The headline of today’s post is not news to anyone who reads this blog very often, but for many, including some academic economists, this basic understanding comes only after years of study of the aftermath. Perhaps I expect too much of academics. They are supposed to be very smart people, or we wouldn’t entrust them with the education of future generations, but sometimes the lack of common sense is truly remarkable.
Today’s featured article appeared in the latest addition of Capital Ideas, a publication of the Booth School of Business at the University of Chicago. I will translate the lofty academic language of the author into common sense terms, not to assist you in understanding it, but to assist other common-sense challenged academics who may need help.
A growing consensus pins the severe US recession and slow recovery on the tremendous negative wealth shock to households, which resulted from the combination of very high leverage and a sharp decline in house prices. We are now witnessing a recovery in house prices and residential investment, with house prices in January 2013 up 10% year over year according to CoreLogic and permits for new residential construction up 17% in March 2013 compared to the previous year. A heightened focus on housing is warranted because it tends to be a great leading indicator of where the economy is going.
Many have pointed to the recovery in housing as a major positive for US economic activity going forward. … So will housing save the US economy? I won’t leave you in suspense: we need to temper our optimism on what a housing recovery can do. I agree that house prices will continue to rise and new residential construction will steadily increase from its current very low level. This is good news. But we will not be returning to the boom years that preceded the Great Recession. The days when housing was the predominant force driving economic activity are gone, and I view that as a good thing.
The days of free money given to house title holders is over, and that is a good thing. We don’t want neighbors stealing from neighbors, and that’s what we have with unrestricted mortgage equity withdrawal. Of course, that also means billions in free money is not being pumped into the economy either.
An increase in house prices drives economic activity in two ways. First, it induces investment in new residential construction. Second, it leads some households to spend, either for home improvement or consumption. The latter effect has generally been called a “housing wealth effect,” but in my view that’s the wrong way of thinking about it.
I wholeheartedly agree. The “wealth effect” is the most dangerous euphemism in economics because it’s a Ponzi scheme! It’s theft! Don’t let the euphemism, wealth effect, distract you from the more accurate dysphemism, Ponzi effect. The boost to the economy is real and quite visible. The economic instability and outright theft is hidden.
Instead, the positive effect of house prices on household spending relies crucially on the degree to which a given household is constrained from spending as much as it would like in the short run, either because of borrowing constraints or behavioral biases. …
He completely misses the point and fails to recognize this is a moral issue. He says some households are “constrained” from borrowing due to “behavioral biases.” I suppose that’s one way to look at it. I think it’s more accurate to say that some households are not so stupid as to take on excessive debt to fuel consumer spending, and some are reluctant to do so because even if they know that will never have to repay that debt, they are morally conflicted about stealing this money from a stupid lender. In my opinion, classifying wise decisions and moral behavior as “behavioral biases” is both misleading and insulting. It suggests that people should behave differently for the benefit of society when nothing could be further from the truth.
Spending as a response to an increase in house prices was not uniform, which is a critical point often neglected in the discussion of housing wealth effects. In our study of the housing boom, we found enormous differences in the propensity of homeowners to extract equity from their home based on credit scores (see figure 1).
Homeowners with the lowest credit scores were very aggressive, borrowing 40¢ against every dollar of increased home equity. Homeowners with the highest credit scores were almost completely passive, pulling almost no equity out of their homes when house prices increased.
Let’s take a moment to reflect on what this means because the author clearly did not.FICO scores represent a continuum from the least likely to repay debts having the lowest scores and the most likely to repay debts with the highest scores. Common sense would tell me that the least likely to consider the long-term ramifications of taking on excessive debts would be those with low FICO scores. If you offer nearly unlimited free money to someone with a low FICOO score and tell them their house will pay off the debt for them, what are they likely to do? Will they carefully consider whether or not they should take on this debt, or will they take all the free money they can and worry about the problems later?
The fact that this point is not often discussed in wealth-effect studies shows just how little academics apply common sense to their work. I would have been shocked if the results didn’t show those with the lowest FICO scores were the most aggressive about taking free money. After all, they never intended to pay it back. Either the house was going to cover the bill, or they were going to default — which they did.
I refer to the low credit score borrowers as “constrained.” Changes in wealth lead to big changes in spending, which suggests these households are constrained from spending as much as they’d like in the absence of housing collateral.
I refer to everyone as “constrained.” I believe everyone would like to spend more money, but they are constrained by the fact they don’t have it. Duh!
Is this something we really need an academic study to tell us?
In research with Kamalesh Rao of MasterCard Advisors, Mian and I also found the exact same relationship during the housing bust. For a given dollar decline in house prices, constrained borrowers cut back on spending much more dramatically than unconstrained households. The marginal propensity to consume out of housing wealth was three-to-four times larger for constrained versus unconstrained households.
Let’s bring in a little common sense again. Let’s call these two groups Ponzis and Prudents. Since the Ponzis depend on fresh infusions of debt to pay their debt service and current consumption, if you cut them off, their spending falls dramatically. If they’ve borrowed beyond the Ponzi limit, they can’t even service their debts with their wage income, so with no discretionary income available, they don’t spend anything. The “constraint” on them is the wisdom of a lender who doesn’t want to pour more money down a rat hole. Prudents on the other hand have savings available. If lenders cut them off, they don’t care much. They don’t need fresh infusions of debt to live their lives.
