Tuesday, June 23, 2009

Housing Wealth Effect on Non-Housing Consumption: MEW Credit Bubble Vs Real Estate ROI

Ringing in the MEW Year and the Illusion of Real Estate ROI

A recent Wall Street Journal (WSJ) article hints at but underdevelops a crucial distinction (the first point is closer to a psychological wealth effect while the second point is more likely to involve a functional change in credit access):

  • Fixed income, increased wealth: Spending more of your current income by decreasing your savings rate (but not your total savings), because of feeling richer from an appreciating asset but without tapping that asset.
  • Increased income, fixed/decreased wealth: An increase in current income via an increase in credit/debt on the appreciated asset, tapping the asset, negating the appreciation, leveraging/mortgaging the appreciated asset, spending the nest egg.
The WSJ article is correct that a policy to try to prop up housing prices is a mistake--but for many reasons well beyond the article's argument:
Many economists have stated that consumer spending can’t rebound until house prices stop falling. But Charles W. Calomiris of Columbia University, Stanley D. Longhofer of the Barton School of Business and William Miles of Wichita State University argue that the wealth effect of housing has been overstated. ("The (Mythical?) Housing Wealth Effect," Wall Street Journal, 6/22/09, hat tip: CR)
However, this next statement confuses a credit boom with real estate Return on Investment (ROI):
[A]n increase in house prices raises the value of the typical homeowner’s asset, but such a price increase is also an equivalent increase in the cost of providing oneself housing consumption. In the aggregate, changes in house prices will have offsetting effects on value gain and costs of housing services, and leave nothing left over to spend on non-housing consumption. ("The (Mythical?) Housing Wealth Effect," Wall Street Journal, 6/22/09, hat tip: CR)
The flaw confuses immediate lump-sum consumption with postponed financed payment--a flood vs. a drip.

If all houses increase $100k, both the Mortgage Equity Withdrawal person (MEWer) and the new house buyer are consuming an additional $100k each while paying only an extra $500/month ($100k @ 5% 30yr Fixe-Rate Mortgage (FRM), rounded off), so the new non-housing consumption from $100k MEW is only partially offset by $12k/year finance payments (extra $6k each from MEWer and new buyer)--and that does not even consider if the number of MEWers (seller pawning his/her house back to the bank) exceeds the number of house buyers.

The home ATM (MEW) accounted for 75% of GDP growth between 2003 and 2006.

The WSJ article's argument that higher house prices constrain renters' non-housing consumption overlooks that a key feature of the housing bubble was the massive divergence in the house-price:rent ratio.

The WSJ article tries to address housing as consumption but still seems to confuse houses with housing (asset vs. consumption).

There is an offset (cancelling out) with a trade-up house buyer who both buys a house and sells a house at the same time but that situation says more about the illusion of real estate ROI:

In other words, when you [a trade-up house buyer] calculate your real appreciation from your house-sale as investment, the proper deflator for the first house is the replacement house’s appreciation over the time period that you lived in the first house (do not use a CPI deflator). Many people will learn that trading keys is like getting a 10% raise to buy items which cost 10% more--they realize no real net gain from appreciation. The profit truism is “Buy low. Sell high” but sell-high-then-buy-high makes no money. You are running yourself ragged on your hamster wheel. ("Homeowner Profits Ignore Huge Costs: Housing Myths Part 4")
High house prices are bad policy and good policy would be to let the housing/credit bubble deflate.

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