The impact of Declining House Prices on Consumption

Tanta discusses The impact of Declining House Prices on Consumption. She thinks that ... the recession will not be severe (unemployment will not rise to 8%), although I do expect the slowdown to linger, and the recovery to be sluggish ...

Here are two rough methods to estimate the impact of declining house prices on personal consumption expenditures (PCE). The first uses Mortgage Equity Withdrawal (MEW) and estimates the portion of the "Home ATM" that is consumed. The second is an estimate based solely on the changes in house prices (See: Carroll, Otsuka, and Slacalek, How Large Is the Housing Wealth Effect? A New Approach October 18, 2006).

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Imagine house price declines of 10% in a given year. With total household real estate assets of approximately $20 Trillion (Fed's Flow of Funds report, Table B.100, line 4), a 10% decline in house prices would reduce household wealth by $2 trillion. Using Carroll's long run estimate of 9 cents per $1 change in the marginal propensity to consume, gives a drag on PCE of about $180 billion.

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Although the impact on PCE from declining house prices will probably be significant, the size of the impact is not huge when compared to the overall U.S. economy. This is one of the reasons I think the recession will not be severe (unemployment will not rise to 8%), although I do expect the slowdown to linger, and the recovery to be sluggish (because housing will not be an engine of recovery this time).

Emphasis Mine

My own ignorant opinion is, (without reading Carroll, et.al. (2006)), is that the analysis assumes a uniform application of decrease in PCE and there is minimal multiplier effect. If there was a uniform decrease of 10% across the whole US, then the US economy would probably behave as Tanta concludes.

However, the nature of this bursting bubble is that it is so non-uniform with multiple modes with a high degree of auto-correlation. The collapse of a bubble at one mode increases the likelihood of a collapse at another mode because of the panic of the actors.

This auto-correlation of panic plus the integration of the US economy would suggest a very high multiplier effect of a decrease in PCE. Less money spent means less sales means less profits and wages which means less money to spend and invest. This downward spiral increases in intensity as more money is withdrawn from circulation to guard against the day there is no money in circulation.