Charles Wheelan, Ph.D. The Naked Economist

Housing prices dropped by over 11 percent at the beginning of this year, the largest drop in the 20 years that such data have been collected. Thank goodness.

Restoring Financial Sanity

Why are plummeting real estate prices good news? Because it's the first sign that sanity is returning to the market. And a sane real estate market -- one in which sellers recognize that they won't get as much for their house as Al down the street got two years ago -- is a precondition for a broader economic recovery.

Recessions, or any economic downturn, are always caused by the same thing: Something goes wrong. That may sound overly vague, but it's rarely the same thing that causes a shock to the system. In an agrarian society, it might be a bad harvest or a failed monsoon season. In a developing country, it might be a slump in the global price of a major export, such as coffee or copper.

In the United States in 1929, it was the stock market collapse. In the early '80s, it was the recession deliberately engineered by Fed Chairman Paul Volcker to break the back of inflation. (The Fed held interest rates high enough for long enough that the economic pain persuaded workers to stop asking for higher wages, and firms to stop raising their prices.)

Bad to Be Good

In all these cases, the recovery begins when either: 1) Conditions get better -- the rains come, the price of coffee rebounds, or consumers stop worrying about another terrorist attack. Or, 2) Things don't get better, but we adapt to the new reality. Coffee prices don't rebound, so farmers start growing something else.

The only route out of our current real-estate-bubble-inspired economic malaise is the latter -- a new real estate reality. Property owners must recognize that some of the prices we saw over the past couple of years were an anomaly, just like Internet stocks in the '90s.

The problem with the housing bubble wasn't just that prices got out of whack for a while. The bigger problem was that those crazy prices sent erroneous signals to the rest of the economy. Artificially high housing prices caused developers to build things that shouldn't have been built; consumers to spend money that they didn't really have; banks to loan money to those developers and consumers; and Wall Street to bundle those shoddy loans into products that most of us still don't understand.

Feeling the Heat

Normally, the beauty of a market economy is that prices convey important information. When starting salaries for engineers go up, more college students major in engineering. When the price of gas gets to $4 a gallon, people drive less (or buy fuel-efficient cars).

But the housing bubble sent bad signals all over the economy. It's as if we had a broken thermometer telling us it was 30 degrees, and now we're all standing outside in 90-degree weather wearing sweaters and ski parkas. The important thing is what we do next: We can either stand there hoping the weather gets much colder, or we can recognize that it's 90 degrees and start taking off the layers.

Falling real estate prices tell me that sellers are finally starting to do the latter. I recognize the pain. A lot of people are going to lose a lot of money; some will lose their homes. But realistically that's already happened. If buyers are only willing to pay you $300,000 for a house you bought for $400,000 two years ago, the $100,000 difference is already gone.

For What It's Worth

Listing the house for $400,000 and leaving it on the market unsold isn't going to get the money back, either. That's essentially just living in the house and hoping it'll appreciate in the future. The "For Sale" sign out front is decoration, something to keep the mailbox company.

Look, I bought 50 shares of Bear Stearns stock at $90 a share. There's nothing stopping me from putting a sell order in with my broker at $90. I can keep that sell order open as long as I want, just like the permanent "For Sale" sign.

But the market reality is that JP Morgan Chase has an offer on the table for $10 a share. If I really want to sell my shares, it'll have to be at a price someone is willing to pay -- which, sadly, has nothing to do with the $90 I paid in the first place.

True Value

If this were just about the price of real estate, I wouldn't care at what price people tried to sell their homes, or how long those properties stayed on the market. But it's bigger than that. Falling prices will help put the "market" back in the real estate market; it'll get us back to a point where sellers are asking prices that buyers are willing to pay.

We'll know the real value of real estate in different markets around the country. That'll give banks a sense of what their loans are worth. It'll also be a signal to buyers that they don't have to wait any longer for the deals that they know are coming.

Both will help stabilize the credit markets so that they can get back to the business of making sane loans based on realistic property valuations. And healthier credit markets will allow Wall Street to price the mortgage-backed securities that will remain illiquid as long as we have no idea which mortgages are likely to go into default and which mortgages aren't.

The Bottom Is Near

What good news am I looking for in the future? Another significant drop in housing prices, albeit smaller, say 4 or 5 percent. That would signal to buyers, sellers, banks, and Wall Street that the bottom is near.

Things have to get worse before they can get better. We're making progress.