Wealth effects

The concept of "wealth effects" has come up twice so far in my senior seminar. Wealth effects are an important factor in two big macroeconomic issues confronting the US economy: the housing market and the value of the dollar. Regarding the housing market, one often comes across commentators noting that a decline in home prices will reduce household wealth, therefore reducing consumption spending and threatening a recession. Regarding the value of the dollar, the argument one sometimes hears is that a depreciation of the dollar (widely expected because of our large trade deficit) would reduce Americans' wealth as well, with the same effects on consumption and GDP. On further reflection, however, neither of these arguments is quite right.

As far as the housing market argument goes, the effect of a decline in home prices depends on how you define wealth. Most economists would treat the value of a person's home as an asset on that person's balance sheet, but in addition consider the present value of rental payments (explicit or implicit) over that person's lifetime as a liability. Suppose I own a house worth $200,000. Now the price of the house (and all others like it) goes up to $300,000 - am I wealthier? Not necessarily, because though I can sell the house and pocket a $100,000 profit, I need to live somewhere. I could rent a house identical to the one I just sold, but in principle rents should rise proportionally to the increase in the price of houses (otherwise landlords wouldn't be able to cover their mortgage costs), and the present value of the increased rent over the course of my life should just offset the profit I made from sale of my home. I could buy an equivalent house, but I'd just have to pay an additional $100,000 for that house (which covers the implicit rental cost that I need to pay), so I still do not come out ahead. So while an increase in the price of my house relative the the price of other houses may increase my wealth, an increase in the average price of houses across the board does not increase households' wealth in the aggregate. Likewise, a decrease in average housing prices does not decrease wealth, does not decrease consumption, and does not contribute to recessionary forces.

When do wealth effects in the housing market matter? Suppose I currently own a 2000 square foot house, but because I'm old and my kids have left the nest, I plan on moving to a smaller house in the future. An economist would say I am "long" in the housing market (a "long" position is a constellation of asset and liability holdings with which a person stands to gain by an increase in prices). The reason is, I could sell my 2000 square foot house for $300,000, then buy a 1000 square house for $150,000, for a net gain of $150,000. The higher the average price of a house, the higher the net gain. On the other hand, if I am young with a growing family and my high income years are ahead of me, I'm probably "short" in the housing market - an increase in the average price of homes increases my liabilities (the future rental payments I need to pay) by more than it increases my assets.

The upshot of this way of looking at wealth effects in the housing market is that while a drop in average home prices has distributional effects (it benefits the young at the expense of the old, for example), it does not have a big effect on aggregate wealth, hence aggregate consumption; therefore we need not worry that a bursting of the housing market bubble will lead to recession.

There are two important caveats to this argument, however. One is that it's possible that Americans in the aggregate are short in the housing market. Between 1975 and 2005, the average size of a new home increased from 1645 square feet to 2434 square feet. To the extent that trend is expected to continue, we are on average short in the housing market, and a fall in prices actually increases our wealth in the aggregate - the collapse of housing prices could actually stimulate the economy!

On the other hand, there's an effect that is probably more powerful working in the opposite direction. One thing that rising housing prices did over the last five or ten years was to relax borrowing constraints for a large number of households. Young upwardly mobile people would like to borrow off their future income in order to achieve a high standard of living now rather than living in (relative) poverty until that big promotion. They are often unable to do so, however, because banks and financial markets are unwilling to lend large amounts of money unless the borrower has collateral (people can and do borrow using credit cards, but at a very high rate of interest). An increase in housing prices increases the equity homeowners have in their homes, giving them collateral that can be the basis of a home equity loan. Thus the runup in housing prices allowed lots of households to increase their consumption. A decline in housing prices would reimpose the borrowing constraint (very severely for those who bought at the peak of the market), which would reduce aggregate consumption and raise the risk of a recession.

So the lesson is that the effects of the crash of the housing bubble are not cut and dried. The distributional effects are perhaps more important (and more interesting) than the aggregate effects.

The argument concerning the effect of a depreciation of the dollar is also misguided. The issue here is that the U.S. is a net debtor to the rest of the world (foreigners own about $2.6 trillion more in U.S. assets than Americans own of foreign assets). About 70% of U.S. holdings of foreign assets are in foreign currencies, while about 95% of foreign holdings of U.S. assets are denominated in dollars. Let's do the math. Americans own about $11 trillion of foreign assets when measured at market value, roughly $3.3 trillion in dollars and $7.7 trillion in foreign currencies. Foreigners own about $13.6 trillion in US assets, roughly $12.92 trillion in dollars and $680 billion in foreign currencies. So considering only dollar assets our net worth is $3.3 trillion - $12.92 trillion = -$9.62 trillion; considering only foreign currencies our net worth is $7.7 trillion - $680 billion = $7.02 trillion. In the aggregate, US residents have a short position in dollars. Suppose the dollar fell by 30% against foreign currencies (this is in the range of most estimates of what would be required to bring our trade deficit close to a sustainable level). This does nothing to our -$9.62 trillion net position in dollars, but raises the value of our net foreign currency holdings to $7.02*1.3 = $9.13 trillion. Our original net investment position of -$2.6 trillion has been shrunk to -$490 billion! We've made out like bandits!

Consequently, a large depreciation of the dollar would have a significant positive effect on American households' net worth (in addition to its stimulative effect on net exports), and therefore could be expected to increase consumption and stimulate the economy. A dollar crash is not to be feared, but welcomed.

Again, the caveats. There are a number of other ways a crash in the dollar could harm the U.S. economy: for example, we have no idea how many bets hedge funds have made on a strong dollar; a decline in the value of the dollar could sink a couple of big hedge funds that owe money to large US banks, causing a financial crisis like the one that almost occurred in 1998 when Long Term Capital Management went under. Also, a crash in the dollar would threaten the dollar's role as a reserve currency in the future. The US economy has benefitted tremendously from the fact that foreign central banks like to hold dollars to support their currencies. If the dollar's value becomes suspect, central banks may choose to hold euros or yen instead of dollars. If that happens, demand for US assets (especially Treasury securities) falls, interest rates rise, and the US has a harder time sustaining the high level of consumption spending to which we have become accustomed. The long-term adverse impact of a dollar crash could outweigh the short-term benefits.

The lesson: no lesson. Just, "ain't economics interesting?"