A ramble while I sit with my daughter as she watches The Little Mermaid:
I’ve never taken an economics course. When I need to educate myself I go out and read what other people have to say – read arguments and counterarguments, examine the facts on the ground, decide which arguments make sense and which don’t. That’s what leads me to read a lot of Krugman and DeLong. Their arguments usually make good sense and are more compelling than the alternatives. That said, I don’t always find that to be the case. Lately I’ve been finding Dean Baker‘s commentaries particularly instructive when the Krugman/DeLong/liberal technocratic argument isn’t compelling. Case in point: Rising home prices. Are they good for the economy? Bad? Indeterminate? (I put in my $0.02 on whether they’re good for homeowners and prospective homebuyers a few week ago.)
Let me take a step back: Our current economic malaise is a result of a depressed GDP. (That’s not controversial.) If we get GDP and GPD growth back to potential then there’s general agreement that will be good for the middle class. I buy that too. The question is how to accomplish that in a constructive manner. (Re-inflating an old bubble or creating a new one seems unlikely to be constructive in the long term even if it reduces near-term pain.) What constitutes “constructive” is a matter of debate. The New Keynesian (liberal) argument is for near-term fiscal stimulus and other government actions to boost GDP. The conservative argument emphasizes balancing the budget and reducing the debt as a means to that end. Suffice it to say I find the conservative argument to be without merit – the underlying theories aren’t supported by the facts on the ground. However, while I agree with the NK arguments in principle, when it comes to particulars some things don’t sit right with me. Economic policy as it affects housing prices is one of areas where I’m not always comfortable with NK “conventional wisdom”.
Looking at how different sectors of the economy contribute to GDP, the deflation of the housing bubble staring ca. 2006 has significantly reduced GDP relative to potential. One can (and some liberal-leaning economists do – links to follow ) make the argument that if housing sector grows (re-inflates?) to the level that its contribution to GDP is more characteristic of pre-2008 levels then we’ll see an increase in consumer spending and life will get better for the middle class. (NB: Supporting an increase in residential construction is not a call to reinflate the housing bubble. I believe an increase in residential construction would be a good thing so long as new homes are affordable to median earners – nominally 3x annual household income.) In terms of cause and effect, the argument is that consumer spending is >70% of our GDP and, figuring consumer spending will remain a more or less a fixed fraction of GDP no matter the absolute amount, then getting it back to what it was pre-2008 will boost the economy. Towards that end, rising home prices lead people to feel more wealthy and the wealth effect leads them to boost their consumption – ergo rising home prices are good for the economy. Baker addresses ‘underconsumption’ and rising home prices in a recent post, Do People With a $300,000 Home and a $150,000 Mortgage Spend Less Than People With No Home and No Mortgage?:
… it is just wrong to imply that consumption is currently depressed. It isn’t. The saving rate in the first half of 2013 was less than 4.3 percent. This is less than half of the average saving rate in the 1960s, 1970s, and 1980s. It is lower than the saving rate at any points in the post-war era except the peaks of the stock and housing bubbles. Unless we see a return of a bubble, there is no reason to expect consumption to increase further relative to income.
The reality is, consumption is high, not low. This is yet another which way is up problem in economics.
We still see a slump because of the unmentionable trade deficit. We need a source of demand to replace the demand lost to this deficit, as widely recognized by fans of national income accounting everywhere.
Backtracking to his discussion of the housing bubble:
When the housing bubble collapsed it destroyed $8 trillion in housing wealth. This bubble wealth was driving the economy in two ways.
First, record high house prices led to an extraordinary construction boom. Residential construction, which is normally around 3.5 percent of GDP, surged to more than 6.0 percent of GDP at its peak in 2005. After the collapse of the bubble, the overbuilding led to a period of well-below-normal levels, with construction falling to less than 2.0 percent of GDP. The difference of more than 4 percentage points of GDP implies a loss in annual demand of around $640 billion in today’s economy…
The other way that the housing bubble was driving the economy was through the housing wealth effect. Economists estimate that homeowners increase their consumption by 5-7 cents for each additional dollar of home equity. This would imply that bubble wealth increased annual consumption by $400 to $560 billion a year. When the bubble wealth disappeared, so did this excess consumption.
The question then is where does debt figure into this picture? The answer is it doesn’t really. People will spend based on their equity, net of debt. This means that we would expect a person with a $300,000 home and a $100,000 mortgage to spend roughly the same amount as a result of her housing equity as a person with a $200,000 home and no mortgage. It is the amount of equity that matters, not the amount of debt…
See an earlier Baker statement on the housing bubble here:
Savings rates had been driven to nearly zero by the wealth created by the housing bubble. It seems to me inevitable that consumption would fall in response to the disappearance of this wealth. The financial crisis gave us a Wily E. Coyote moment where everyone stopped spending at the same time, but I would argue that this just brought the decline in spending forward in time.
The savings rate remains much higher today than at the peak of the bubble, although still low by historic standards. (It’s currently around 4.0 percent, the pre-bubble average was over 8.0 percent.) We have two alternative hypotheses here. I gather Brad [DeLong] would say that people are spending at a lower rate because they are still freaked out by the financial crisis. I would argue that they are spending at a lower rate for the same reason that homeless people don’t spend, they don’t have the money.
Homeowners are down $8 trillion in housing equity as a result of the crash. I would expect that loss of wealth to have a substantial impact on their spending.
It’s real wages not rising home prices which most affect consumer spending, see, e.g., Pedro da Costa, Forget the ‘wealth effect’: real wages drive U.S. consumer spending.