"Everyone is facing a deterioration in wealth – home and equity owners alike – and this time around, consumption is bound to decline…further."

I liked Rebecca Wilder's summation of the numbers that came out from the Fed this week on News N Economics:

"Households debt falls for the first time...ever (at least since 1952)!

The Federal Reserve released its third quarter flow of funds account. I have never been so anxious to get a release as I was today for the flow of funds account. Third quarter highlights GO something like this:

• Household net worth declined 4.7%
• Household debt decreased an annualized 0.8% - a sign of real delevering, given that the 0.8% contraction is in nominal terms and prices rose 1.6% over the same quarter.
• Total business debt decelerated to a 2.94% pace (down from 5.6%).
• Federal debt grew an annualized 39% in the third quarter, which is 33.5% above the average 5.5% quarterly debt growth from q2 2007 to q2 2008. This is the biggest surge since 1952.

But there is also a very troubling effect that may emerge, and that is the wealth effect.

The chart illustrates the ratio of household net worth to disposable personal income spanning 1952:Q1 to 2008:Q3. In the third quarter, the share of net worth fell to 5.3% times current disposable income, driven by falling equity and home values. Consumer wealth is falling, and unless housing and equity markets stabilize and grow SOON, wealth will likely fall for two more quarters…at least.

The continuous decline in net worth is likely to hammer consumption, and with that, GDP. It seems like the wealth effect – which is previously questionable as an empirical determinant of consumption – is now quite strong.

Households are watching their stock of housing wealth fall when they return home from work, when they turn on the TV, and when they sit down for dinner. Everyone is facing a deterioration in wealth – home and equity owners alike – and this time around, consumption is bound to decline…further.

There is some serious slack building in this economy. Go Policymakers~!"

I've questioned the Wealth Effect in the following way:

I believe that there is one, but it's based on perception by individuals. I don't see it correlating exactly with any set of numbers. However, Rebecca makes a good point, that this graph does suggest a general correlation that is much closer than I'd assumed. This goes back to my talking about people's perception of the value of their homes being higher than the market warranted. I'd like to know more about those perceptions before I accept a graphic way to determine the Wealth Effect.

The falling household debt does suggest a general aversion and fear of risk and flight to safety, which will have to be addressed at the level of households.

"If ‘quantitative easing’ is never reversed, in present value terms, and never expected to be reversed, liquidity trap equilibria cannot occur "

Let's see how far I get with this:

“Let us suppose now that one day a helicopter flies over this community and
drops an additional $1000 in bills from the sky, …. Let us suppose further that
everyone is convinced that this is a unique event which will never be repeated,”
(Friedman (1969, pp 4-5)."

So far, so good.

"The aim of this paper is to provide a rigorous analysis of Milton Friedman’s famous
parable of the ‘helicopter’ drop of money."

Rigorous = A lot of math

"This is achieved through a reformulation of the real balance effect - the wealth effect of a change in the stock of government-issued fiat money."

Now from Amos Web:

"Before examining the details of the real-balanced effect, consider the specifics of what it does. A typical aggregate demand curve is presented in the exhibit to the right. The negative slope of the aggregate demand curve captures the inverse relation between the price level and aggregate expenditures on real production.

When the price level changes, the real-balanced effect is activated, which is what then results in a change in aggregate expenditures and the movement long the aggregate demand curve. To illustrate this process, click the [Change Price Level] button.

Along the Curve

The real-balanced effect is based on the realistic presumption that the supply of money in circulation is constant at any given time. Money is what the four basic macroeconomic sectors use to purchase production. How much production they are able to purchase (that is, aggregate expenditures) depends on the amount of money in circulation relative to the prices of the goods and services produced (that is, the price level). When the price level changes, the purchasing power of the available money supply also changes and so too do aggregate expenditures. A higher price level means money can buy less production. A lower price level means money can buy more production."

If the amount of money stays the same, the rise in prices will mean less money can be used to increase production.

"Suppose, for example, that Duncan Thurly's share of the nation's money supply is $10. At a price of $2 each, he can afford to purchase five Wacky Willy Stuffed Amigos (those cute and cuddly armadillos and scorpions). However, if the price level rises, and with it the price of Stuffed Amigos, then he can no longer afford to purchase five of these cuddly creatures. At $2.50 each, he can now afford to buy only four Stuffed Amigos. His share of aggregate expenditures on REAL production declines from five Stuffed Amigos to four. The purchasing power of his $10 of money has fallen and with it his aggregate expenditures on real production. He has succumbed to the real-balance effect."

