Bursting of a Housing Bubble and the Wealth Effect

A sensible conservative suggested that I read the latest from John Tamny. While this sensible conservative and I are both in utter disbelief at what Tamny has written, I’ll not say who this smart conservative is as I’m still upset that I had to read the likes of this:

To begin, Makin said the “U.S. real estate bubble is a crucial ingredient in sustaining global demand growth;” the demand growth presently sustained by an “innovative mortgage sector [that] arranges for the easy withdrawal of rising equity in homes.” What Makin seems to miss is that whether we’re talking international or domestic savings, there is someone on the other side of each mortgage origination forgoing the very consumption he claimed is presently driving economic growth. At best the wealth effect he spoke of is a wash.

If Tamny is referring to purely a wealth effect, he seems to have confused financial wealth and real wealth. It is true that my mortgage obligation (my financial liability) is someone else’s financial asset so if the present value of the lendor’s financial wealth declines, the present value of my financial liability also declines. However, the value of my house (a real asset) also declines.

Makin may be arguing that individuals in the past could not spend whatever equity they had built up in their house – that is some form of borrowing constraint. Economists have long debated whether households face such borrowing constraints – and whether financial innovations relieve such constraints thereby increasing consumption. The existence (or lack thereof) of a borrowing constraint, however, is not the same thing as the wealth effect. And my house is a real asset – not a financial asset. At least, I hope it is each night that I go to sleep.