Economists and economic reporters continually try to make the problem of the weak economy and prolonged downturn appear more complicated than it is. After all, if it is very simple then these people would look foolish for not having seen it coming and figuring out a way around this catastrophe. Fortunately for us, if unfortunate for them, it is simple.

One of the efforts to make it more complex than necessary is to assign an outsized role to the debt associated with the collapse of house prices. This is the argument that we heard on Morning Edition this morning. The argument is that when house prices plunged after the housing bubble burst in 2007, homeowners were left with large amounts of debt, pushing many of them underwater. This debt supposed discouraged them from spending, leading to a sharp falloff in consumption.

There is a big problem with this story. Consumption is not low, it is actually still quite high. The graph below shows consumption as a share of GDP. It is actually higher than during the bubble years and essentially at an all-time peak. That makes it a bit hard to explain the downturn by weak consumption. (Some folks may recall hand wringing about inadequate savings for retirement, as in this NYT column by Gene Sperling yesterday. Too little savings and too little consumption are 180 degree opposite problems, sort of like being too heavy and too thin.)


There would be a modest decline in consumption from the peak bubble years if it was shown as a share of disposable income (tax collections are lower today than in 2004-2007), but it would stiill be unusually high by this measure. The basic story is straightforward. The run-up in house prices created by the bubble created $8 trillion in housing bubble wealth. Standard estimates of the housing wealth effect suggest that this would increase annual consumption by 5-7 percent of this amount, or $400 billion to $560 billion a year. This would have been equal to 3-4 percent of GDP.

When the bubble burst this wealth effect went into reverse, with people cutting back consumption in line with their loss of wealth. The consumption share of GDP did not fall both because GDP fell and also there was a sharp drop in tax collection due to both tax cuts and simply the drop in income. The fact that people had debt may have made some difference, but it was really secondary to the loss of wealth. If a homeowner owed $100,000 on a home whose price dropped from $300,000 to $200,000 (leaving them with $100,000 in equity), we would expect them to cut back annual consumption on average by between $5,000 and $7,000.

If the homeowner owed $250,000 on this house, so the drop in price left them $50,000 underwater, then their decline in annual consumption may be somewhat greater, but this difference would have a relatively modest impact on the economy as a whole. To see why this almost certainly has to be the case, consider that the median income for homeowners is around $70,000. How much do we think their consumption could have fallen from bubble peaks? If we say they fell by an additional $3,500 because of being indebted (beyond the housing wealth effect) and multiply by 10 million underwater homeowners, that gets us $35 billion a year. If we plug in a multiplier of 1.5 that gets us to $52.5 billion a year or a bit over 0.3 percentage points of GDP. That won't explain much of the downturn.

Again, the story of the downturn is simple, too bad the economists missed it.


Note: Typos corrected.



I have a few quick points after reading the comments. First, the wealth effect is based on equity net of mortgage debt. This is people's wealth. If the argument is that people's debt rose relative to their equity when the bubble burst, then this is simply a wealth effect story. For there to be a point to the argument, there has to be some importance to the fact that people actually had negative equity. And to see the significance of the numbers I used, suppose the underwater homeowners' consumption had been on average $3,500 higher each year since 2008. We are now in the 7th year, so in this case, that would have translated into a cumulative increase in spending of close to $24,000. If we assume that these people have been spending close to all of their income, this means a cumulative increase in debt of close to $24,000. Even if these people were marginally above water, as opposed to underwater, in their mortgages, who would have lent them an additional $24k? I just don't see this one as making any sense.

There were some questions raised about whether we "need" more consumption. We need more demand to get to full employment (unless we redivide work), which could come in part or entirely through consumption. But the question is not whether more consumption, or as I wrote the other day more investment, would be good for the economy. The question is whether to believe that the economy would generate more consumption or investment. The answer in this case and the previous case with investment is no.

The basic point is that we have an enormous demand gap created by the trade deficit. The current deficit amounts to $500 billion in annual demand (3 percent of GDP) that is going elsewhere rather than creating growth and jobs in the United States. There is no magical process through which the economy will replace this demand. We can do it with large amounts of government spending, but this is blocked politically. That leaves getting the trade deficit down, most obviously by lowering the value of the dollar, as the only route back to full employment or something like it.




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