By cloaking commons sense if academic euphemisms, we lose that essential understanding of the basic morality behind these issues. Perhaps that’s by choice. If the general population realized how dependent our economy was on individuals running personal Ponzi schemes, the Prudents might become upset enough to enact some substantive changes to curtail Ponzi behavior.
The fact that unconstrained homeowners do not consume more out of home equity should not be surprising. Standard economic theory casts suspicion on housing wealth effects, because an increase in house prices is also an increase in implicit rental payments. For an unconstrained household with good access to credit markets, an increase in the value of a home is unlikely to significantly alter spending behavior. But for a constrained homeowner who desperately wants to spend more, a change in home value affects spending. This is exactly what we find in the data for both the housing boom and housing bust. We should not think of the housing wealth effect as a constant parameter in a macroeconomic model. It varies substantially based on which types of homeowners have access to credit.
Only constrained borrowers consume aggressively out of home equity, but today these constrained borrowers have been shut out of housing and mortgage markets. The only households that can buy a home or borrow against one are precisely the unconstrained households that are least likely to spend out of an increase in housing wealth. Therefore few homeowners are aggressively borrowing against their homes, precisely because they have high credit scores. If we take the results from our previous research, the housing wealth effect for these households may be close to zero, which would substantially dampen the effect of house prices on spending.
Halleluia! There is hope for us.
The same pattern can be seen in refinancing volumes. Interest rates on mortgages are the lowest they have ever been, but nobody is taking money out of their homes. This partly reflects tighter credit conditions. But it also reflects the fact that there has been a major compositional shift in the homeowners who are able to refinance their mortgages. Individuals with high credit scores are much less likely to use their home equity to spend.
Individuals with high FICO scores recognize that tapping home equity requires debt. They are not stupid, constrained, or suffering from behavioral biases. They are smart. They recognize the debt trap for what it is. They see that HELOC money is not free money, and almost nobody with a high FICO score is running a personal Ponzi scheme.
What does this mean for the effect of housing on economic activity? If the trend continues, the most direct effect would be a permanent return to homeownership rates in the United States of 65% or perhaps even lower. I would argue that the marginal 5% of Americans who switched in and out of homeownership over the past decade have high marginal propensities to consume out of wealth and income. During the boom, these households consumed aggressively out of home equity.
We’ve flushed many of the Ponzis out of the system. Now, if we can just keep them out, they shouldn’t be able to steal from everyone with massive government bailouts.
I believe we have learned a painful lesson from the 2002–12 experience. We cannot rely on debt-fueled collateral-based consumption for economic growth.
No kidding? What a remarkable insight. He may win the Nobel Prize for that one. ~~ giggles to self ~~
Is our understanding of Ponzi schemes so limited that we actually have to learn this lesson? I don’t know whether to celebrate that someone is finally learning this lesson, or if I should be disheartened that the obvious has eluded people for so long.
Easy credit-fueled house prices and consumption during the boom, and the collapse in spending, were exacerbated by excessive debt burdens and a failure to provide any relief to underwater homeowners. Fueling consumption through easy household credit may help in the short-run, but it inevitably has long-run painful consequences.
I said years ago that the economic recovery would be weak, and it would drag on for years. Collapsed Ponzi schemes always take the longest to recover from because it requires deleveraging. The author of this study was one of the early proponents of widespread principal reduction. He clearly does not understand the moral implications of the issues he explores, and Moral hazard is central issue in housing bust.
The Secretary of Housing and Urban Development
The recorded owner of today’s featured property is the The Secretary of Housing and Urban Development. I had never seen that before.
The former owners were Ponzis, but they didn’t extract a great deal from the property, probably because it was in Santa Ana and didn’t go up as much as some other markets. They put $25,500 down when they bought it, and they extracted about $90,000 over the next several years. The final cash-out loan was handed out in 2009. I thought underwriting standards were tougher then, but it didn’t stop this Ponzi from playing the game.
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Proprietary OC Housing News home purchase analysis
331 CARRIAGE Dr #57 Santa Ana, CA 92707
$280,000 …….. Asking Price
$253,482 ………. Purchase Price
4/29/2003 ………. Purchase Date
$26,518 ………. Gross Gain (Loss)
($22,400) ………… Commissions and Costs at 8%
$4,118 ………. Net Gain (Loss)
10.5% ………. Gross Percent Change
1.6% ………. Net Percent Change
0.9% ………… Annual Appreciation
Cost of Home Ownership
$280,000 …….. Asking Price
$9,800 ………… 3.5% Down FHA Financing
4.55% …………. Mortgage Interest Rate
30 ……………… Number of Years
$270,200 …….. Mortgage
$85,822 ………. Income Requirement
$1,377 ………… Monthly Mortgage Payment
$243 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$58 ………… Homeowners Insurance at 0.25%
$304 ………… Private Mortgage Insurance
$235 ………… Homeowners Association Fees
$2,217 ………. Monthly Cash Outlays
($213) ………. Tax Savings
($353) ………. Principal Amortization
$17 ………….. Opportunity Cost of Down Payment
$55 ………….. Maintenance and Replacement Reserves
$1,723 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$4,300 ………… Furnishing and Move-In Costs at 1% + $1,500
$4,300 ………… Closing Costs at 1% + $1,500
$2,702 ………… Interest Points at 1%
$9,800 ………… Down Payment
$21,102 ………. Total Cash Costs
$26,400 ………. Emergency Cash Reserves
$47,502 ………. Total Savings Needed