What if it's a Wealth Shock?
By Arnold Kling
For a different and important perspective on the financial crisis, I want to draw your attention to Robert Merton’s remarks at Thursday’s Harvard forum, linked to here. The Nobel Laureate begins with a back-of-the-envelope calculation. Data suggest that between June of 2007 and June of 2008, average home prices in the U.S. fell by 16 to 18 percent. Near the peak of the housing market, total housing wealth was between $20 and $23 trillion.
Simple multiplication says that we have lost somewhere around $3.5 to $4 trillion. As Merton says,
When you have this wealth loss, nothing that’s done here will resurrect it.
On top of that, not mentioned by Merton but alluded to by Rogoff, there is the drop in wealth represented by the decline in the dollar. Marking our assets to world prices, a lower dollar lowers our wealth. Furthermore, Rogoff and other economists believe that the dollar decline has further to go.
As an aside, for those of you who think that the Fed can solve the problem by “defending the dollar,” that is simply wrong. The Fed can defend the nominal value of the dollar, but not its real value. The only thing that the Fed can defend is the rate at which dollars exchange for euros. It cannot defend the rate at which dollars exchange for French wine or Italian shoes. The view of Rogoff and others is that our trade deficit represents a subsidy to American consumption from foreign savers, and eventually that has to be reversed. When it does, the cost of foreign goods will rise, regardless of what the Fed does. We will experience that as a decline in wealth.
So, we have these two big wealth shocks underway–a decline in our purchasing power on world markets and a decline in home values. This is in addition to the increase in liquidity preference that is what we are calling the “financial crisis.”
Now, let’s turn to the bailout. If we focus on the liquidity preference shock, the bailout can be viewed as an attempt to counteract the flight to the safety of Treasury bills.
In the alternative narrative of a wealth shock, all of us have suffered a loss of wealth, but the financial sector is feeling it first. In part, this is because the financial sector is particularly sensitive, because folks in that industry recalculate their net worth daily, if not hourly or by the minute. In part, this is because they are just smarter than the average American.
Of the $3.5 to $4.0 trillion in wealth that has been lost, only a small fraction is reflected in losses on mortgage securities. The rest of the loss has been incurred by home owners. On top of that, ordinary Americans face the ongoing loss of wealth from the likely rise of foreign goods prices.
But the bailout is a transfer from ordinary Americans to the holders of mortgage securities. That is like giving rich people priority access to lifeboats on the Titanic. At some point, ordinary Americans are going to figure that out, and there will be hell to pay.
If we implement the Paulson plan, we will make the wealth shock more painful for ordinary Americans. The Democrats’ approach for offsetting that is to try socialism (government taking equity in financial firms, etc.) Socialism will destroy even more wealth.
I do not deny that we are experiencing a liquidity preference shock. But we must reject the bailout as an inefficient and inequitable attempt for addressing it.
The down side of rejecting all variations on the Paulson plan is that the Paulson plan is a “focal point.” If we start from scratch, it will take time to forge a consensus. But I strongly believe that the risks of delay are less serious than the risks of doing something as awful as what has been proposed. The Bush Administration has made such a bad opening proposal that it should not serve as a focal point.
My preference would be to keep doing ad hoc crisis management until the next Administration. Meanwhile, let various experts develop and evaluate alternative proposals.