On Baker & DeLong on House Prices Mortgages and Consumption
I commented on Brad DeLong commenting on Dean Baker asking Brad Delong a challenging question.
Brad decided my comment belonged on his front page, so I guess it belongs here too.
Brad DeLong tells us that he is moving away from the cult of the financial crisis (the weakness of the economy in 2014 is somehow due to Lehman having collapsed in 2008 — economists can believe lots of mystical claims about the world) and to the debt theory of the downturn. Being a big fan of simplicity and a foe of unnecessary complexity in economics, I have always thought that the story was the lost of housing wealth pure and simple. (And yes folks, this was foreseeable before the collapse. Your favorite economists just didn’t want to look.)
Just to be clear on the distinction, the loss of wealth story says it really would not have mattered much if everyone’s housing wealth went from $100k to zero, as opposed to going from plus $50k to minus $50k.
Finally, getting to the question in my headline, the current saving rate out of disposable income is 5 percent. This is lower than we ever saw until the stock wealth effect in the late 1990s pushed it down to 4.4 percent in 1999, it hit 4.2 percent in 2000. The saving rate rose again following the collapse of the stock bubble, but then fell to 3.0 percent in 2007. The question then for our debt fans is what they think the saving rate would be absent another bubble, if we eliminated all the negative equity.
Baker is very smart and reality based, but he only discusses two components of aggregate demand, consumption and net exports. Consumption has, indeed, recovered. The anomalies are in government purchases of goods and services and residential investment. As I recall, your version of the debt story is that mortgage finance remains blocked. This is not a story about consumption by households burdened by mortgages and the counterfactual does not involve a lower estimated savings rate.
I do not entirely share your view that changes in mortgage finance are the cause of low residential investment. It could be that lending standards remain extraordinarily tight on the once burnt twice shy principal. But it could also be that the perceived user cost of owner occupied housing is extraordinarily high because the forecast relative appreciation of house prices is extraordinarily low (Shiller argues that it is also accurate, but certainly lower than it was for decades).
Back to Baker: I think he has trouble communicating with many economists exactly because he is reality based. His argument is based on the empirical regularity that the aggregate consumption time series is well fit mostly be disposable income and then by wealth including stock and housing wealth. Most economists consider the correlation of housing wealth and consumption an anomaly. High house prices imply both wealth and a high cost of housing services. The effects should roughly cancel. High house prices should cause high measured consumption (measured because not including consumption of owner occupied housing services) by causing people to substitute out of housing. In fact, they are correlated with high residential investment.
A simple model of rational inter-temporal utility maximization without liquidity constraints doesn’t fit the data at all. The immediate reaction of many economists is to conclude that the key issue must be liquidity constraints. I tend to suspect that Baker has no problem with assuming people are irrational and that high house prices make home owners feel richer even if they have no intention to sell and do not make young people who don’t own a house and will buy one eventually feel poorer. In any case, that’s what I believe. but no one should be surprised that most economists aren’t attracted to a simple story which depends on irrationality.
The “once burnt twice shy principle” is certainly a factor and is part of the residential investment problem, many of those factors are included above. And quite frankly this will be a problem until the banks convince the regulators to further emasculate Dodd-Frank, and to get them to redefine reps and warranties violations and reduce the penalties for those violations(they are lobbying right now for that).
But I think residential investment will never(OK, not never but for a long time) approach the trend line. And I think a major factor in that is what we have done(and continue to do) to the young buyers.
Think of these kids that got out of school in 2008. They are now 30 years old. They have experienced a horrific job market since leaving school, and though things have improved lately, we are still 3% below the trend line of the population that is working. And let’s not even talk about wages. Or worse, student loan debt. And the same holds true for those that left school in 2009……. and 2010…….. And 2011…and let me know when I can stop……
We are building a generation of Americans that simply cannot invest in housing. And I see no end to that problem.
The housing bubble which preceded the crisis in 2008-2009, was the last gasp before depression. If Federal Deposit Insurance, Unemployment Insurance, Social Security and other depression era programs had not existed, we would have recognized it as another Great Depression.
First and foremost the housing bubble enabled borrowing in a rather massive way. You could purchase much more home than than your income could possibly justify because your loan was in demand. Also, you could easily refinance at any time, taking equity out of your home to pay off other debts because your loan was in demand.
Your loan was in demand because investment bankers could package your loan with others into mortgage back securities and sell them, while collecting fees for themselves. Your loan being in demand meant that appraisers who would not play ball would find themselves out of work. Your loan being in demand meant that your financial information would be carefully altered or ignored. Subprime loans, adjustable rate loans which could adjust after 2 years and move by 3%, and the failure to demand documentation of income for 3 or 5 years, all enabled consumers to supplement their incomes beyond any reason.
Lower and lower interest rates, and higher and higher appraisals kept the housing bubble building. The primary lasting effect on consumers has been huge debt loads.
Total household debt went from $4.54Trillion in the 1st qtr 1999 to $12.675trillion in 3rd qtr 2008. That was an increase by a factor of 2.8 times in 9 years. See this page: http://www.newyorkfed.org/microeconomics/data.html
Since 2008, total household debt has seen much smaller movements and it had fallen to $11.827trillion at the end of 3rd qtr of 2014. (After 6 years had passed.) It seems obvious to me that in the aggregate, households had exhausted their ability to borrow.
Arguing about wealth effect and savings is unnecessary in light of that massive growth in debt.
In a November 1930 issue of Quarterly Journal of Economics, Professor Charles E Persons documented the rise in consumption of new or lower costs consumer products, and the resultant growth of debt in the economy. He was careful not to jump to rash conclusions but he warned that now that the new credit channels were filled, the consumer would be forced to live off of current income. (And I would add, make payments on their loans.)
Note: “Credit Expansion, 1920 to 1929, and its lessons” by Charles E Persons is not easy to find but it is worth the effort.
In 1932, Professor Irving Fisher wrote “Booms and Depressions”, and in 1933 he wrote “The Debt-Deflation theory of Great Depressions”. In those he warns that over indebtedness first and deflation second were the primary causes of the Great Depression. I would argue that the over indebtedness caused the deflation. (Consumers can not spend what they do not have.)
Note: A google search will find both of these at the St Louis FED.
Alan Greenspan and James Kennedy published a study titled “Sources and Uses of Equity Extracted from Homes“ That study documented the higher personal consumption expenditures (PCE) enabled by the extraction of equity from the consumers’ homes. This study covered the period of 1991 to 2005 but the trend continued until at least 2007.
So the question is, what drove modern consumers to borrow against equity for over 15 years?
Notice that this period coincides with a period of stagnant domestic wages, and rapidly increasing foreign trade deficits as there was less domestic production.
And it also coincides with a period when the ‘boomers’ expenses were increasing as their children got older.
Sometimes people do irrational things, but assuming that they would be consciously reckless with their largest asset, seems irrational to me.