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Do People With a $300,000 Home and a $150,000 Mortgage Spend Less Than People With No Home and No Mortgage?

Friday, 16 August 2013 04:38

Readers might think that they would after reading Wonkblog's piece, "Five facts about household debt in the United States." The piece begins by telling readers:

"The U.S. economy has been growing glacially for the last four years. And, by almost all tellings, the overhang of debt from the pre-crisis years is a big part of the reason why."

Is that so? There seems to be a very simple story that does not hinge on debt overhang. When the housing bubble collapsed it destroyed $8 trillion iin 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. (Residential construction is now recovering and is currently a bit more than 3.0 percent of GDP.) 

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.

This doesn't mean that there may not be some differences across households. If the value of Bill Gates' home rises by $10 million, it would probably have less effect on consumption than if 100 miiddle income homeowners saw the price of their homes increase by an average of $100,000. But this has nothing directly to do with debt. It is a question of the distribution of wealth.

In fact, 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-ware 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. 

Comments (14)Add Comment
written by Last Mover, August 16, 2013 8:02

OMG! A Dean Baker original. It's not debt overhang. Even Paul Krugman hangs his hat on debt overhang. How are we going to explain the trillion dollar output gap now?

Glenn Beck was right. It all started with Francis Fox Piven in the '60s when she and the pot smoking hippies duped millions of gullible Americans down the road to socialist serfdom with government backed housing loans that interfered with the freedom to pee in your own back yard.
written by A Populist, August 16, 2013 8:32
Re "The reality is consumption is high, not low."

I would agree that consumption is high relative to income. However, income is too low for most, which is why consumption is lower than it needs to be, in order to achieve full employment.

Raise the minimum wage?
High or Low is Irrelevant
written by Paul Mathis, August 16, 2013 9:30
In fact, it is just wrong to imply that consumption is currently depressed.

The relevant question is where can increased demand originate?

Minimum wage increase? Good idea; not happening.

Government spending increase? Politically impossible.

Reduce trade deficit? More fracking feasible; deliberately devaluing the dollar not feasible.

Increase consumption? Yes and yes. Auto sales are up 60% from the bottom 4 years ago with employment up sharply. Housing sales are up strongly and construction is returning to normal.

Increasing consumer demand is not only feasible, it is essential in these circumstances as Keynes said in The General Theory. Sure, increasing government spending and reducing the trade deficit would be great, but consumption increase is all we've got.
Percentages are not always good
written by DC, August 16, 2013 9:48

I agree with you that percentages should be used more often when reporting on budget items, but sometimes they can be misleading. Consumption rate or saving rate don't tell us whether consumption is high enough when the economy is below its potential output. If the consumption rate now is the same as before the recession, it simply means that consumption has shrunk by the same factor as the economy. If we agree that this recession is driven by a fall in aggregate demand, then we need to raise consumption in order to get back to the potential output.

Debt fits here
written by U. N. Derwater, August 16, 2013 2:34
Where does debt fit into the picture? It is the means by which home equity is transformed into effective demand. People don't sell their house to spend equity. They borrow to spend against that equity leaving them with debt when the spending is done. Then if the value of the home later declines as it did for so many, the debt remains and there's your overhang of negative equity.

here comes the daffodil bubble
written by watermelonpunch, August 16, 2013 10:49
government backed housing loans that interfered with the freedom to pee in your own back yard

Ah! No wonder there are so many web sites offering tips on deer-proof landscaping. Will this all lead to a narcissism boom?
How many homeowners know how much equity they have?
written by Melissa, August 17, 2013 6:57
Is there evidence that the average mortgaged homeowner has a clear and conscious sense from year to year as to how much equity they have in their home? As a homeowner myself, I don't really know at all until I'm either close to finishing paying off the mortgage or about to refinance and going through the process of having it re-appraised. But all those years in between, I'm just making those P&I payments with no sense of how much is P and how much is I and what my "equity" in it is. So it really doesn't affect my consumption/savings behavior at all, only my actual monthly mortgage payment amount does.
Paul - How to generate *sustainable* demand
written by A Populist, August 17, 2013 9:45
Re: "The relevant question is where can increased demand originate?"

Absolutely correct.

