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House Prices Need To Go Down: Vernon Smith

Calling for home prices to fall further probably won't win Vernon Smith a lot of friends. But that isn't stopping him.

"I am just amazed how consistent housing is at the forefront of recoveries, which is also assisted by durable good expenditures," said Vernon Smith, winner of the 2002 Nobel Memorial Prize in Economic Sciences (with Daniel Kahneman) and professor of economics at Chapman University's Argyros School of Business and Economics and School of Law in Orange, California.

"I consider housing the most durable good of all. Going back to the Great Depression, you can see house expenditures started to go down in 1926 and they were down substantially by the time the stock market crashed in 1929 and I think that tells you why the banks were in trouble.

The banks were in trouble because of a balance sheet problem. Really bad recessions are essentially balance sheet crunches. The value of bank mortgage portfolio assets is all of a sudden down substantially and you not only have households under water but you also have banks under water."

LL: How do you restore demand back into housing?

VS: Prices need to go down. I'd rather see programs that would help people who are underwater in their homes than subsidies for new home buyers because preventing foreclosures would help keep the price of homes up.

The problem is the relative price of homes has to fall. Homes have to be cheaper than the relative price of other goods.

One way to do that is to try and produce some inflation. Well, good luck!

The Federal Reserve has done its best to do that and it hasn't done anything. Our policies of trying to support the demand for housing was part of our problem to begin with. All of these subsidies created artificial support for the demand for housing. So the problem now has become the solution. Larry Summers has referred to it as a paradox.

LL: How much more should real estate prices drop?

VS: Probably another fifteen to twenty percent. The best thing to look at is the relationship between home prices to income. That's the thing that got really inflated because it was driven by credit and it was not sustainable.

Either that or other prices need to rise by that much. If other prices or wages rose by fifteen to twenty percent that would restore the balance. If not, house prices need to continue to fall.

LL: In terms of looking at the banks are you expecting a big wave of bank failures given the state of the economy?

VS: I think the regional banks are going to continue to see losses and that will likely continue into next year because its the regional banks that are into commercial real estate.

These strip malls are in trouble and they were already in trouble because of what was going on in the retail industry. You are seeing a huge decline in rentals and market values of those office and store facilities.

LL: How would you characterize the economy right now?

VS: I think the most hopeful thing to happen is we have a slow recovery and we don't have another big dump downward. Its very hard to call that, but it is still a very large risk.

Housing has done almost nothing to recover. New housing starts are at record lows and you have this huge weight on bank balance sheets which are those troubled assets. The fed did a lot to correct that by buying that one point two or three trillion worth of assets, but my impression is that's why the banks are still cautious. They still have problems.

LL: You mentioned earlier you hope we don't have a double dip. What percentage do you give?

VS: I would still give it a 50/50 chance. I don't understand the stock markets ebullience. Other than the fact there is so much money around and you really can't get anything in the money markets. It's not because of great expectations in the near term future in the stock market.

LL: What is your biggest fear that could derail this recovery?

VS: My worst fear would be that the concerns we have been talking about would be realized and expectations will turn south. That would create a major additional collapse in the stock market as well as housing prices.

LL: In terms of looking at the Obama policies, how would you grade the administration in their efforts to stimulate the economy?

VS: I would not grade him or Bush well at all. On these kinds of things, there is really not much difference between Republicans and Democrats. Its true that Bush's stimulus were much more modest but there wasn't a realization that things were as bad as they turned out to be.

LL: You were one of 300 plus economists that recently signed a letter sent to Congress in support of extending the Bush Tax Cuts. Why do you want to see the Bush Tax Cuts made permanent?

VS: There is all this criticism of dropping the Bush Tax Cuts for the wealthy, but listen — you can't cut income taxes if you aren't cutting them for the wealthy because they are the ones paying the tax.

There are calculations that estimate the upper 50 percent of the income tax bracket pays 97 percent of the taxes. Those in the lower half pay three percent. Well, come on, if you are going to cut taxes its going to be for the people better off.

LL: This this battle over the tax cuts just a way to garner votes in the midterm elections?

VS: Its mostly rhetoric, yes.

LL: What do you think of the U.S. tax system in general?

VS: I would prefer a new tax system and I would do a complete overhaul. I would have no taxes on business.

Everything that goes out of a company turns into a product right? So I would say tax the product when it is sold. Then it becomes income.

I favor a little capital gains tax but what I really prefer is allowing direct investment in savings to be deductible from income and arriving at your income tax. If you do that, you don't have to make the distinction between capital gains or income.

The reason why I like a low capital gains tax is because so much of the income people get from capital gains is plowed back into reinvestment. Its not pulled out and used for consumption. But supposedly you didn't make a distinction between capital gains and ordinary income but allowed everyone to deduct their savings or direct investments.

As long as your income is in the economy working for everyone you don't tax it. Of course right now, people are worried that Americans are saving too much so you change that, by making the interest rate lower rate.

I would also abolish all the poverty programs and welfare programs and make that tax a negative. That means the tax is on consumption. I would make it a negative consumption tax. But I would not agree to that unless all the poverty programs are eliminated.

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A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."

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