rose more than five times from December 1995 to December 2008. As in the US, this was accompanied by a sharp increase in household debt.

The fall in house prices in SA after 2008 was quite modest and has now largely been reversed. Adjusted for inflation, house prices are about 10% down from 2007. The effect on construction and volume of house sales has been far greater. The fall in residential construction has been compounded by the end of the pre-World Cup infrastructure boom. The value of buildings completed has fallen more than 40% in real terms since 2008. The pipeline is not being replenished as building plans passed are currently about 45% below their 2007 peaks in real terms.

Household savings have risen modestly. For those in employment, earnings have increased in real terms and retail sales are showing signs of recovery.

Nonetheless, the pace of recovery is sluggish and accordingly the government has delayed plans to reduce the budget deficit. This means that debt and interest thereon will continue to rise for some time. There are also warning signs that inflation is rising.

Correctly timing the reduction in the deficit and raising interest rates without hampering economic recovery will require nimble footwork on the part of the government and the Reserve Bank. Tightening too soon will retard economic recovery still further. But delaying too long will require even tougher remedial action in the future.

nKeeton is with the economics department at Rhodes University.

Source: Business Day