In fact, the contraction in spending on housing construction subtracted a full percentage point from U.S. real GDP growth last year, and nearly as much the year before. It seems likely that this sector will be a major drag on the overall economy through the end of this year and into 2009.

Until recently, the deflating housing bubble had not spilled over to the rest of the economy. But now it has. It appears that growth in consumption and business investment spending has slowed markedly after years of robust performance, and, as a result, the economy has all but stalled and could even contract over the first half of the year.

The factors weighing down consumer spending go beyond the effects of the credit crunch and the falling house prices. Consumers also face constraints due to the declines in the stock market, which have diminished their wealth. Furthermore, energy, food, and other commodity prices have risen sharply in recent years, essentially “taxing” their incomes. Finally, and very importantly, labor markets have weakened.

To a great extent, the bubble in housing was a classic case of the bigger-fool theory and efficient-market theory run amok.

     SCHUMER: But don't you feel there is a dichotomy between federal intervention, taxpayer money, to prevent systemic risk -- it's appropriate to do for a large investment bank; isn't it just as appropriate to do it in the housing market? Because that also prevent, as a whole, presents systemic risk issues.

     That's the dichotomy many of us are troubled about. Not saying one is a bailout and one is not a bailout or anything like that.

     BERNANKE: Well, the Federal Reserve was acting in its sphere of influence to address financial issues. As I've said, I think housing is very important and we need to address it. But of course that's the Congress' sphere of influence, not the Fed's.

From the Q&A session

Everyone agrees that it is long-term interest rates and mortgages that ultimately determine the demand for homes and hence the price. What became clear in the early part of this decade is that central banks, not only the Fed, . . . began to lose control over long-term interest rates. That was a major issue in 2004. The Federal Reserve started to raise short-term rates very significantly and found that instead of long-term rates rising with them in unison, it failed . . . I call it the conundrum. What the conundrum was was evidence that long-term interest rates were being dominated by long-term forces.

On the power of the Fed

The linkages are complex, but here is my synopsis of recent market turmoil. Since mid-2006, home price appreciation slowed, and recently prices have fallen in some markets. Earlier in 2007, markets perceived that subprime mortgage credit quality was deteriorating markedly. Delinquencies among subprime borrowers have been rising and are expected to continue to rise as many borrowers have difficulty refinancing. The initial low rates on their adjustable-rate mortgages are resetting to higher rates that imply much higher monthly payments. At the same time, stagnant housing prices have eliminated their option of refinancing at lower rates or selling their house at a profit.

Real gross domestic product has expanded a little more than 2 percent over the past year, compared with an average annual growth rate of 3-3/4 percent over the preceding three years.  The cooling of the housing market is an important source of this slowdown.  Sales of both new and existing homes have dropped sharply from their peak in the summer of 2005, the inventory of unsold homes has risen substantially, and single-family housing starts have fallen by roughly one-third since the beginning of 2006.  Although a leveling-off of sales late last year suggested some stabilization of housing demand, the latest readings indicate a further stepdown in the first quarter.  Sales of new homes moved down to an appreciably lower level in February and March, and sales of existing homes have also come down on net since the beginning of this year.

...given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.  The vast majority of mortgages, including even subprime mortgages, continue to perform well.  Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.

[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well.

More recently, some home builders have reported tentative signs of stabilization in demand, and some data—for example, applications for mortgages and sales of existing homes—are consistent with this assessment. Furthermore, conventional mortgage rates remain low by historical standards, lending support to housing demand. However, other data are weaker, such as the inventory of unsold new homes, which has increased further this year. Unless sales rebound dramatically (and unexpectedly), construction will be depressed for some time in order to reduce inventories to more desirable levels.

...After considering the various developments, including the problems in the subprime mortgage market, I expect that residential construction will stabilize as we move through 2007. However, it could be next year before we see any noticeable increases in home building.

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.

Some observers have called this extraordinary behavior of the housing market in recent years a bubble. I don’t find that term useful or particularly accurate, since the behavior of housing appears to have been based on solid fundamentals. 

First, there were good reasons for the homeownership rate to rise and for homeowners to spend more on housing...People base their investment plans on current and anticipated income growth, and it is not surprising that households would move increasingly from renting to buying their own home.

Second, inflation fell to below 2 percent in the mid-1990s, and over time, financial market participants became more confident that inflation would remain low and stable; that confidence, in turn, led to low mortgage interest rates.

The latest data show that prices of new and existing homes are no longer falling, and inventories of unsold homes have dropped a bit. However, a sharp decline in building permits still suggests that investment in new housing will remain weak at least through the first half of this year, as the adjustment process continues. This current housing slump is temporarily pushing overall economic growth below its longer-term growth path.

While the decline in housing activity has been significant and will probably continue for a while longer, I think the concerns we used to hear about the possibility of a devastating collapse—one that might be big enough to cause a recession in the U.S. economy—have been largely allayed.

A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress... A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed... A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy is that a central bank actually knows the appropriate monetary policy to deflate a bubble Because I doubt that any of the three assumptions needed to justify a special monetary policy focus on asset prices holds up, I am in the camp of those who argue that monetary policy makers should restrict their efforts to achieving their dual mandate of stabilizing inflation and employment and should not alter policy to have preemptive effects on asset prices.

Uncertainty about where we stand in the housing cycle remains considerable. In part, that is because this housing downturn has differed from some of those in the past in important ways. It was not triggered by a restrictive monetary policy and high interest rates; indeed, relatively low intermediate and long-term interest rates are helping to support the stabilization of this sector. But the current contraction in housing did follow an unusually large run-up in sales and construction and, even more so, in prices relative to the returns on other financial and real assets. Our uncertainty about what pushed home prices and sales to those elevated levels raises questions about how the market will adjust now that expectations of the rate of house price appreciation are being trimmed. And changes in the organization of the construction industry, with activity more concentrated in the hands of large, publicly traded corporations, may also affect the dynamics of prices and activity in response to the inventory overhang.