American homeowners will collectively lose more than $2 trillion in home value by the end of 2008, according to a report released Monday. The real estate Web site Zillow.com calculated that home values have dropped 8.4% year-over-year during the first three quarters of 2008, compared with the same period of 2007.
Life-cycle models of consumption tend to suggest that a drop in wealth would lead to a decline in consumption. If one assumed that each $1 decline in wealth leads to a $0.05 decline in consumption, this $2 trillion estimated decline would mean a $100 billion decline in consumption. Real consumption (all figures 2000$) declined by almost $80 billion on an annualized basis last quarter. Since 2006QIV, consumption has increased by only $142.2 billion per year even though real GDP increased by $355.9 billion. Had the ratio of consumption to GDP remained at its 2006QIV level of 71.5 percent, we would be seeing an additional $112 billion in consumption demand.
Maybe a rise in savings might be seen as a good thing if investment demand were also rising, but currently the fall in investment demand is so large that it is largely wiping out the progress in export demand. As private consumption declines, we will need a boost from government purchases if we are to avoid what Keynes called the paradox of thrift.
Speaking of the paradox of thrift – check out this cartoon with hat tip to an Angrybear.