Re: "Minimum wage increase? Good idea; not happening."

Out of all the *sustainable* ways to increase demand, this is the *most* politically feasible.

If the only sources of demand you advocate for are financially unsustainable consumer debt, or politically unsustainable government debt, then we are in big trouble.

World wide, we have an "interesting" situation regarding a lack of demand, and the policies which are exacerbating that lack of demand.

Have you read about the situations in Japan, India, and other nations trying to devaluate their way to prosperity, *without* raising wages to maintain domestic demand? This is a race to the bottom.

Ironically, as each nation engages in competitive devaluation to increase their share of world demand, their import prices become higher, suppressing domestic consumption and demand. Wages are not rising in proportion to the nation's currency - which is the only way to maintain domestic consumption - given rising import prices. Since the free market will not raise wages due to high unemployment, and governments are not raising minimum wages - consumption and demand stagnate - or even decrease.

This is not going well.

We need a stable source of increased demand - higher wages.

But the wealthy of each nation cannot or will not consider that as an option.

The *people* will consider higher wages as a political option. Don't judge what is politically possible by what you hear on Fox, CNN, or read in the NYTimes, WAPO - or any other mouthpiece of the elite.

One more thing on competitive devaluation
written by A Populist, August 17, 2013 10:19
One might be quick to dismiss competitive devaluation as a factor reducing net worldwide demand. After all, the increased value of exports in local currency should compensate. However, cash from exports goes primarily to business owners, who may be more likely to save, or invest in productive capacity. But, with present conditions (productive capacity already in excess), that reduces net demand, vs having that cash spent on consumption.

So, inequality is reducing net demand by preventing increased consumption, which is not fully compensated by increased investment in productive capacity - since that capacity is not needed.

And, competitive devaluation (combined with stagnant wages) is just one more mechanism which will exacerbate that inequality.

I suppose that (like Krugman) we could just (in the absence of "absolute proof") go with the assumption that inequality does *not* reduce net demand under present conditions, but there is bad stuff happening around the world, and I think we may need to come up with a solution pretty quick.
Competitive devaluation doesn't affect wages
written by Dean, August 17, 2013 12:30
A Populist,

if the US pushes down its currency by 10 percent, and then other countries respond by pushing down their currency by 10 percent, we're right back we started and no relative prices have changed. That means wages and profits are not affected. You actually have to see a change in relative prices to affect anything.
Please explain: high consumption vs. low aggregate demand
written by Highf, August 17, 2013 1:27
Could you please explain in a follow-up post as to why, with consumption high, aggregate demand remains low. What factors are in play?
What I am really talking about, is devaluation, one nation at a time
written by A Populist, August 17, 2013 1:54
Point taken on "competitive devaluation".

If everyone devalues in sync, then nothing really changes.

However, suppose Japan devaluates (they have), but their wages stay the same. So, won't their domestic consumption decrease, due to higher import prices?

Won't this cause a net reduction in domestic demand?

And, in an environment with most nations having a demand shortfall, no one is really going to want to start buying more from Japan.

I guess I am more concerned about places like Japan, where they may "inflate" and devalue, but perhaps that without rising wages, there will be no net increase in demand, and maybe even a decrease in demand.

What do you think about the idea that Japan could be more effective at getting out of this hole, by taking advantage of the recent devaluation, by raising minimum wages. This can help ease the debt and demand problems, without hurting exports, since the devaluation cancels the rise in nominal wages, right?

pushing down the currency.
written by pete, August 17, 2013 10:29
Currently its around 2% per year push. This has not been enough to get real wages down enough to suck up the unemployed. Krugman has suggested 4% to speed the process. And even faster in the Euro to get Greek and Spanish real wages down to earth. Wages there were simply unrepresentative of productivity.
Yes! Yes! We desperately need to fix the trade deficit!
written by indiana guy, August 18, 2013 5:04
Thank you for speaking truth to power!

It's likely the trade deficit with China is MUCH larger than stats indicate. US companies overprice their intermediate exports to the PRC in order to ferry profits out of the country. US exports to China are much smaller than indicated. We are a larger version of Ireland in this regard. [Ireland has a phantom current account surplus that owes entirely to corporate tax avoidance practices.]

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.