Underwater Homeowners Cannot Explain the Weak Recovery
|Friday, 23 November 2012 08:05|
Anyone wanting to learn about the economy who talked to the nation's top economists in 2006 would have been wasting their time. Almost none of them had any clue that the collapse of the $8 trillion housing bubble was going to wreck the economy. This presumably reflects a rigid dogmatism and conformity on the part of these economists, since it should have been both very easy to recognize an unprecedented run-up in house prices as a bubble and also to understand that the collapse of the bubble, which was quite evidently driving growth, would lead to a severe downturn.
Remarkably, it seems from a Washington Post article that attributes the continuing weakness of the economy to the indebtedness of underwater homeowners, that many of the country's top economists have no better understanding of the economy today than in 2006.The claim is the drop off in consumption due to the debt burden of these homeowners explains the weakness of the recovery.
Some simple arithmetic shows the absurdity of this view. The amount of underwater equity is estimated at between $700 billion (Core Logic) and $1.1 trillion (Zillow). Suppose that we can disappear this debt through some decree, how much additional consumption would we see? If we assume that these households spend an incredibly large share of this increase in their net wealth, say 15 cents on the dollar, this would imply additional consumption of between $105 billion (Core Logic estimate) and $165 billion a year (Zillow estimate).
However we would have also destroyed the wealth of the mortgage holders. Let's assume that they just spend 2 cents on the dollar of their wealth. This would imply a net boost to demand of $91 billion to $143 billion. While this would be a helpful boost to the economy, equivalent to a government stimulus program of this size, this would hardly be sufficient to make up a shortfall in annual output that the Congressional Budget Office puts at close to $1 trillion.
Furthermore, even this gain is almost certainly a huge exaggeration of the actual effect. With 11 million homeowners underwater, the above calculation implies an increase in average annual consumption of between $9,500 and $15,000 a year. The median homeowner has an income of less than $70,000 a year. It doesn't seem likely that such a family would either have this amount of savings each year that they could instead decide to consume if they were no longer underwater in their mortgage or that they could borrow this amount on any sort of sustained basis. In short, the numbers in my calculation above almost certainly hugely overstate the economic impact of eliminating underwater mortgage debt.
In fact, there is no need to turn to implausible underwater mortgage debt explanations for the weakness of the economy. The economy is acting exactly as those who warned of the bubble predicted. We saw a sharp falloff of residential construction as we went from a near record boom, with construction exceeding more than 6.0 percent of GDP at the 2005 peak, to a bust where it fell below 2.0 percent of GDP. This meant a loss in annual demand of more than $600 billion a year.
We also saw a large falloff in consumption due to the loss of $8 trillion in housing wealth. The housing wealth effect is one of the oldest and most widely accepted concepts in economics. It is generally estimated people spend between 5 and 7 cents each year per dollar of housing wealth. This means that the collapse of the bubble would be expected to cost the economy between $400 billion and $560 billion in annual demand.
There is no mechanism that would allow the economy to easily replace the combined loss of between $1 trillion and 1.2 trillion in demand that would be predicted from the collapse of the housing bubble. Therefore it is hard to see why anyone would feel the need to look to explanations involving the indebtedness of underwater homeowners, the whole downturn is easily and simply explained by the collapse of the bubble.
In this respect it is worth noting that, contrary to the impression given by the article, consumption remains unusually high relative to disposable income, not low.
Source: Bureau of Economic Analysis and author's calculations.
As can be seen consumption as a share of disposable income is well above the level of the 60s, 70s, 80s, and even the 90s prior to the point where the stock bubble led to a consumption boom in the late 90s. If anything, we should be asking why consumption is so high, not why it is low. (Adjusted disposable income refers to the statistical discrepancy in the national income accounts.) In short, the underwater homeowner story is an explanation for a mystery that does not exist.
There are a number of other points in this piece that incorrect or misleading. For example, it refers to the Obama administration's failure to address the situation of underwater homeowners as:
"a persistent and largely unaddressed problem that represents the missing link in what many economists consider the administration’s overall strong response to the recession."
Actually, many economists did not view the administration's response to the recession as strong, pointing out at the onset that the proposed stimulus was woefully inadequate. These economists were not surprised by the subsequent weakness in the economy.
At another point it explains to readers:
"Some people reduced spending because they had lost their homes to foreclosure, damaging their ability to borrow. Others no longer could tap home-equity lines of credit. Still others, facing high monthly payments, used every extra penny to pay off debt."
This comment is extremely confused. If someone loses their home to foreclosure, then they are no longer in debt, except in the extremely rare case where a lender pursues a deficiency judgment against the homeowner. Lacking the ability to borrow because they are not homeowners or losing access to a line of credit because they have no equity are not problems of indebtedness, they are problems of lacking equity in their homes. This is the standard housing wealth effect story. No one has proposed that the government should not only eliminate the negative equity of underwater homeowners, but also give them substantial positive equity so that they can again borrow against their home. Therefore this argument has nothing to do with the underwater homeowner story that is the central theme of this piece.
The economics profession did an astounding amount of damage to the country as a result of its complete failure to see the housing bubble and the dangers it posed to the economy. Economic reporters also failed the country by not being able to exercise any independent thought to understand that the bulk of the profession was missing something important. (There were prominent economists like Robert Shiller at Yale and Paul Krugman who did warn of the bubble.) It is unfortunate that economics reporters still write pieces that rely exclusively on economists who could not see an $8 trillion housing bubble.
By the way, we certainly should be trying to help underwater homeowners as a simple matter of fairness. We bailed out Wall Street billionaires, it seems a pretty minimal proposition to offer assistance to homeowners who bought into a bubble that all the top economists insisted did not exist.