America’s history is dominated by its relative isolation from the rest of the world, and perhaps no where is that isolation more keenly felt than here in the industrial Midwest.  Trends seem to arrive here last, if they ever get here at all, and many of us like it that way.  Headlines about new phenomena or contentious issues in places like California or New York are often discounted as having little relevance to the normalcy we see out our windows.

When it comes to the economy, such thinking is foolish or even dangerous.  Markets everywhere are connected, as the farmers and main street merchants who initially scoffed at the Wall Street crash of 1929 later discovered to their chagrin.  The sobering lesson of our economic history is that what traders are doing in markets thousands of miles away can matter a great deal, and we’d be wise to pay attention.

The correction in housing markets, now underway in force in markets like Arizona and southern California, is a case in point.  Indiana’s more sedate real estate markets have endured nothing like the boom many other parts of the country have seen, and for that reason there is little reason to expect the sizable fall in housing prices that some communities are already seeing and others are bracing for.  But there is every reason to be concerned about it nonetheless.

Economists can become annoyingly doctrinaire when asked about speculative bubbles, in housing, stocks, or any other market.  Our beliefs about the efficiencies of markets as processors of information and expectations makes us defensive when others suggest that markets are behaving irrationally, but one fact emerges above the din of these intellectual arguments quite clearly.  That is that all markets, especially housing markets, have occasionally produced large price corrections, and that the impact of those corrections can be quite painful.

And there is no doubt that we are in the midst of such a correction as these words are written.  Existing home sales have fallen nationally for six consecutive months while unsold inventories have ballooned, and the 2.5 percent year over year decline in median prices across the country reported for September is the largest such decline in nearly 40 years.

But those statistics are bland compared to what is occurring in individual markets.  Prices have cratered in large markets like Phoenix, Los Angeles and San Diego.  For some categories of housing at current rates of sales it is now estimated that there is a 3-4 year supply of housing on the market.  Forecasts of 15 or 20 percent declines for next year, particularly for western cities, are beginning to appear. 

The fear is not for homeowners, who can ride out the declines by simply living in their house.  Rather it is the behavior of speculative investors, particularly the newer, amateur investors, that has policymakers worried. Interest rate hikes and housing price declines are a double whammy to those who were unable to resist the lure of quick profits that has given us “Flip this House” television shows and zero money down real estate seminars in the last few years.  Once buttressed by unconventional or downright sloppy lending practices of banks and other lenders, the prospect of these now-overextended investors cutting their losses and dumping their properties on the market is one that unnerves many, as it could turn the price rout into a stampede.

How does that come back to Indiana?  Even in the best case scenario, the tightening of loan standards, not to mention the decline in home equity-financed spending by consumers nationwide, will exert a braking force on the entire economy.  A less benevolent scenario, with foreclosures and individual bank failures, could make those impacts more severe, and even push some liabilities towards taxpayers.

The more these problems are confined to a few individual markets, the better are the chances for avoiding this unhappy outcome.  But the fate of the economic expansion next year may hang in the balance on this question.