What if it's a Wealth Shock?
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.
Sep 28 2008 at 4:49am
What exactly do you mean when you say that wealth has been lost? Isn’t the loss to homeowners due to a reduction in home values offset exactly by the benefit to whoever ends up buying it?
Sep 28 2008 at 7:36am
Wasn’t the decrease in wealth when the dot com bubble burst of roughly the same magnitude? If so, why the difference in the wealth effect then and now?
Sep 28 2008 at 8:14am
How have you managed to write so much nonsense in one post?
Think again about the wealth effect you talk about. The only significant cause of a negative wealth effect has been the 20-25% decline in stock prices, but this has followed the positive effect of 2002-6 (there has been neither a positive nor a negative wealth effect from housing or from any durable consumption good, and there has been no wealth effect from changes in exchange rates–only changes in relative prices).
You limit the financial crisis to the increase in liquidity preference. You know that for many people, firms and financial institutions is more than that. Politicians know that it is more than that and they see either a threat to their position or an opportunity to improve their position.
And you argue that the bailout amounts to a transfer of funds to rich people and compare this transfer to access to the Titanic’s lifeboats. I have expected this rhetoric from Dodd, Obama, Pelosi or even McCain. But from you?
Sep 28 2008 at 8:37am
I agree with Brandon (and disagree with Merton). Where’s the mistake in this line of reasoning:
The flow of “housing services” available in the economy hasn’t changed significantly; all that’s changed is that the consumption opportunity set of those who were planning on decreasing their consumption of housing services has shrunk, and the C.O.S of those who were planning on increasing their consumption of housing services has become larger.
There surely has been a loss of wealth associated with the misallocation of resources into the housing sector, but I don’t think you can equate that with the decline in market value of houses.
Sep 28 2008 at 8:57am
Its all very dandy but we are having a panic, a massive nervous breakdown, a general run on the banks, that can easily develope inin the closing down of all financial institutions and cause lasting psychological damage to the American consumer and saver. People may start digging holes in the night and store gold coins in the garden.
Sep 28 2008 at 9:25am
Re; “At some point, ordinary Americans are going to figure that out, and there will be hell to pay.”
I’m pretty ordinary, and I figured it out the first time I saw Paulson open his mouth. But there will be no hell to pay. Ordinary Americans are being shown who really runs the country, but they are so thoroughly indoctrinated that they will just find a way to fit it into their favorite political understanding.
Sep 28 2008 at 11:33am
It seems to me that the $3.5 – $4 trillion is not a real wealth loss, and only a small fraction of the population has been affected. There was a housing bubble… that was illusory wealth, not real. House prices are still only down the level of a few years ago. The only people with real losses are those who bought at the top of the bubble; that surely is much less loss than $3.5 – $4 trillion.
Sep 28 2008 at 12:16pm
The decline in house prices since mid-2007 is about equal to the rise in house prices over the previous two years. It’s absurd to call this decline “a big wealth shock”. Rather, it’s a case of easy come, easy go.
The decline in the value of the dollar isn’t a “wealth shock” either because (a) the bulk of a US consumer’s expenditures are for non-importable goods and services, and (b) the price of a whole lot of importable goods has been declining in real terms due to rising manufacturing productivity worldwide especially in Asia. Everybody who’s shopped at Target and WalMart knows shoes, clothes, computers, children’s toys, kitchen utensils, etc., are no more expensive today than they were in 2002 notwithstandng the fall in the dollar exchange rate, and indeed quite a few goods are actually cheaper today.
I’ve been finding Arnold educational on this “crisis” and generally agreeing with his prescriptions. But there aint no wealth shock, except for the mortgage derivatives people. And those people should go to the wall.
Sep 28 2008 at 12:47pm
Like many of the commenters, I did not think that when houses in my neighborhood were selling for $600,000 that I should count on that being the value of my house.
But a lot of people did. You hear the phrase “using their houses like ATM machines.” Also, think of all the people who bought houses near the top. Remember, it’s the nature of a Ponzi scheme that a lot more people get involved at the very end than at the very beginning.
Finally, the drop in home values may not be over. My mental model is that my house is worth $400,000 instead of $600,000, but if I tried to sell it today I might not be able to get even that much. Nobody knows what it will take to restore equilibrium. And nobody will as long as the anti-foreclosure movement in Congress is so strong and effective.
Sep 28 2008 at 1:49pm
YES. I agree. I dunno about the other commenters, but I think houses are very overpriced. Paulson doesn’t, apparently commenters here don’t… But there was a huge wealth bubble.
Gosh, it’s not a coincidence that it is similar to the dot com bubble — all the people who lost in that ran to real estate as their savior. They are *connected*. The real estate housing bubble is an extension of the dot com crash. It accelerated what was already happening as people panicked.
Sep 28 2008 at 4:30pm
I was just re-reading Chapter 8 of Brian’s book, in which he asserts that there aren’t really any market fundamentalists out there in the economics profession:
But you, his very cohort, give us this:
If fundamentalism means accepting propositions based on faith rather than evidence, this bald, unsupported statement is fundamentalism.
