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Wealth Shock
It's surprising how often I agree with Dean Baker. In It's the Housing Bubble, Not the ***** Credit Crunch he writes:
No one will lend me $1 billion, that's how bad the credit crunch has gotten. There are probably reporters at major news outlets who would print that.
...they are still badly misinforming the public, first and foremost by attributing the economic downturn to a credit crunch.
This is truly incredible. Homeowners have lost more than $5 trillion in housing wealth. There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption. This implies that the loss of wealth to date would cause consumption to fall by $250 billion to $300 billion annually (1.7 percent to 2.0 percent of GDP). If you add in the loss of around $6 trillion in stock wealth, with an estimated wealth effect of 3-4 cents on the dollar, then you get an additional decline of $180 billion to $240 billion in annual consumption (1.2 percent to 1.6 percent of GDP).
These are huge falls in consumption that would lead to a very serious recession, like the one we are seeing. This would be predicted even if all our banks were fully solvent and in top flight financial shape. Even the soundest bank does not make loans to borrowers who it does not think can pay the loans back (except during times of irrational exuberance).
Posted by Alex Tabarrok on November 9, 2008 at 07:20 AM in Economics | Permalink
Comments
Isn't the credit crunch a major cause of the stock market wealth loss? Without that people would be wealthier and would thus spend more. Also, the credit crunch and its news cycle made housing demand even worse. While it is not everything, it is also not nothing.
Posted by: liberalarts at Nov 9, 2008 8:19:31 AM
Can we group mortgage loans in with derivatives when talking about Weapons of Mass Destruction. Becuase of government every mortgage comes with an implicit put option. 99% of Americans do not know this. 1% of Americans took advantage of the stupid bankers and played a game of chicken pushing prices as high as they could, while the other 99% were blindly along for the ride. In Cape Coral Florida, once house prices began to fall home equity extraction soared. The criminals borrowed every dollar they could with every intention of walking away from the house if they could not sell it at the peak price.
We should eliminate non-recourse mortgage loans going forward. House prices will fall further than they would otherwise, but they will be at sustainable levels and less prone to the 1% (speculators) causing housing bubbles. Non-recourse mortgage loans only leads to undisciplined homebuyers.
Posted by: Jay at Nov 9, 2008 8:34:44 AM
Is the "well-established wealth effect" a simple correlation of spending and home prices?
Posted by: Andrew at Nov 9, 2008 8:46:06 AM
Dean Baker gets it partly right, but ignores the cause of the downturn for the symptom. The ultimate cause was the Fed's easy monetary policy under Easy Al, an unindicted counterfeiter who remains at large. This is what caused the housing bubble, although it was helped along by government interventions that enabled otherwise unqualified home buyers to obtain mortgages.
Dean Baker also overlooks two other bubbles that contributed to the downturn, namely the commodities (remember oil at $147?)and securities/derivates bubbles.
There has been a decline in consumption thanks partly to the bursting of the housing bubble, but the bursting of the other bubbles together contributed even more to this, as he seems to recognize, at least in the case of the decline in stock wealth.
Economics is a coordination problem, as Gerold P. O'Driscoll Jr. put it in his book on Hayek. Markets for capital, land, labor, and consumers' goods are coordinated by interest rates and profits and losses. When the Fed lowered interest rates in the run up to the alleged Y2K problem, and then again when the tech bubble burst, then after 9/11, and again in 2003 and 2004 (real rates were negative during this last period), this eventually caused more buyers of new homes (as well as home builders, mortgage lenders, and other entrepreneurs in the housing supply chain) to overinvest in housing, which led to a real estate bubble and a real estate structure of production that was too long for the available supply of capital. When real interest rates increased toward their free market level, much of the investment in real estate was revealed to be malinvestment and had to be liquidated or restructured.
This Fed-caused discoordintion of markets also happened in commodities markets, as well as in the stock market (e.g. home building stocks, bank stocks, stocks of commodities producers). The structures of production in these markets were too long for the available pool of savings called forth by real interest rates, and the malinvestments that went into them had to be liquidated, with asset and stock prices being marked down to reflect the market values of the underlying cash flows that supported them.
