why should there be a “wealth effect” at all? If the price of my house falls and I suffer a capital loss, I do in fact feel less wealthy. But all potential buyers of my house just gained the opportunity to obtain my house at a lower price. For them, the implied wealth gain is the same as my loss. If buyers and sellers essentially behave the same way, why should there be a large impact on consumption?
This was the crux of his blog post, although he later crossed it out because a colleague suggested it was oversimplified. Pointer from Mark Thoma.
Some comments:
1. When land prices rise, we are looking for asymmetries between the behavior of the winners from higher land prices (home owners) and the losers from higher land prices (non-owners). Conversely, when land prices fall, the winners are non-owners and the losers are owners. If the winners and losers behave symmetrically, then the effect on overall consumption should not be large.
2. As Altig points out, it could be that access to credit behaves asymmetrically. Owners experience large swings in access to credit to finance consumption via home-equity extractions, while non-owners do not experience such swings.
3. There may be a Shillerian channel, based on expectations of house price changes. That is, the effect of past changes in house prices is symmetric. However, as prices rise, owners tend to be people with high expectations for future price increases. They expect their wealth to rise, and they spend some of these anticipated gains. If non-owners had similar expectations of rising land prices and were symmetrically concerned about future increases in their living costs as a result, then they would save more. But they are not symmetrically concerned.
4. If we get out of the AS-AD framework and into the PSST framework, a broad-based land-price bubble might be less distorting than an uneven land-price bubble. A broad-based bubble creates too many real estate agents, mortgage loan officers, and homebuilders. An uneven bubble causes all sorts of ancillary businesses to locate differently. Entrepreneurs open restaurants and high-end shopping centers in booming areas*, and then when the bubble bursts they are stuck with bad investments.
*But why are they not closing such businesses in lagging areas?
One thing I never hear anyone acknowledge is just how much capital has flowed into improvements to residential real estate (and maybe commercial real estate too). My generation behaves very differently than our parents did. Is there a valuation bubble, or has there been just too much investment in home improvements? I’m guessing these issues are driven much more by too many granite counter-tops than by unrealistic valuations.
There are owners and non owners, but also soon to be owners and soon to be non owners. Rising prices favor owners and soon to be non owners, and impress on soon to be owners the necessity of buying sooner or paying more. Other non owners are oblivious as the price that matter to them are rents. Only if rents rise are they impacted and as more investment returns are expected from appreciation, rents will fail to represent higher prices. Falling prices diminish prospects for owners and soon to be non owners to extract wealth and reinvestment returns, and impress on soon to be non owners the urgency of selling and on soon to be owners the option to wait and pay less. Other non owners will only see this as larger numbers of would be owners delay increasing rents which is also bad for them, so falling prices are good only for the small number of delaying soon to be owners who if they delay long enough also face rising rents. Falling prices have no benefit to those not intending to buy and will eventually be worse off when the bottom is reached and rents begin to rise.
All land bubbles are uneven with high growth metropolises and no growth rural areas, but some are larger, incorporating more areas for a longer period of time, and some smaller and shorter. Business lags residential so usually haven’t over invested to the same degree by the time the bubble bursts. Granite is expensive if you are paying $5/sf for land, cheap when paying $100/sf.
@Lord has part of it. Simple observation – owners buy houses at fixed prices, with fixed or constrained debt service. When the apparent market value of the house goes up, it looks and feels like a gain on a long capital trade. Renters see current market rental rates (outside of rent control areas) regardless, and don’t care. Incoming buyers see the better consumption value of a house and care about the price, and are probably unaffected by any wealth effect.
So in some sense, RE prices are a kind of funky version of the stock market wealth effect.
I will note that rentals, long term leases, ownership with debt, and outright ownership, are NOT fungible – the strenght of the stake increases in that order.
Your #3 gets to the psychological issue.
It is the ** direction** of asset prices which set the “tone” of attitudes, and those assets having the higher rates of transfers (transactions – market activity) have the wider effects.
I would suggest that this passage towards the end of the David Altig piece is vastly more significant than most realize with regards to the current anemic pace of recovery …
“But it is also possible that we have entered a period of deep structural repair that only time (and not merely government stimulus) can (or should) engineer: deleveraging and balance sheet repair, sectoral resource reallocation, new consumption habits, new business models driven by both market and regulatory imperatives, you name it.”