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Home Publications Blogs Beat the Press Housing Wealth Effects: Arithmetic Lesson for Neil Irwin and the Washington Post

Housing Wealth Effects: Arithmetic Lesson for Neil Irwin and the Washington Post

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Saturday, 26 January 2013 08:46

Knowledge of arithmetic is a skill in short supply for people involved in economic policy debates. This is especially the case for the Washington Post (Wonkblog excepted).

Neil Irwin gives us an example of the problem when he expresses the hope that increasing house prices will provide a large boost to consumption and thereby spur growth. Irwin cites a recent academic paper on the size of the housing wealth effect:

"In a paper last year, Charles Calomiris, Stanley Longhofer, and William Miles found that the wealth effects from housing vary significantly depending on whether the homeowner is old or young, poor or rich—but their overall estimate is that a dollar of extra housing wealth triggers five to eight cents in additional spending."

He then notes that with house prices rising by roughly $1 trillion this year, this would imply an increase in consumption of between $50 and $80 billion (0.3 to 0.5 percent of GDP).

So far, so good. The Calomiris, Longhofer, and Miles estimate of the wealth effect is certainly within the range of other estimates, although it is worth noting that about 40 percent of the gain in house prices last year could be attributable to inflation. In other words, if house prices had not risen by at least 2.0 percent last year, the real wealth effect on consumption would be lower in 2013 than in 2012. The gains in terms of consumption have to be adjusted accordingly.

But the real problem is when Irwin tells us:

"In the Great Recession, spending fell by even more than could be attributed solely to the wealth effects caused by falling home prices. A vicious cycle set in through which falling home prices contributed to people being underwater on their mortgages, which had an outsized impact on their spending. Research by Atif Mian, Kamalesh Rao, and Amir Sufi last year found that in counties with high degrees of household debt and home price declines, retail sales fell much more than elsewhere."

Hmm, spending fell by even more than could be attributed to the wealth effect. Let's check that one.

If we run over to the Fed's balance sheet tables (Table B100, Line 49), we find that at the end of 2005, near the peak of the bubble, households had $13.2 trillion in housing equity. This was roughly equal to GDP in 2006. Using the Calomiris et al. estimates of the wealth effect, this would imply that housing wealth in 2006 was boosting consumption by an amount equal to 5 to 8 percent of GDP.

If we go to the most recent Fed data, we find that housing equity was equal to $7.7 trillion at the end of the third quarter. We'll call that 50 percent of GDP. We should then expect to see a housing wealth effect on consumption equal to between 2.5 and 4 percent of GDP.

The drop in the size of the housing wealth effect on consumption is between 2.5 and 4.0 percentage points of GDP. If we go back to 2006 we see that consumption was equal to 69.6 percent of GDP ($9.3 trillion out of $13.4 trillion). Turning to the data for the first three quarters of 2012, we find that consumption is equal to 70.6 percent of GDP ($11.0 trillion out of $15.6 trillion). That seems to go the wrong way for Irwin's assertion that "spending fell by even more than could be attributed to the wealth effect."

It's true that disposable income has risen relative to GDP as a result of lower taxes, but even if we look at consumption relative to disposable income we can't find any evidence to support Irwin's assertion. In 2006 the saving rate was 2.6 percent. In the first three quarters of 2012 it averaged 3.7 percent. That's a rise of 1.1 percentage points. The Calomiris et al. estimates of the wealth effect would have predicted a 3.0-5.0 percentage rise in the saving rate, much more than we actually saw.

In short, there is zero evidence that consumption has fallen by more than would be expected given the estimate of the size of the wealth effect that Irwin uses in his piece. Therefore there is no reason to expect the "disproportionate positive effect on spending" that Irwin holds out as a hoped spur to growth as underwater homeowners again come above water.

See what arithmetic can bring to the analysis of economic policy?

Comments (6)Add Comment
Future Housing Wealth Effect Likely Diminished
written by Robert Salzberg, January 26, 2013 12:03
There are at least 6 reasons why the wealth effect will be less in the near term than the historical average:

1. A greater percentage of home mortgages are underwater than average historically which means that increased home values translate less into increased equity and more into less negative equity.

2. The availability of home equity loans has significantly tightened for the foreseeable future.

3. We're halfway into a decade of high unemployment and a decades into declining real wages which will likely create a generation of Americans that save more when times are good.

