There is an emerging consensus that housing is weighing down the U.S. economy. The Federal Reserve’s housing white paper in January declared that “ongoing problems in the U.S. market continue to impede the economic recovery.” The 2012 Economic Report of the President argued that “declines in housing wealth can have a far greater effect on the economy than equivalent losses in other financial assets.”
Are these arguments sensible? Why should declines in house prices affect the broader economy? And why should the drop in housing wealth matter more than, say, a drop in stock-market wealth?
The key to understanding these questions is a four-letter word: debt.
In the absence of debt, economic theory tells us that house-price declines should have a negligible impact on aggregate output. To understand this argument, imagine a young recently married couple who own a one-bedroom condominium. They plan to start a family soon, and are looking to buy a bigger, more expensive house in the same neighborhood in the next few years.
Given their plan to upsize, a decline in house prices in the neighborhood makes them unambiguously “richer.” In the parlance of finance, the young couple are “short” housing services, and are better off when the price of such services declines.
The point is general: Housing is a service we must all consume, whether we rent or own. A decline in the price of housing services is a good thing for those of us who plan on increasing our consumption. If my home value declines, I should only feel poorer if I was planning to decrease my consumption of housing services or moving to a less expensive area.
So from a macroeconomic perspective, in a world without mortgages, falling house prices would have negligible aggregate effects. Some households would be richer and some would be poorer. But there is no reason to believe that there would be a large aggregate “housing-wealth effect.”
So why is housing holding back the economy? It is because most homeowners use substantial amounts of debt to purchase houses. Once we acknowledge that housing is a highly leveraged sector, the conclusions of the theory are totally different. In this case, there are a number of reasons why house-price declines will affect household spending.
First, the collateral value of housing is extremely important. Households can only borrow at a 3.9 percent, 30-year fixed rate if they have home value to back the loan. A severe decline in house prices takes away this channel.
Second, the debt associated with homes means a higher rate of defaulting households. This leads to lower credit scores and more foreclosures, both of which have negative effects on household spending.
And third, even for households that choose to continue paying their mortgages, the decline in home values will lead to deleveraging as homeowners struggle to improve their financial position.
The evidence overwhelmingly supports the view that high debt levels are the central reason that house-price declines negatively affect household spending. For example, our research shows that for a given drop in home value, a household cuts back on auto purchases much more if it is highly leveraged. We also find that the reductions in household spending in counties experiencing large house-price declines are far too large to be explained by a housing-wealth effect alone.
Another useful tool is to compare the drop in wealth due to housing post-2007 with the decline in stock-market wealth when the dot-com bubble burst in the early 2000s. The housing collapse has wiped out about $6 trillion in wealth. The dot-com meltdown resulted in a comparable loss of $5.5 trillion in wealth. Yet the bursting of the Internet bubble wasn’t as disruptive for aggregate spending. Why? Because the loss of value in the dot-com bust wasn’t associated with a highly leveraged sector.
Prominent macroeconomists and journalists have argued that house-price declines alone can explain weak household spending, even in the absence of any issues related to debt or deleveraging. This argument doesn’t make sense theoretically, and we shouldn’t be surprised that the data don’t support it. In the absence of debt, there is no way a decline in house prices would explain the magnitude of the reduction in household spending in some of the hardest-hit areas of the country.
And importantly, this distinction matters for policy. If one mistakenly believes that housing-wealth effects have nothing to do with debt levels, then the only policy solutions are those that attempt to artificially boost house-price growth. One such policy was the homebuyers’ tax credit, which was extremely costly and only temporarily prevented price declines.
In contrast, when one acknowledges the importance of debt, policies aimed at reducing refinancing frictions and restructuring “underwater” mortgages via principal reduction make a lot more sense.
(Atif Mian is professor of economics, finance and real estate at the Haas School of Business at the University of California, Berkeley. Amir Sufi is professor of finance at the University of Chicago Booth School of Business and a contributor to Business Class. The opinions expressed are their own.)
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