The Wealth Effect of House Price Declines

Dean Baker reckons that wealth effects alone would be sufficient to cause a massive recession, even absent any kind of financial crisis:

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).

Alex Tabarrok agrees, and I have quite a lot of time for this position myself. But it's worth pointing out what Baker doesn't mention here: that his $5 trillion number is speculative, and doesn't come from any official statistics.

Baker explained to me that in order to arrive at $5 trillion, he started with the Fed's valuation of America's housing stock as of end-2006: $21.8 trillion. If US residential houses were worth about $20 trillion a couple of years ago, and if they've fallen by 20% in nominal terms since then, it's not hard to come up with a total loss of $5 trillion in real terms. Baker got the 20% figure from the Case-Shiller house price index.

Note that using Baker's real-money math, if you had a $100 bill in your wallet for the past two years, he'd say that you've lost $7 over that time, thanks to inflation. Does that kind of loss show up in wealth effects? I'm not sure. But even if you ignore the inflation adjustment, 20% of $21.8 trillion is still a loss of $4.4 trillion: more than enough to cause a big drop in consumption.

The problem is that the most recent figures from the Fed peg the value of America's housing stock at... $21.8 trillion, exactly the same as it was two years ago. In order to buy Baker's calculation, you have to believe that the Fed has miscalculated to the tune of more than $4 trillion over the past two years.

Is that possible? Yes. As Baker explained to me:

For [house price] movements the Fed uses the OFHEO index which has shown a much lower rate of decline. The main reason is that OFHEO excludes subprime and jumbo loans. In the bubble markets, the median house price is close to the conformable limit, so the OFHEO index is missing much of the price decline in the bubble markets (it also missed much of the increase).

The Fed does rebase using the Census of Housing, but there is a 2-3 year lag for this.It's certainly possible that the Case-Shiller index overstates the decline somewhat because it overweights the bubble areas, but the Case-Shiller data is likely to be much closer than the OFHEO index, since it doesn't exclude such a large portion of the market with the most movement. The Fed measure also includes new construction and improvements, which would have been around $1 trillion over the last two years.

This is all entirely reasonable, and if you buy Baker's reasoning here then his estimate of housing-related wealth effects could be quite accurate. Indeed, it could be an underestimate: after all, housing wealth is a function not of home values but rather of home equity. And if home values have fallen by 20%, home equity has surely fallen much more than that. If during normal times a marginal drop in home equity has a 5% wealth effect, it's easy to imagine that the wealth effect associated with an outright eradication of home equity could be substantially greater.

Update: Ryan Avent weighs in. "Household consumption was a positive contributor to GDP, right up until the last quarter. Surely that says something about the action of the wealth effect, no?"

Comments

[Smarty_Pants:]

House and stock wealth effects probably pale in comparison to the "I might lose my job" effects.

Just a hunch.

2008 Nov 10 12:45 PM

[jstratt:]

I think you make a good point. I did a little analysis to develop my own opinion on the economy and the forward looking recessionary effects. If you model a impact on what has happened on citizens like an average citizen, a 55 yr old pre retiree, 30-40 yr old younger families etc. the imact is crushing.

Take a composite example a citizen with 200k assets, 100k debt and 100k equity. Assume a 20% drop in asset prices. The equity has dropped from 100k to 60k. That is a 40% drop.

If I look at the mega consumer group, big houses, expensive cars, good jobs and income and huge debt the picture is worse.

My conclusion is for a longer recession.

2008 Nov 10 06:25 PM

[John Preston:]

Jobs will be a problem if the consumer cannot or will not consume...anyone who has berated the consumer-driven economic mindset in the past had better fear the "I-want-to-save" mindset quietly developing in the economy....it sounds like nice rhetoric to say that all American's should should save...the question is are we prepared to downsize the economy rapidly to accomplish this..

If you believe the Shiller Index, homes are down 40%. The stock market is down 40%. Are we prepared to see real income go down by 40%...???

Can Tax revenues, both federal and state, fall 40% and if they do, how will things look.

It wasn't just housing which was getting revalued...all aspects of the economy...ALL....will be affected.....

2008 Nov 11 10:50 AM

[dr.doolittle:]

right on with the commentary here--jobs, jobs, jobs, jobs, jobs. Hoover said it best--"the problem with capitalism are the capitalists--they're all so god-damn greedy." That's why private interest must never trump the public one--basically the capitalists are suicidal and you "rescue them" at your own peril in an environment such as this. You certainly cannot trust their judgement because there exists a purity of private interest (and animus) in their heart and soul. In other words, their only instinct in this environment is to fire everybody and tell them, "kiss the ring, bitch." My personal view is that an Obama administration has an implicit understanding of this reality. Having said that if they try and effect this understanding by "cutting off funding for the war" they will be committing the greatest policy blunder since the Great Depression and indeed may be well on their way to creating a second one, only this time with the added twist of massive social unrest with a very real possibility of what I think can be loosely called a "Hitler moment."