4. The Baby Boomers built lots of bigger houses and McMansions that will have fewer buyers from the generation that follows them.

5. The steadily increasing home values since the Great Depression trend was broken by the housing bubble and burst. It's likely to be at least a few decades before Americans place the same confidence in the potential growth of home values.

6. Last but certainly not least is climate change and global warming which makes homes on the coasts and in flood and tornado prone areas more expensive to maintain and insure and has already negatively impacted home values.
...
written by Chris Engel, January 26, 2013 2:45
I'd like to just echo the sentiment of Robert.

Don't you think psychologically that people have learned the lesson of using rising home equity as a credit card?

How can we possibly think that rising home prices would even lead to any wealth effect after everyone was just bitten so hard just a few years ago?

This makes the "disproportionately positive" hoped effect even less probable.

The dynamics are totally different now...I can't imagine people would be AS dumb as before, the assumption would be that people would be LESS dumb and the wealth effect would be far less pronounced.
but who's going to support higher housing prices?
written by watermelonpunch, January 26, 2013 10:50
My question is... if we have housing prices rebound, without overall wage increases... How could that be sustainable? Would it not be just another bubble rather than "recovery"?

Robert Salzberg's points sound likely.

Except I question whether the actual data would place the blame for most McMansions & larger houses during the high bubble years, on people born between 1946 and 1964.
Any source for that?
I'm serious, I couldn't imagine how to begin looking for that information.
But I would be interested in it.
I thought it was my generation that was hip deep in the buying-too-much-house frenzy. (For reference, I'm too old to join the U.S. military, and too young for AARP.)

And while I agree with the 1st half of #3, I'm less sure about the possibility of the 2nd half of that, for numerous practical and cultural reasons. It's not quite the same culture my grandmother emerged as an adult into in 1929. I think people were a little more flexible to making abrupt changes in their lifestyles & attitudes.
The reason I suspect that is because for example, these days, a lot of people with severe financial difficulties have to have it explained to them that cable tv is NOT a necessity.
What about the income effect?
written by Blissex, January 27, 2013 3:12
«Neil Irwin gives us an example of the problem when he expresses the hope that increasing house prices will provide a large boost to consumption and thereby spur growth»

Sure this happens to some extent, but why not explore the income effect on spending?

If massive tax free capital gains result in a boost to GDP, why not try instead of the effect of gains in wages?

It is perhaps because higher house prices are pure income redistribution from less wealthy to more wealthy people, and 60-70% of voters think they are in the latter category...

«If we have housing prices rebound, without overall wage increases... How could that be sustainable? Would it not be just another bubble rather than "recovery"?»

Eventually that will end as sooner or later sales must be used to realize the capital gains, but more immigration and more income redistribution from less wealthy people to more wealthy people happen, and there is a gigantic increase in credit to allow wealthier people to borrow against the increased value of their properties without selling them, thus keeping prices going up and up.

When the richest 10% of a nation try to exploit the poorer 90% it can work for a long time. In the USA the richest 60-70% voters are trying to exploit the poorer 40-30% via house price and rent increases, and that while not being sustainable can last for a surprisingly long time, if there is a political will.
...
written by watermelonpunch, January 28, 2013 6:02
@ Blissex
Thank you for your response.
t is perhaps because higher house prices are pure income redistribution from less wealthy to more wealthy people, and 60-70% of voters think they are in the latter category...

They think, but is it true?
In the USA the richest 60-70% voters are trying to exploit the poorer 40-30% via house price and rent increases

I have had this suspicion for a long time... I've never heard or seen anyone say it outright before.
I certainly never have, and even feel awkward saying I've thought of it...
It's like a serious social taboo, as a renter, to say anything like this in the presence of home owners or heaven forbid landlords. You just don't say it.
Maybe that's part of the problem.
housing "wealth"
written by pete, January 28, 2013 11:11
It should be unexpected increases in housing prices, if anything, which may have some irrational "wealth" effect. If housing is rising with real incomes, or projected real incomes, essentially what is going on is people perceive rising future rental costs, and drive up housing prices to reflect this. Kind of like a stock which looks like it will have good profits going into the future, then the value rises today to reflect that.

With the bubble, housing prices were artificially driven up by crazy borrowing practices. That was not a change in wealth in any sensible meaning of the term. Ergo, any fall in prices should not have a negative wealth effect...just back to where we were in say 2000 or so. Economists need some logic courses.

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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.

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