Housing Prices, Wealth, and the Current Depression Comment

The Federal Reserve's unsound monetary policy in the early 2000s pushed down interest rates excessively, resulting in asset-price inflation, particularly in houses because they are bought primarily with debt. Eventually the bubble burst and house prices fell precipitately; they are still falling.

Becker's interesting post argues that the boom and bust in housing have not had as large an effect on consumption (and hence, this implies, on the nonfinancial economy) as the size of the price fluctuations might suggest. He illustrates with the example of a homeowner who has a bequest motive: if people intend to leave their house to their kids, changes in the value of the house will affect the size of the bequest rather than current spending by the owner-parent. More generally, an increase in home values increases the cost of housing by the same amount. If all house prices double (and assume no other prices change), but the owner is not intending to downsize, he cannot "spend" the increased value of the house.

However, although increased home values are unlikely to be translated into equal increases in consumption spending, those increased values are likely to have a strongly positive effect on consumption. To begin with, a significant amount of borrowing during the bubble involved the refinancing of existing mortgages rather than the financing of home purchases, and often the incentive for the refinancing was to obtain cash for consumption. Furthermore, some people may downsize, or even become renters, because they want to increase their consumption expenditures, as they can do if they cash out some of the increased market value of their house. And if people feel wealthier because the market value of their savings (which includes the value of a house) is rising, they may reallocate more of their income to consumption, which they can do without impairing the expected value of their savings if their houses are worth more. In other words, a house is a "store of value" (as economists say) rather than just a home, and even if one has no intention of downsizing, the fact that one has a valuable house that could be sold if one needed cash provides a store of value that may persuade you that you can afford to consume more. As a form of savings, a house is illiquid and risky relative to cash, but it is still savings, in the sense of an asset that one could turn into cash if necessary, to increase consumption in the future. And if one's savings shoot up because of an increase in the price of one of one's assets, one may decide to allocate a portion of the increased savings to current consumption.

These considerations persuade me that the run-up in housing prices probably did increase consumption significantly. More important, the collapse of those prices, together with the fall in the stock market, has almost certainly had a significant negative impact on current consumption expenditures. Because of rising house and stock prices, the market value of people's savings rose during the housing and stock bubbles and as a result people reduced their savings rate, to the point where it actually was negative for a period during the early 2000s and was no higher than about 1 percent before the crash last September. (This is related to the "store of value" point.) The personal savings rate has since risen to more than 4 percent. The fall in house and stock prices, combined with increased unemployment and fear of unemployment, convinced many people that they didn't have enough precautionary (safe) savings, and so their current savings are heavily weighted toward cash and other riskless, or very low-risk, forms of savings. The reallocation of income from consumption expenditures to very safe forms of savings reduces current consumption without increasing productive investment significantly, and so contributes to the depression.

The Federal Reserve's unsound monetary policy in the early 2000s pushed down interest rates excessively, resulting in asset-price inflation, particularly in houses because they are bought primarily with debt. Eventually the bubble burst and house prices fell precipitately; they are still falling.

Becker's interesting post argues that the boom and bust in housing have not had as large an effect on consumption (and hence, this implies, on the nonfinancial economy) as the size of the price fluctuations might suggest. He illustrates with the example of a homeowner who has a bequest motive: if people intend to leave their house to their kids, changes in the value of the house will affect the size of the bequest rather than current spending by the owner-parent. More generally, an increase in home values increases the cost of housing by the same amount. If all house prices double (and assume no other prices change), but the owner is not intending to downsize, he cannot "spend" the increased value of the house.

However, although increased home values are unlikely to be translated into equal increases in consumption spending, those increased values are likely to have a strongly positive effect on consumption. To begin with, a significant amount of borrowing during the bubble involved the refinancing of existing mortgages rather than the financing of home purchases, and often the incentive for the refinancing was to obtain cash for consumption. Furthermore, some people may downsize, or even become renters, because they want to increase their consumption expenditures, as they can do if they cash out some of the increased market value of their house. And if people feel wealthier because the market value of their savings (which includes the value of a house) is rising, they may reallocate more of their income to consumption, which they can do without impairing the expected value of their savings if their houses are worth more. In other words, a house is a "store of value" (as economists say) rather than just a home, and even if one has no intention of downsizing, the fact that one has a valuable house that could be sold if one needed cash provides a store of value that may persuade you that you can afford to consume more. As a form of savings, a house is illiquid and risky relative to cash, but it is still savings, in the sense of an asset that one could turn into cash if necessary, to increase consumption in the future. And if one's savings shoot up because of an increase in the price of one of one's assets, one may decide to allocate a portion of the increased savings to current consumption.

These considerations persuade me that the run-up in housing prices probably did increase consumption significantly. More important, the collapse of those prices, together with the fall in the stock market, has almost certainly had a significant negative impact on current consumption expenditures. Because of rising house and stock prices, the market value of people's savings rose during the housing and stock bubbles and as a result people reduced their savings rate, to the point where it actually was negative for a period during the early 2000s and was no higher than about 1 percent before the crash last September. (This is related to the "store of value" point.) The personal savings rate has since risen to more than 4 percent. The fall in house and stock prices, combined with increased unemployment and fear of unemployment, convinced many people that they didn't have enough precautionary (safe) savings, and so their current savings are heavily weighted toward cash and other riskless, or very low-risk, forms of savings. The reallocation of income from consumption expenditures to very safe forms of savings reduces current consumption without increasing productive investment significantly, and so contributes to the depression.

I reply to a comment on the following passage in my posting last week on housing: "The reallocation of income from consumption expenditures to very safe forms of savings reduces current consumption without increasing productive investment significantly, and so contributes to the depression." The commenter states: "surely much of the conservative savings are going into FDIC-backed bank accounts where each $100,000 backs over a million bucks of lending capability. So current consumption is reduced by one unit while lending in enhanced by 12 units?"

The error in the statement is the assumption that every dollar in an FDIC-insured bank account (or any other bank account, for that matter, according to the logic of the statement) is lent. Banks do not lend all their capital, especially in a depression. If a bank is undercapitalized, if it is worried that borrowers will default at an unpredictably higher rate (and that charging them a sky-high interest rate to compensate will increase the default rate), or if the demand for borrowing is down because many consumers and producers are overindebted and have to curtail their spending and avoid taking on more debt, then the bank will hoard most or even all of any cash it receives. Excess bank reserves, which are cash or equivalent (balances in the bank's account with a federal reserve bank), rose from $2 billion in August 2008 to $725 billion in March of this year. That is money the banks could lend (a bank is not permitted to lend its required reserves), but is not lending. This is rational hoarding, but it means that people who are depositing their money in bank accounts are not doing much if anything to increase lending and thereby stimulate economic activity.