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Wednesday, Sep 19, 2007 3:40 PM UTC

Rate cut delirium battles housing starts unhappiness

As Wall Street parties on, the author of "Irrational Exuberance" invokes the memory of the Great Depression while testifying at a Senate Committee hearing.

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Topics: U.S. Economy, Globalization, How the World Works,

On Tuesday, we learned that home builders are in their worst mood since 1991. On Wednesday, the Commerce Department released numbers that explained why. Housing starts dropped again in August, down to their lowest annualized rate since 1995, and applications for building permits also fell sharply.

The new numbers provided a nice backdrop for economist Robert Shiller’s glum testimony at a Senate committee hearing Wednesday morning.

According to the Financial Times, Shiller said “the collapse of home prices might turn out to be the most severe since the Great Depression.”

Shiller is the co-creator of the Case-Shiller index, considered the most accurate gauge of home prices. He has a pretty good track record of calling bubbles as he sees them.

So how much could home prices decline? In today’s New York Times, columnist David Leonhardt suggests that home prices may be overvalued by around 20 percent. A 15 percent decline in home prices across the board would represent a $3 trillion decline in U.S. household wealth, the Senate was told Wednesday.

That kind of decline would make what has happened so far in the subprime meltdown seem like a minor speed bump.

But what about the rate cut? What about the deliriously happy stock markets all over the world? In New York, even as Shiller was testifying, the Dow Jones industrial average was climbing back toward 14000, seemingly shrugging off all the worries of the long subprime summer.

Ah, but as Dean Baker warned this morning, the last time the Fed abruptly cut rates, in 2001, the markets were similarly delighted. But the Fed’s action did not end up preventing the recession that ensued.

The lesson from the 2001 experience is that cutting interest rates is not necessarily a very effective tool in counteracting the impact of a collapsing asset bubble. My guess is that rate cuts will provide even less effective stimulus now than they did in 2001, primarily because they will not reverse the decline in house prices and the wave of defaults and foreclosures that will follow.

Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21. More Andrew Leonard.

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