Read Nijkamp and Poot. Read Barro. Look at the data. The evidence from economists who have actually studied this question is resounding: in developed modern economies, over multiple decades, higher taxes and larger government do not correlate with slower growth. It just ain’t so.
It’s true, as Brian’s analysis of the SAEE makes clear, that a lot of economists still aren’t aware of this fact. (Though more of them are aware of it than the irrational electorate, who are far more likely to believe in statements like the one that you make, above.)
How about another analysis: comparing economists who actually study particular subjects to the larger populace of…irrational economists?
Sep 28 2008 at 5:02pm
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.
Surely you didn’t mean to say this? If the Fed contracts the money supply enough, a dollar will buy more Italian shoes. It’s even more certain that if the Fed increases the supply of US dollars enough, a dollar will buy fewer Italian shoes.
Maybe what you meant to say is that the Fed can’t control how many hours a US worker has to work to pay for a pair of Italian shoes?
Sep 28 2008 at 5:15pm
I’m not familiar with the evidence for and against socialism and growth (I’m sure there is some on both sides of the issue, no?), but how is socialism (in the more modern sense of it) much different from what we have now?
As an outside observer, its always seemed to me that the federal and state governments design markets such as health care and finance. Sure, they don’t actually directly run those markets, but so what? I’m not sure how you can draw a line between heavy regulation and socialism, and so I’m not really that scared of the coming socialism in finance.
Sep 28 2008 at 6:33pm
Grant: “I’m not familiar with the evidence for and against socialism and growth (I’m sure there is some on both sides of the issue, no?)”
Yes, there is. Nijkamp and Poot is a metanalysis. Barro is a key voice. (See the link I provided.) But even those that find a correlation find a small and in most cases insignificant correlation. (That doesn’t even count file-drawer bias–insignificant results don’t get published.) Barro, for instance, finds insignificant positive correlation for “developed” countries, and an insignificant negative correlation for “industrialized” countries. In the same paper.
Comes down to a matter of 1) degree and 2) smart, well-crafted policies. USSR failed, Scandanavia is doing very nicely, thank you.
Sep 28 2008 at 6:54pm
For all your splicing of semantics, most of you failed to express a fundamental disagreement with Arnold on the bottom line: “…we must reject the bailout as an inefficient and inequitable attempt for addressing [the economic crisis.]”
If you believe this proposal is destructive, I would ask that you please spend at least as much effort and determination contacting your legislators as you have philosophizing, or this bailout will get passed on our watch. Speaking of the Titanic…assuming the iceberg has already hit, are we going to load the wealthiest people into life boats or attempt to repair the damaged ship? I don’t know, I’m not an economist. Neither are our representatives, so if you know what your talking about, inform them while there is still time.
(FYI – commentors, if you want your point to be taken more seriously, spend 30 more seconds to fix your spelling and grammar errors before sending;)
Sep 28 2008 at 7:27pm
Comes down to a matter of 1) degree and 2) smart, well-crafted policies. USSR failed, Scandanavia is doing very nicely, thank you.
Sweden has a more free enterprised based education system than the United States does, at least for K-12 grades.
But let’s say for the sake of argument that Sweden represents a more socialist model and the United States represents a more free enterprise model.
From, say, 1978 to 2008, how much has Sweden’s GDP grown compared to the growth in the US’s GDP during the same time period?
I understand that Norway has performed well, but they also have a large ratio of oil resources compared to their population. Perhaps if the US wanted to immitate Norway, it wouldn’t become more socialistic, but it might engage in off-shore oil drilling.
Sep 28 2008 at 9:50pm
TC: “From, say, 1978 to 2008, how much has Sweden’s GDP grown compared to the growth in the US’s GDP during the same time period?”
I don’t have that exact, particular fact handy.
But I can say: growth in the EU15 has been the same as the US for decades. You can cherry-pick periods either way, but in toto, it’s a draw:
Context: US taxes 28% of GDP. European countries tax 30-50% (Sweden), average 40%.
You gotta wonder: if they’d had smaller governmemnt, would they have been kicking our asses for the last few decades? That’s the inevitable logic of the small-government-causes-growth meme.
Sep 28 2008 at 9:54pm
Oh and TC, do read the previous link I sent. The economics literature, when reviewed comprehensively, is quite resoundingly clear on this fact.
Sep 28 2008 at 11:30pm
I’d have much preferred a reasoned approach. I think the President made that impractical by establishing that doing nothing would result in a global meltdown. We’ve nothing to fear except fear, and we’re running scared without a courageous leader to calm us down.
I thought Arnold’s logic was spot on. Most people who bought, or leveraged against their homes, in the past two years are now submerged. It’s easy come, easy go if you’ve owned half a dozen years or so and didn’t borrow against illusory equity. And at 6% of GDP per year, the borrowing spree from abroad when it eventually unwinds will hurt, especially if we’ve got deflating assets other than commodities.
Home prices still need to align better with incomes. I somewhat agree with Arnold about letting that proceed apace, but I think the shock and dislocation is sufficient that some assistance for people who occupy homes they purchased to avoid foreclosure has enough advantages to have merit. And that’s certainly a lot easier to evaluate than the leveraged financial products treasury will soon be holding. Would but Treasury could simply unravel those instruments and buy the underlying mortgages.
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