What happens when the home equity is tapped out?

Right wingers love to blast Paul Krugman as a kind of Cassandra doomsayer, but he has an interesting column today on the housing bubble that no one wants to admit exists:

In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. "There is room," he wrote, "for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing."

As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst.

Now the question is what can replace the housing bubble.

Nobody thought the economy could rely forever on home buying and refinancing. But the hope was that by the time the housing boom petered out, it would no longer be needed.

But although the housing boom has lasted longer than anyone could have imagined, the economy would still be in big trouble if it came to an end. That is, if the hectic pace of home construction were to cool, and consumers were to stop borrowing against their houses, the economy would slow down sharply. If housing prices actually started falling, we'd be looking at a very nasty scene, in which both construction and consumer spending would plunge, pushing the economy right back into recession.

That's why it's so ominous to see signs that America's housing market, like the stock market at the end of the last decade, is approaching the final, feverish stages of a speculative bubble.

Some analysts still insist that housing prices aren't out of line. But someone will always come up with reasons why seemingly absurd asset prices make sense. Remember "Dow 36,000"? Robert Shiller, who argued against such rationalizations and correctly called the stock bubble in his book "Irrational Exuberance," has added an ominous analysis of the housing market to the new edition, and says the housing bubble "may be the biggest bubble in U.S. history"

With wages down, health care costs up, and the new jobs being created not paying what the old jobs did, it would be easy to wonder where all the consumer spending is coming from if we didn't know that Americans are swimming in debt. Some of it is just plain old consumer debt fueled by 0% introductory credit card rates, but much of it is from Americans who have benefitted from the preposterous increases in home prices tapping into their home equity to finance an ever-more-lavish lifestyle...and it's all tax-deductible, too.

Here in the Brilliant household, we give lenders fits. Not a day goes by that we're not bombarded with credit card solicitations and home equity loan solicitations and postcards from realtors wanting to sell our house. In our neighborhood of 1950's Cape Cod and ranch houses, it seems every other house is in the midst of construction. Sometimes it's an add-a-level, sometimes it's a spanking new (and usually hideous) McMansion rising from the rubble of a demolished smaller house. Trying to get a contractor these days is like getting a table at the latest hot restaurant -- it's next to impossible. Presumably much of this building boom is being paid for with home equity, because home prices in my neighborhood have more than doubled in the nine years we've lived here, despite near-10% increases in property taxes every year.

But unlike most Americans, we waited to have work done on the house late last year (siding, windows, roof) until we'd saved the CASH. So if the housing bubble bursts, we'll still be sitting pretty, unlike those tapped up to their 2005 limit, who not only will have a house that's fallen in value despite the improvements, but is now worth less than they owe.

I'm all for making homeownership more feasible for more people. We were able to buy because PMI made a 20% down payment no longer necessary so we were able to buy with 10% down. But now it's getting ridiculous. 3% down mortgages, ARMs that adjust every six months, interest-only mortgages that never build any equity at all for many years -- all are designed to leave homeowners holding the bag when the bubble bursts.

I don't know what's going to happen with housing, but if income keeps falling, this can't go on forever. And that's probably a good thing, because to have to pay over $400,000 for a house like mine is just insane. I wouldn't do it.