Monday, December 15, 2008

Drop in Housing Values and Consumption Demand

CNNMoney reports:

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 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.

1 comment:

Anonymous said...

Interesting post pgl and I need to ask some simple questions here to wrap my head around the magnitudes of the boost you (and me too) think we will need from government spending.
Leaving alone the assumption that a $1 GDP decline leads to a $0.05 decline in consumption, would it B worthwhile to measure the recent performance of GDP and house prices, say from 1990...note the lag, consumption/GDP, housing related consumption/consumption and get a range of values and possibly a trend for this..instead of your ballpark $0.05?
Secondly, given the revaluations in the Finance sector, is there a way to back the previously registered GDP values to the new, and lower values? Or izit just built in: wealth creation is fine, but wealth destruction is heresy?
Thirdly, and lastly for now, does the distribution of wealth impinge on this relationship, no matter how accurately we wish to pin down $1 GDP loss causes $X loss of consumption? If the GDP decline is due to a wealthy few houses burning down does that result in more or less decline in consumption than a thousand cheap houses?
Ok, keep up the good work.