Friday, September 19, 2008

There is a real economy out there: Housing equity set to slaughter consumption

While the financial system is being nurtured back to health by a government that is now confused with Venezuela’s, there is a real economy out there that is just waiting in line for slaughter. I am still not sure whether or not the U.S. is in a recession (nobody is really, and it is certainly not a trivial matter), but one thing is for sure, there is a big and heavy hiking boot that may soon drop (to get away from the shoe metaphor).

Paulson and Bernanke have seriously gone off of the deep end, and there seems to be no end in sight to their plights to save the world. But what they can’t do, and what they want most desperately to do, is to halt the historical correction in the U.S. housing market. Securities backed by bad mortgages are wreaking havoc all across the world, and so much so, that they have forced the Fed and the U.S. Treasury to cry uncle!

Housing wealth has plummeted for two consecutive quarters, and a nasty wealth effect is just waiting to kill consumption.

The statistical impact of wealth on consumption (wealth effect) is rather controversial, as there is no strong evidence to support or deny it. Theoretically, an increase in wealth (assets minus liabilities) will raise consumption with the new stock of resources available for lifetime consumption (more money, at least on paper); this positive wealth effect reduces personal saving since saving is measured as income minus consumption. On the other hand, a reduction in wealth will lower consumption; this negative wealth effect increases personal saving. Falling consumption can greatly reduce economic growth, since it accounts for 70% of measured GDP.

It is not uncommon to see household wealth falls precipitously during a recession with plummeting financial asset values (see chart 2). However, it is uncommon for real estate wealth to turn negative.

Real estate equity has not gone negative on an annual basis since 1952! In the first quarter of 2008, households lost -1.7% in home equity, and in the second quarter of 2008, households lost a whopping 3.6%. Even in the last housing correction, real estate equity slowed to the 2%-3% range, but never turned negative.

Since home values are not expected to stabilize until well into 2009 (simply hit bottom, rising thereafter) (also stated in an interview with Alan Greenspan), home equity will continue to decline. It’s just a matter of time before negative wealth effects really start to drag down economic growth. At any rate, who says that they haven’t already?

This chart plots the personal saving rate (monthly series converted to quarterly) against household and nonprofit net worth (wealth). In the second quarter of 2008, households and nonprofit wealth tumbled 3.5% since last year. At the same time, saving surged from its laughable 0.9% average 2004-2007 to 2.5%. Net worth is tumbling with home equity since real estate owns a large share of household wealth and saving is rising: Negative wealth effect.

If this is the function of a negative wealth effect, then expect a precipitous drop in consumption going forward. The third quarter may still be strong, but a sharp decline in fourth quarter 2008 consumption is on the horizon, which will continue into 2009.

Some may say that the saving rate surged due to the government’s famous/infamous 2008 stimulus act. Martin Feldstein argued quite convincingly that it failed to stimulate consumer spending, and had the unintended effect of increasing consumer saving. Without the needless government intervention, transferring money for spending or saving, we would have a better idea of the actual wealth effects in play. However, one thing seems certain, if home equity continues to decline, negative wealth effects will surely emerge, which does not bode well for the real economy through 2009.

A final note: Regarding events of late, I concur with Mish’s Global Economic Trend Analysis, Peak Insanity: SEC Plans to Temporarily Ban Short-Selling,” and with Nouriel Roubini’s post, The transformation of the USA into the USSRA (United Socialist State Republic of America) continues at full speed with the nationalization of AIG. Both articles paint a very vivid picture regarding the onslaught of government nationalization, regulation, whatever you call it – intervention – in world (and I stress world, here) financial markets.

Rebecca Wilder

1 comment:

  1. I think part of people's thinking was that home ownership was savings; my home is my pot of gold for the future. Too bad the pot of gold is shrinking. The "Peak Insanity" column is prophetic - love the partial list of participants in the debacle.