"Succumbed" is an odd choice.

"How in the world did economists come up with the phrase "real-balance" to indicate this effect? The "real" part refers to the "real" purchasing power of money. That is, how much real production can be purchased with the money. The "balance" part is included because money is often referred to as money "balances." This effect could be called the real-money effect just as easily."

So Buiter's going to use this Real-Balance to help explain the "Helicopter Drop".

"A related objective is to show that even when the economy is in a liquidity trap, that
is, when all current and future short nominal interests rates are at their lower bounds, a
helicopter drop of money will stimulate demand, but a helicopter drop of government bonds
will not."

Here's the main point for today's crisis that I want to point out. If the Fed goes down all the way to zero interest, and it does not increase demand, stimulate the economy, cause an upturn, then putting money into the economy will help do these things, but selling bonds will not. Printing money to fund a stimulus, versus government selling bonds to fund a stimulus.

"The government’s decision rules are exogenously given. Like the household sector, it
is subject to a solvency constraint. The government solvency constraint is the requirement
that the present discounted value of its non-monetary debt (bonds) must be non-positive in
the limit as the time horizon goes to infinity. Unlike bonds, government fiat money, by
assumption, does not have to be redeemed ever by the government. This means that, while
money is in a formal, legal sense a liability of the government, it does not represent an
effective liability of the government: there is no obligation for the issuer ever to redeem it or
convert it into anything else."

Okay. If you print the money, in other words, just dump a freshly minted bundle of cash into the economy, it's like the helicopter drop, in that you can simply leave it there ( Caution: A bunch of things could change this, but, in principle, it could stay there ). However, if you issue bonds, and fund the stimulus that way, you will have to pay the money back, as well as interest. So, all things being equal, you can't simply leave it there. The bonds needing to be redeemed is a contract that will possibly effect the amount of money you can leave in the economy from the bond sale going forward. God I hope that's it.

"Definition 1. Monetary policy is said to have a pure wealth effect on household consumption
demand if changes in the sequence of current and future nominal money stocks can change
consumption demand, holding constant the initial financial asset stocks, the sequences of
current and future values of nominal and real interest rates, the initial price level, real
government spending on goods and services, and before-tax endowments."

So, holding all these factors at bay, the amount of money in the economy can effect demand, i.e., actual buying and selling.

"Proposition 1.
A liquidity trap equilibrium does not exist, even asymptotically, in the flexible
price model if the growth rate of the stock of nominal base money is equal to
or greater than the nominal interest rate on base money, that is, if ν $ i¯M."

Got that. If the amount of money thrown into the economy is equal to or greater than the interest rate, demand will go up in the real economy, causing an end to the liquidity trap, by effecting demand upwards.

"Proof: Assume a liquidity trap equilibrium exists, beginning in period t1 $ 1. By definition,
in a liquidity trap the opportunity cost of holding money is zero ( ) and gMt
' 0, t $ t1
therefore the nominal interest rate is constant ( it )."

In a liquidity trap, by definition, the interest rate is constant at zero.

"From (15) and (16), when
' ¯i M, t $ t1
the short nominal interest rate is constant, Ωt is constant. This implies, from (41), that the
real interest rate is constant: rt . "

Some of the math is left out, so, take my word for it, the nominal interest rate and the real ( inflation adjusted ) interest rate are constant ( Stuck ).

"Since η> 0, the demand for real money balances is positive in
period t $ t1 . The monetary equilibrium condition (42) is violated. "

Lucky for us, the result of all this was that the demand for money goes up.

"Corollary 1
With irredeemable money, when the nominal interest rate on base money is
zero, there can be a liquidity trap equilibrium in the flexible price level model
only if, in the long run, the authorities (are expected to) reduce the nominal
stock of base money to zero. Any monetary rule that does not lead (and is not
expected to lead) to eventual demonetisation of the economy precludes a
liquidity trap equilibrium. Friedman’s OQM rule supports a stationary
liquidity trap equilibrium in which the nominal stock of money goes to zero in
the long run.

