House Prices, the Wealth Effect and the Cash-in-Hand Effect
House prices are collapsing, which means that homeowners' equity in their houses is plunging. According to Federal Reserve flow-of-funds data, homeowners' equity dropped by $399 billion quarter-to-quarter in Q1:2008 and $880 billion year-over-year - both record absolute declines (see Chart 1). The drop in homeowners' equity contributed significantly to the $1.7 trillion decline in household net worth in the first quarter (see Chart 2).
Chart 1
Chart 2
Economists refer to something called the "wealth" effect. It is hypothesized that households tend to spend relatively more of their income when their wealth is increasing and vice versa. Mind you, households do not have any more cash in hand to spend when the value of their stock portfolios or houses go up. They are just wealthier "on paper."
In this past cycle, it had become very easy for households to turn their increased "paper" housing wealth into actual cash by borrowing against their increased home equity. This borrowing is called mortgage equity withdrawal, or MEW. Active MEW can be defined as mortgage equity withdrawal consisting of refinancing and home equity borrowing. In contrast, inactive MEW consists of turnover. At an annualized rate, active MEW peaked at $576 billion in the second quarter of 2006. Active Mew has slowed to only $114 billion in the first quarter of this year - the smallest amount since the fourth quarter of 1999 (see Chart 3). There is no doubt in my mind that active MEW, which actually puts additional cash into the hands of households, played an important role in boosting consumer spending in this past expansion. And there is no doubt in my mind that the recent and likely continued decline in active MEW will play an important role in retarding consumer spending in this recession. Because it has been easier to borrow against the increased wealth in one's house than in one's stock portfolio, dollar-for-dollar, falling house prices will have a more important negative effect on household spending that will falling stock prices.
Chart 3
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Author: Paul Kasriel
Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675
Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.
Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.
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