"Having dismally failed in their jobs to inform the public, reporters are still relying almost exclusively on sources that completely missed the housing bubble. As a result, 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).
Obviously the problems of the banking system make the situation worse, but the real cause of the downturn is the collapse of the housing bubble, and the reporters who talk about the economy should know this. (Of course, they should have seen the housing bubble too.)"
So, I asked a simple question, but he didn't reply:
"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."Can you tell me where I can find this analyzed?
"Wealth Shock
It's surprising how often I agree with Dean Baker. In It's the Housing Bubble, Not the ***** Credit Crunch he writes:"
Here, Alex Tabarrok quotes the post I mention, and so agrees.
I ask my question again:
" 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
I got this response from another reader:"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"
Here's my response to him:
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
Then Felix Salmon talks about the Baker post. Read the whole post:"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."
I guess I have to address this issue, because it's all over my favorite blogs. I was hoping to defer it, but here goes. Here's a paper from the SF Fed called "Disentangling The Wealth Effect: Some International Evidence".
"Over the past several years, movements in asset prices have substantially raised household wealth. For the U.S. and many other industrialized countries, the most recent boost has come more from the appreciation of house prices than financial assets. In the U.S. housing wealth has moved back above financial wealth in terms of the share of assets. In a number of other industrialized countries, including three examined in this Economic Letter, housing wealth makes up an even larger share of individuals' portfolios than is the case for the U.S. (see Figure 1). "
Okay. The housing boom caused the price of houses to go up faster than other assets, so the percentage of personal wealth in one's house went up as did the homeowner's personal wealth.
"the so-called wealth effect channel—the extent to which consumer spending responds to changes in wealth (asset values). With the recent cooling in the U.S. single family housing sector and potential "correction" in other countries, analysis of the possible wealth effects from housing have moved front and center. "
Okay. The homeowner should have felt wealthier when his house was going up in value, and spent more, poorer when his house is going down in value, and spend less. Just to say, this should presumably apply to all personal assets, but right now we're focusing on houses.
"First, we investigate whether consumption responds differently to changes in housing and financial wealth. Second, we investigate whether there are differences in consumption responses to changes in wealth across different age groups."
So:
1) Is there a wealth effect in housing appreciation and decline?
2) Does it vary with age?
"The response is also larger if households think the asset value is easier to measure, if they perceive the asset to be more appropriate for financing current consumption, and if they view the shock to be more permanent. "
But what if the asset, read house, is:
1) Harder to measure it price
2) Less appropriate for borrowing against for buying things now to live ( I would distinguish investment, which would have to be compared to the interest rate of the loan )
3) Decline will last a while, but not forever
4) not easy to sell ( Liquidity, mentioned earlier )
"We use data available through the Luxembourg Wealth Study (LWS), a project under development within the larger Luxembourg Income Study (LIS), which makes cross-country analysis with more comparable data possible. Based on the availability of expenditure data, our analysis focuses on a sample of homeowners in three countries, Canada (1999), Finland (1998), and Italy (2002). "
Here's where they obtained their data.
"As a first pass, we allow age and the other demographic and socioeconomic variables to affect only the average level of consumption. Our estimates show that, for all three countries, the housing wealth effect is substantially larger than the financial wealth effect. The estimated effects are the percent change in consumption caused by a 1% change in wealth. As shown in Figure 2, our estimate with respect to financial wealth is negligible in Canada, about 2% in Finland, and 4% in Italy. The housing wealth effect is much stronger. A 1% increase in households' housing wealth raises households' expenditure by about 12% in Canada, 10% in Finland, and 13% in Italy. "
I have to say that I find this hard to believe. The difference in housing and financial wealth is huge, and the change in consumption based on the housing wealth effect seems huge."We caution, however, that our estimates must be considered tentative as the analysis is based on the beta version of a developing data source and as the existing econometric evidence does not completely agree on this subject. Our finding that the housing wealth effect is consistently stronger for older households in the three countries we examine also lends some support to the life cycle theory and bolsters the results of other studies."
Caution accepted.
"These results suggest that it is important for policymakers to keep an eye on housing market developments separately from financial markets. If it is true that the housing wealth effect dominates the financial wealth effect, at least in some countries, then the effects of a softening in the housing market in a number of industrialized countries could have a more dramatic impact than the historically large stock market declines that began in 2000. Additionally, if the wealth effect is stronger for older households, the demographic changes around the world could make housing wealth effects even more important in the future."
Is there a difference in wealth effect between going up and going down? Also, does the perception of the general economy make a big difference in the movement of the wealth effect? How about the unemployment rate? In other words, comparing the difference in wealth effect between the end of the tech bubble and a wealth effect on declining stocks, against the current situation in which both are declining and the general economy seems far worse doesn't seem that easy to separate out.
Now check this out, from the WSJ:
"Almost half of U.S. homeowners think their homes are insulated from the broader national decline in prices, according to a survey by real-estate Web site Zillow.com.
Despite a financial crisis, market volatility and continued indications of declining home prices, 17% of homeowners told Zillow they think their own home’s value stayed the same over the past year, while 32% said their home has appreciated in value. Zillow estimates that nearly three-quarters of homes have lost value in the past 12 months.
However, the numbers in the third-quarter indicate that more homeowners are seeing the effects the bursting of the housing bubble has on them. In Zillow’s second-quarter survey, 62% of respondents thought that their home value had increased or stayed the same over the past year."
Okay, so it's going down, but not completely.
"The survey was conducted Oct. 7-9, while stock markets tumbled in one of the worst selloffs in history, making the results all the more surprising.“The human irrationality in terms of pricing and valuing what is ours has always been a barrier to good decision making, and the housing market is no different,” Duke University Professor of Behavioral Economics Dan Ariely said is response to the survey results. Worries persist that unrealistic expectations by sellers can prolong the housing downturn, as prices take longer to find a bottom.
Most homeowners see stability on the horizon. Some 40% believe their home’s value will stay the same over the next six months, while 21% think their home will appreciate. But that stability ends at their door, as 57% said home values in their local market will decrease over the next six months.
“We’re seeing a fascinating distinction in consumer psychology — on the one hand, homeowners appear to understand the reality of today’s economy and are curbing their household spending, but on the other handsaid Stan Humphries, Zillow vice president of data and analytics. “There’s clearly still some denial.”
Someone has got to explain to me how this wealth effect actually works on individual humans. It looks to me that people are responding more to the general economy than the decline in the value of their houses, which they seriously misjudge.Addendum: Matt Yglesias:
"I don’t think I would agree with all the conclusions he draws from this, but Dean Baker makes the excellent point that there’s a lot more than a “credit crunch” going on to explain the onset of recession — the simple effect of asset prices tumbling is to make people reduce their spending and therefore the economy contracts:"
Here are my comments:
Posts
November 10th, 2008 at 12:55 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.”
“But because of what was happening in the stock market it was an inopportune time to be selling shares so I sold fewer than I’d planned and bought cheaper furniture, figuring I might just buy nicer stuff later on if at some future point the animal spirits of the market drove my net worth up. Thus someone missed the chance to sell me a coffee table (pictured above) that I liked very much but that cost a lot of money. Their loss was Ikea’s gain, but that kind of decision drives GDP down.”
You sold a financial asset. I think that you prove my point, not Baker’s, that it’s the general economy that is causing this slowdown, more than the decline of buying due to the wealth effect of housing assets declining.
November 10th, 2008 at 12:58 am
Sorry. I hit the button before I was done. Your decision was based on the decline and market condition of your financial assets, not housing assets.