Interesting article about the California economy.

http://www.sacbee.com/content/opinion/s ... 6900c.html

Daniel Weintraub: UCLA says economy is rising on a housing bubble
Bee Columnist
Published 2:15 am PDT Tuesday, June 21, 2005
California's economic recovery over the past two years has been driven by an unusually large surge in housing prices that cannot be sustained, says a new economic forecast to be released today from the University of California, Los Angeles. And when that housing boom ends, the effects will ripple through the economy, weakening job growth, incomes and, probably, government tax receipts.
"There is no reason that a house should be worth 40 percent more today than it was two years ago," writes Christopher Thornberg, a senior economist with UCLA's Anderson Forecast project. "This is a bubble. And this housing market is far beyond the point of sustainability."

Housing bubbles don't usually burst overnight, so a catastrophic end isn't necessarily in sight. But even a flattening of the market is likely to have far-ranging effects on the rest of the economy, given how important real estate has been to the recent expansion.

Almost every aspect of the state's economy, from the type of jobs created to the pace of consumer spending, seems to be tied to the housing market. And that is a very thin reed on which to rest the well-being of 36 million people.

Thornberg, for example, looked at California job growth following the last two downturns, at the start of the 1990s and early in this decade. In both cases, the state added about 160,000 jobs in the two years after the economy hit bottom. But the character of those new jobs was quite different.

Compared to the last recovery, this one has been marked by much faster growth in the construction industry, finance and insurance, retail trade and food services. Jobs in the information industry, warehousing and transportation, and administrative support positions within companies have been far less prevalent. And while manufacturing employment declined during both recoveries, the drop this time has been four times as large.

Much of the recent job growth, Thornberg notes, is coming from industries that service the needs of other Californians, not from demand generated outside the state or country. And what is fueling that internal demand? A surge in consumer spending built largely on the growth in home prices.

To illustrate the magnitude of this effect, Thornberg estimated that the total value of residential real estate in California was $1.7 trillion in 1997. It is now well over $4 trillion. In the past two years alone, the average California adult is $40,000 richer thanks to housing appreciation. That's about half what the average person has earned in regular income.

That surge in home equity has fueled consumer spending even more than the 1990s stock market boom because real estate is more evenly distributed than stocks and more likely to be held by individuals. Tax laws make it easier to turn housing equity into cash, and real estate equity is easier to borrow against.

"People feel flush and they are spending accordingly," Thornberg writes. "Unfortunately, that $40,000 check your average Californian has received is mostly illusion, and not real. And the feelings of being flush are also incorrect."

Among the warning signs: Taxable sales are growing much faster than incomes and have done so for 10 quarters now, which is very unusual and a sign of a fundamental imbalance between what people are earning and what they are spending.

The average price of a home in California, meanwhile, is now 12 times greater than per capita income, a ratio that is higher than it has been in at least 30 years. Rents, which should be rising with housing prices, remain relatively low.

The current expansion also looks excessive when compared with the last two run-ups in California's housing market. In the late 1970s, housing prices, adjusted for inflation, climbed 55 percent from the trough to the peak. In the late 1980s, they climbed by 46 percent.

Today, housing prices stand 80 percent higher than they were when the frenzy began, and, Thornberg notes, they "have not even hit a peak yet." But eventually that peak will come, because the housing market is not unlike a pyramid scheme.

People who bought early and rode the escalator up, turning equity in one home into a stake in another, might do all right. But the escalator can keep going up only as long as new buyers are coming in at the bottom, and that can't happen forever.

When the end comes, and no one can predict when that will happen, consumers who have been spending their equity will suddenly feel pinched. And some people who entered the market late, if they are forced to sell, could lose everything.

"All those people who were banking on continued appreciation of their house to finance their children's college education will suddenly find they need to go back to the old-fashioned way of saving for the future - spending less," Thornberg writes.

The big question for California is whether a recent, encouraging uptick in exports can fuel a lasting expansion outside the housing sector and pick up the slack when real estate inevitably cools off. In the best-case scenario, rising exports would provide a relatively soft landing for the rest of the economy. If not, watch out.