Thursday, July 24, 2014

Ivory Tower Economics

Here’s a sterling example of the manner in which economists are disconnected from the real world. They sit in their ivory towers and totally ignorant as to how real people live, and therefor do not have the slightest clue of what they are talking about. Dean Baker is talking today about the “wealth effect” of housing on consumer spending, and he says,

If a homeowner owed $100,000 on a home whose price dropped from $300,000 to $200,000 (leaving them with $100,000 in equity), we would expect them to cut back annual consumption on average by between $5,000 and $7,000.

Oh really? Why would you expect that, Dean, and why that amount?

The “we” there is presumably him and Paul Krugman, because any person who works for wages and owns a house with such a mortgage would not really expect that homeowner’s consumption to change at all. Those of us who live in the real world know that the equity in our homes cannot be spent until we take that equity out of our homes. I have no earthly idea where Baker gets the idea that someone will spend $5000 to $7000 more per year, regardless of income, simply because of untapped equity in his house.

My wife and I may or may not be typical, probably aren’t, but the equity in our home went from about $50,000 when we bought it, to about $400,000 at the peak of the market, and then down to about $280,000 at the 2008 slump. Want to know how much our spending habits changed throughout those fluctuations? Right. Zilch.

The “wealth effect” of overvalued houses was not that people would spend a lot of money merely because they had a high-priced house, as Dean Baker seems to think. The effect was caused by people taking that equity out of their houses in the form of refinancing and second mortgages and using that money for consumer spending.

The reduction of spending when home values collapsed was not due to some sort of psychological trauma inflicted on the homeowners involved; it was the result of there being no more equity available to take out in the form of spendable cash. If Dean Baker would come out of his ivory tower and meet some real people, he would know that.

1 comment:

bruce said...

If the homeowner owed $250,000 on this house, so the drop in price left them $50,000 underwater, then their decline in annual consumption may be somewhat greater....

Technically, it's drop in value, not price. Also, Would their consumption actually go down as a result of the underwater status? Maybe, if they had a variable interest loan, then their payment would dgo up. If it was fixed rate, nothing is changed spending wise. (caveat - I'm not a homeowner, so there could be variables I'm not aware of).

I maintain that the downturn was a combination of many factors - public, private, political and business, and thus any "solution" will include all of that as well. I do not include Rapunzel economists in that.

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