How the fall of home prices deflates the consumption balloon
Posted by nithi.vivatrat on June 25, 2009
I’ve always felt that a balloon was a better analogy than a bubble (in no way am I claiming to be the first) to describe an economic contraction in a particular sector or area, such as housing or consumer spending. It’s not that the market in question “pops” and disappears — it just deflates to a different size after the “air” get sucked out.
The lost “air” in our economy was inflated consumer spending fueled by borrowing — borrowing largely leveraged against rising housing prices. Thus, as housing prices have fallen, consumer spending has dropped as well — causing this significant contraction of our economy. If you don’t believe me, see today’s post by Atif Mian and Amir Sufi of the University of Chicago Booth School of Business in WSJ Real Time Economics (thanks to CalculatedRisk for highlighting the post). A key finding:
Using this methodology, we find striking results: from 2002 to 2006, homeowners borrowed $0.25 to $0.30 for every $1 increase in their home equity. Our microeconomic estimates suggest a large macroeconomic impact: withdrawals of home equity by households accounted for 2.3% of GDP each year from 2002 to 2006.
Now, here in the pretty pricey DC metro area, where we have seen enormous increases in home prices over the past decade, there are findings that strike close to home:
Our results demonstrate that homeowners in high house price areas borrowed heavily against the rise in home equity from 2002 to 2006. We also provide evidence that real outlays were a likely use of borrowed funds. Money withdrawn from home equity was not used to buy new homes, buy investment properties, or invest in financial assets. In fact, homeowners did not even use home equity withdrawals to pay down expensive credit card debt! These facts suggest that consumption and home improvement were the most likely use of borrowed funds, which is consistent with Federal Reserve survey evidence suggesting home equity extraction is used for real outlays.
Sound like anyone you know? We’ve all seen this.
I’ve made the point in the past that housing prices will be a lagging economic indicator because jobs and the general economy must improve first. Mian and Sufi argue that the converse is true, that because housing prices enable consumer leverage that fuels consumption, that housing prices must improve for the general economy to improve:
Our analysis of the microeconomic data has led us to the conclusion that the severity of this economic downturn is rooted in the household leverage crisis, which in turn is closely related to the housing market. If the housing market continues to deteriorate, then further de-leveraging of the household sector will likely keep a lid on any rebound in consumption. In other words, the future of consumption and house prices are closely linked.
Both effects can be true, since economic impacts (both positive and negative) ripple and reinforce across the system. The value of the indicator is a matter of perspective and timing.
Back to the DC area: watch to see how local businesses (particularly retail and dining) are affected by the decrease in consumer spending due to falling home prices in our area. Hopefully at some point we will also watch these trends go the other direction as well.