Neither monetarists, who view the world through the prism of economic aggregates, such as the supply of money, the velocity of money, or the price level, nor Keynesians (e.g. Dean Baker?), who look at changes in consumption, are in a position to understand the microeconomics of the business cycle, and the crucial role of interest rates in coordinating the structure of production.
Posted by: Bill Stepp at Nov 9, 2008 9:33:17 AM
The government can't fix deflated property values unless they start buying up everybody's homes, or send in units of the military to tear down the excess homes that have been overbuilt. But the Feds can fix a "credit crunch" by printing money. Perhaps then the media is a puppet of the government, who is trying to monetize the debt?
Posted by: Jeff C at Nov 9, 2008 9:41:05 AM
The credit crunch is an agreement between me and the banks that I cannot keep my consumption streams and continue to be globally competitive.
No one committed fraud of a great extent. I was warned for many years, and I planned to heed the warnings at the proper time. I did heed the warnings, we have a major drop in consumption streams, and everything worked out on queue, just like me and the other 100 million consumers agreed.
The only surprise was the preparation we made using derivatives, a preparation which isolated the turning point with such great accuracy, and for that I am grateful. Because of the use of derivatives, we were able to turn this around on a dime yielding great efficiency.
Posted by: M at Nov 9, 2008 9:41:59 AM
"Is the "well-established wealth effect" a simple correlation of spending and home prices?"
Surely you are aware that one of the central tenants of the religious left is that correlation proves causation.
Posted by: Jay at Nov 9, 2008 9:42:36 AM
" There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption'
I asked him on his blog as well, but can you tell where to find this analysis? I also asked him on an earlier post to explain to me the WSJ story showing how many people didn't believe that their houses were really that much less. In other words, they discounted the values put on their houses. I asked him how this might figure in, but he didn't answer.
Posted by: Don the libertarian Democrat at Nov 9, 2008 12:01:59 PM
Now that households want to save more, we need to make sure those savings are traslated into investment. Infrasturcture is a prime need: roads, bridges, airports. This will require ways to channel federal (borrowed) dollars to states and cities. A lower dollar will evenutally encourage investment in capacity for exporting.
Posted by: Thomas at Nov 9, 2008 12:37:25 PM
To J and Don, just google "wealth effects of housing" and you get a lot of academic literature, including http://www.frbsf.org/publications/economics/letter/2007/el2007-02.html
and you can evaluate the studies yourselves.
Posted by: peterw at Nov 9, 2008 2:39:57 PM
Peter, Thanks. I'm going to analyze the S.F. Fed paper on my own blog for my own benefit. The problem is that when authors make claims based on studies, I like to see the actual study that they're using myself. This was very useful recently when I analyzed a post on Reason by S. Chapman about wages. I managed to find the paper he quoted on my own, but it would have been easier if he had linked to it on his post. I did read the paper a bit differently than he did, so it turned out to be very useful. I've also seen statistics on borrowing against our houses over the last few years which, on first look, bothered me. But I'm still puzzled by the worth, if there is any, to these surveys comparing housing prices in an area and what homeowners believe their houses are worth. They remind a bit of studies done of people who eat out a lot, and are asked for the calorie count of their meals, and are surprised to learn that the two differ quite a bit. The question then becomes, when they are so informed, do they change their eating habits?
Posted by: Don the libertarian Democrat at Nov 9, 2008 3:25:08 PM
The gov't would be far better off buying houses for half of the last mortgage, if no better low-ball formula can be found, than investing in financial paper. Especially not of banks.
If $5 tr has disappeared in housing wealth, which was leveraged up to $50 tr in derivative wealth, then how much financial wealth is now in the financial markets? If it was $60 tr, but now $55 tr is lost, over 90% of financial, or 'fictitious wealth' is gone.
How many bankers were getting paid to distribute that paper wealth?m How many are needed now?
We have some 4 mil. unsold houses (at prior expected prices). We have far, far, too many bankers. Collecting far too much cash in salaries and especially bonuses.
All Big Banks dealing in CDSs should die.
Probably too many economists, too.
I'm reminded of a VERY old SNL skit about Reagan: "time to put them all on welfare..."
Posted by: Tom Grey at Nov 9, 2008 6:41:32 PM
The recent drop in gas prices is probably comparable in value to the loss in wealth. Net we are in the same place.
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