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Don't worry, they'll just slash interest rates to -4% and pay people to buy houses. As long as house prices keep going up, our debt-fuelled bubble economy is *fine*.

According to this report from CAAMP http://www.caamp.org/meloncms/media/Fall%20Consumer%20Report%20WEB.pdf, we can find at page 28 that 46 billions were borrowed last year as HELOC. Close to half of borrowers (45%)responded that the money would be used for debt consolidation or repayment. So today we can say that we borrow for our daily consumption and we mortgage it for 30 years.

When I was young, a fair proportion of the people were paying their car cash. 10-15 years later, they were using the value of their old paid car against a rented car. Another 10 years and the whole car was financed.

All this happen during 30 years of lowering interest rates. They cannot go very much lower (inflation could...).

We also have a stock market worth at least 5X what it was worth in 1980 when the average salary went up 2-3X. Housing is +/- 6X what it was in 1980.

How can all this be sustainable?

The net worth is based on 2 major items - housing and pension funds. Both are at historic high when compared with the average salary.

For me, this is a gigantic house of cards.

I think wealth effects were traditionally viewed as small because these estimates were derived calibrating models poorly suited for this purpose, not because the wealth effects were actually small.

See, for instance, //econ.jhu.edu/people/ccarroll/papers/cosWealthEffects.pdf

"we estimate that the immediate (next-quarter) marginal propensity to consume from a $1 change in housing wealth is about 2 cents, with a final eventual effect around 9 cents, substantially larger than the effect of shocks to financial wealth."

Given that housing accounts for about 60 Trillion in assets in the U.S., a 30% drop in house prices should lead to a 1.62 Trillion loss in demand, taking into account the initial shock and follow on effects.

Moreover, the effect of wealth effects depends very heavily on the distribution of wealth and on leverage.

If you have $2 million, then a change in asset prices making that $1.7 million isn't going to change your consumption a whole lot. But if you've been counting on selling your house to fund your retirement, and your equity declines from $300,000 to 0, then that will change your consumption. In both cases, the incidence of who suffers the loss and their balance sheet state makes a big difference in the aggregate response to a change in wealth.

You can see this by comparing the 2000 stock market crash with the 2008 housing crash. Most households hold very little of their savings in equities, but much in houses, whereas the wealthy tend to hold most of their savings in equities. A hit to equities leaving housing wealth untouched will have a much smaller effect on consumption than a hit to housing wealth.

Finally, households, if they borrow without collateral, are forced to pay the credit card interest rate, not the risk free rate. So as market wealth drops to zero for marginal households, they hit up against credit constraints, whereas typical models assume no credit constraints. Moreover, if market wealth does drop to zero, then in the presence of employment risk, households will choose to not borrow, even if they could borrow at the risk free rate, unless they have some guaranteed form of income with which they can repay the loan should they not be employed in the next period.

So wealth effects play a large role in the economy if you know where to look and which model to use. Look at housing wealth, and use a lifecycle savings model that takes into account a very unequal distribution of wealth, employment risk and credit constraints.

Just prior to the crisis, net home equity lines of credit withdrawals were 10% of household disposable income. After the decline in house prices, net HELOC withdrawals swung to a negative position (meaning that households were repaying their HELOC balances).

That alone accounts for about a 10% change in private sector demand.

It won't just be a wealth effect if housing slows down, residential investment will plunge, along with all the other related industries (home reno, mortgage brokers, banks, etc.), not to mention the impact on the money supply if banks can't keep printing money via mortgages, plus the loss of labour mobility once people are underwater, plus banks pulling back on other types of lending to lick housing related wounds, and I'm sure I'm forgetting other impacts.

Net worth is often less what official statistics would suggest because banks and other financial institutions sometimes don't write down the value of their assets as much as they should (so-called extend and pretend).

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