2008 Nov 11 12:35 PM

[Still Renting:]

My wife and I like to say that if everyone suddenly started spending their discretionary income the way we do, this economy would collapse in a week. Well, with frugality being the new chic, we may test that (I think we already are).

I am anticipatorily (is that a word?) watching for the the retail numbers from black Friday.

2008 Nov 11 01:54 PM

[Still Renting:]

I think things would have gone way south had McCain been elected. I think with obama it will cross the equator down to Antarctica.

"Course, I'm one of those that thinks FDR's new deal made things WORSE, not better.

It was the government, not the capitolists that forced banks to loan to lousy credit risks. And how did that work for us?


On Nov 11 12:35 PM dr.doolittle wrote:

> right on with the commentary here--jobs, jobs, jobs, jobs, jobs.
> Hoover said it best--"the problem with capitalism are the capitalists--they're
> all so god-damn greedy." That's why private interest must never trump
> the public one--basically the capitalists are suicidal and you "rescue
> them" at your own peril in an environment such as this. You certainly
> cannot trust their judgement because there exists a purity of private
> interest (and animus) in their heart and soul. In other words, their
> only instinct in this environment is to fire everybody and tell them,
> "kiss the ring, bitch." My personal view is that an Obama administration
> has an implicit understanding of this reality. Having said that if
> they try and effect this understanding by "cutting off funding for
> the war" they will be committing the greatest policy blunder since
> the Great Depression and indeed may be well on their way to creating
> a second one, only this time with the added twist of massive social
> unrest with a very real possibility of what I think can be loosely
> called a "Hitler moment."

2008 Nov 11 01:57 PM

[Still Renting:]

What you have just described is deflation. HUGE deflation. Right now it is better to own dollars rather than stuff. Heck, look at the price of the famous inflation hedge, gold. It is doing what it does during deflation - going down.


On Nov 11 10:50 AM John Preston wrote:

> Jobs will be a problem if the consumer cannot or will not consume...anyone
> who has berated the consumer-driven economic mindset in the past
> had better fear the "I-want-to-save&am... mindset quietly developing
> in the economy....it sounds like nice rhetoric to say that all American's
> should should save...the question is are we prepared to downsize
> the economy rapidly to accomplish this..
>
> If you believe the Shiller Index, homes are down 40%. The stock market
> is down 40%. Are we prepared to see real income go down by 40%...???
>
>
> Can Tax revenues, both federal and state, fall 40% and if they do,
> how will things look.
>
> It wasn't just housing which was getting revalued...all aspects of
> the economy...ALL....will be affected.....

2008 Nov 11 01:59 PM

[User 232593:]

it was phony wealth backed by crooked phony ratings & appraisals.if the sheeples had saved they would not have to eat their granite counters as they lose their jobs & the fleecing continues.the pres. is busy making out his pardon of cronies list.paid my mortgage in 20yrs(30 yr mort.)paid cash fo my 2 cars(one 17 yrs old,the other 10yrs).no heloc as i figure my house is the roof over my head & not an asset but a liability.my credit cards are paid off every month.i am the scammer,scoundrel's nightmare.never bought stock on margin & avoided interest payments whenever & wherever i could.the smaller the print in this country the more careful you have to be before you sign anything.the insiders must be laughing all the way to their swiss bank accts.

2008 Nov 11 03:30 PM

[Mowog:]

Re User 232593,
It's not to Swiss bank accounts any more, because they're being forced open and those in Liechtenstein have been compromised by a former banker who took the account data and sold it to Germany's version of the IRS (and others). I think Austria is the go-to place now.

I've "enjoyed" 15 years of deflation in Japan. My salary's steadily increased (age and experience) but many prices have remained flat until quite recently. That said, demographics here is ugly and the national debt even worse. Yet there is the calm that is born of cultural homogeneity and, in particular, one that fosters respect for hard work and the law. That is, however, decaying.

2008 Nov 11 10:08 PM

[Suziclue:]

Home price being the biggest money pit for most middle class citizen, it's not surprising as the value of homes continue to go down the more citizens are either filing bankruptcy or just getting foreclosed on their property.

Sources: www.homepricetrend.com

2008 Nov 12 02:25 AM

[john1:]

Just more unpatriotic negativity from liberals who hate America, and freedom.

2008 Nov 12 11:42 AM

[Tran Harry:]

The spiraling vortex of falling home prices and the unstable job market are catalyzing the fall of wealth.

Sad thing is as people spend less, companies need to make less, and as companies make less, they need less labor. Resulting in a cycle that ends with job losses. But how can you spend if you don't have a job.

Our country has gone off the scale when it came to the thought that we were immune to economic fluctuations and the way we consume more than we ever produce anymore is idiotic.

2008 Nov 12 12:16 PM

[Tran Harry:]

Sounds like you still got a job. Congrats


On Nov 12 11:42 AM john1 wrote:

> Just more unpatriotic negativity from liberals who hate America,
> and freedom.

2008 Nov 12 12:16 PM

[FP:]

For those who wanted to see housing prices drop now you have it. Patrick & friends enjoy it ! - Missery is waiting for all.

2008 Nov 12 09:00 PM