Proposition 1 also has obvious implications for the existence of deflationary bubbles
in the flexible price level model."

If you add money to the economy, demand will rise, and the liquidity trap will be defeated. Hence, there will be no deflation.

"Corollary 2
In the flexible price level model, deflationary bubbles do not exist when base
money is irredeemable, even though base money is not the only financial
liability of the government. Without the irredeemability of base money,
deflationary bubbles can exist in models in which the government issues both
monetary and non-monetary financial liabilities, under the FFMP given by
equations (30)-(33)."

You have to use an increase in the money, and not use bonds, to get out of the liquidity trap.

"Proposition 2:
In the representative agent model, it does not matter how money gets into the
system: Because of Ricardian equivalence, unanticipated money-financed tax
cuts (real-time helicopter money drops) have the same effect on real and
nominal equilibrium prices and quantities as unanticipated open market
purchases."

To hell with this model. Let's stick with the flexible price model. I like it better.

"Proposition 3.
In the New-Keynesian model, the augmented Taylor rule (given in (34)),
suffices to rule out non-OQM liquidity trap equilibria that are also rational
expectations equilibria."

Can't have a liquidity trap.

"Corollary.
If the nominal interest rate on base money is zero, any monetary rule that
prescribes a positive growth rate of the nominal stock of base money when the
nominal interest rate is at its zero lower bound, suffices to rule out liquidity
trap equilibria that are also rational expectations equilibria."

Okay. If the nominal interest rate is zero and you throw extra money into the economy, you can't have a liquidity trap, whatever equilibria you throw at it.

"Proposition 429:
When the interest rate on money is zero, perverse expectations, that is, expectations
that the authorities will demonetise the economy in the long run (that is,
P(t ) can cause the economy to be on a non-OQM liquidity ))&1lim
s64
e &(s&t ))¯i MM(s) ' 0
trap solution trajectory at time t ' t ."

Funny how perverse expectations show up, even in economics papers. Anyway, this can all change if idiots start decreasing the amount of money in circulation.

"The paper provides a formalisation of the monetary folk proposition that government
fiat money is an asset of the private holder but not a liability of the public issuer. It shows
how the irredeemable nature of the monetary liabilities of the state can be incorporated into
otherwise conventional approaches to monetary economics."

If the government prints money and gives it out to people, it's not a bill to the government.

"Fiat base money is net wealth to households and influences consumption through a
real balance or Pigou effect, in the restricted sense that, when the households’ and
government’s intertemporal budget constraints are consolidated, the present value of the
(infinitely distant) terminal stock of fiat government money is part of perceived consolidated
comprehensive wealth. The issuance of irredeemable base money can therefore have a pure
wealth effect on consumption (holding constant all prices, endowments and real public
spending). In equilibria that are not liquidity traps, this paper’s asymmetric treatment of the
solvency constraints of the private sector and the state has no implications for the behaviour
of nominal or real equilibrium prices and quantities. It plays a role whenever, with
symmetric treatment of private and public solvency constraints, the economy would be in a
liquidity trap."

In a liquidity trap, throwing money into the economy will increase demand.

"Any positive long-run expected growth rate for the nominal stock of base
money is sufficient to rule out a liquidity trap equilibrium. Liquidity trap equilibria are
therefore possible as rational expectations equilibria only if monetary policies are strongly
contractionary in the long run. With non-rational expectations - e.g. the incorrect belief that
the monetary authorities will, in the long run, reverse and undo any past and present
increases in the stock of base money - liquidity trap equilibria can exist for as long as these
incorrect but irrefutable expectations persist."

Problem solved. Goodbye liquidity trap. Print money. That was my solution. You don't think that I went through all this futile reading for nothing, do you. It buttresses my argument. Period.

There will be a wealth effect if money is thrown into the economy, and inflation and growth will follow.

This is probably all wrong, and didn't help anyone but me, but I'll be damned if I throwing this away now.

"they still aren’t ready to admit that these woes might extend to their own homes,”

Dean Baker has a post about the failure of the press:

"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?

Posted by: Don the libertarian Democrat | November 9, 2008 11:56 AM

So, here's a post on Marginal Revolution:

"Wealth Shock

Alex Tabarrok

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:

1. Don the libertarian Democrat Says:
   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.

2. Don the libertarian Democrat Says:
   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.