Economic behavior is based upon expectations. Among other things, there are three major sets of expectations that stand out to us as having influenced behavior over the last twenty years. First, that except for unusual regional shocks home prices only rises. Second, credit is readily available and increasingly available to lesser credit quality households and certainly for housing finance. Finally, recessions, while they will always occur, will be mercifully brief and shallow. All three of these expectations have been shattered by the experience of the last two years.
Over the past few years we have developed a number of models that have quantified the economic behavior of employment and the general economy.1 In this note we use one of our regional models to graphically illustrate the challenges posed by recent experiences to the conventional wisdom of expectations.
Our regional index model combines the influences of several economic factors to illustrate the character of metropolitan economic growth in many U.S. cities. As illustrated in the maps on the following pages, there has been a transparent unfolding of structural change in all three assumptions. In our first graph, Figure 1, we notice that the declines in metro economies had begun by the third quarter of 2007, long before talk of recession and the credit crunch began to intensify. Weakness was noticeable in local regions such as Detroit, the central valley of California and southwest Florida.
Employment peaked in December 2007 and since then the National Bureau of Economic Research (NBER) has deemed that the U.S. economy had peaked and begun to contract, meaning a recession was under way. The next map, Figure 2, illustrates the state of local economies two quarters into the recession, second quarter of 2008, before the massive financial shocks of Lehman Brothers and AIG. What is interesting here is that the weakness in metro areas had spread markedly before the financial shocks appeared. This is particularly true for the “bubble” markets of Florida, Nevada and California, where many of the metro areas had already ranked among the absolute worst in the nation.
In our final map for the fourth quarter of 2008, the most recent period for which data are available, we can see the impact of the combined adjustment to deteriorating economic fundamentals as well as the first round of impacts from the massive financial shocks of September and October 2008 (Figure 3). The number of cities with an index score below negative 40 reached 73 or almost twenty percent of all areas in the fourth quarter of 2008.2 For comparison in our first map, representing Q3-2007 just two metro areas, both in Florida, Punta Gorda and Naples had crossed this threshold. In fact at that point, 81 cities still had positive index values, today it is just two.
For economic agents, such massive declines have led to significant changes in our three assumptions. First, metro weakness has prompted declines in home prices across the nation. Second, credit is not widely available to lesser credits and unlikely to be available again on the same easy terms as in the recent past. Finally, the current recession has already reached the length of the longest recessions in the post-War period at 16 months and will likely be deeper in terms of housing and employment than any of the recessions over the same period.
