September 25, 2014
It’s often said that the economy is far too simple for economists to understand. There is probably no better example of this problem that the invention of the “balance sheet” recession. The story is that because households have large amount of debt (generally mortgage debt), they cut back on consumption, thereby reducing demand and growth. In Wonkblog today, Matt O’Brien tells us that falling house prices in China may cause the country to face such a balance sheet recession.
The problem with the debt issue is largely secondary. The point is that people cut back consumption because they lose wealth. This is a straightforward, and old, economic concept.
To see the point, imagine someone has a home on which they owe $200,000 and is worth $250,000. Imagine that it rises in value to $350,000. We would typically expect that people would spend more money based on this additional wealth. The usual estimates on the size of this effect are on the order of 5-7 cents on the dollar, implying that this homeowner would spent an additional $5,000 to $7,000 a year based on her increased wealth. Now if the house price plunged back to $250,000 we would expect to see spending to fall back by roughly this amount.
Now let’s do this with debt. Suppose the person borrows an additional $100,000 when the house price goes up to $350,000. They would then owe $300,000 on the house. When the price plunges, she would then owe $50,000 more than the value of the house. In this case we would also expect to see a drop in her annual consumption of $5,000 to $7,000. We could blame debt (she owes $50,000 more than the value of the house), but the main point is that she lost the wealth that was driving her consumption, not the fact that she is now in debt. Focusing on the debt in this story is simply an unnecessary complication.
Of course people are not identical. Many people will not increase their spending at all as a result of the increase in their housing wealth. These people will then not reduce their consumption when their house price falls. The people who did increase their consumption are the ones most likely to find themselves in debt, but that doesn’t change the fact that the story is really one of a wealth effect, not debt.
This point can be easily seen if we look at the macro data. The consumption share of disposable income is actually quite high now, contrary to what is often reported. In other words, given their income levels, people are spending more on average than they did at any point in the post-war period, except the peaks of the stock and housing bubbles. This means that debt is not keeping people in aggregate from spending more, the reduction in wealth is what is keeping people from spending at their bubble peaks.
The debt story creates an unnecessary complication. It perhaps is a useful excuse for economists who somehow missed the importance of the largest asset bubble in the history of the world, but the real story is and was very simple. Economists had all the tools needed to see the problem at the time, they were just not willing to use them.
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