The real estate wealth effect is really a Ponzi scheme built on debt, not a passive byproduct of naturally rising house prices.

When many individuals act for the same reasons at the same time, they take on the characteristics of a herd. In those instances, the behavior of the herd can largely be explained by the behavior of the individuals that comprise the herd. Macro economists seek correlations to infer causations for economic events; however, they often fail to investigate the individual incentives driving the herd behavior that shows up in their data. As a result, macro-economists often conjure up completely erroneous interpretations for trends in data, trends easily explained by looking at the micro-economic level.

My favorite example is the notion of a wealth effect. Economists noted that people spend more when asset values rise and less money when values fall. Of course, times of rising asset values also correspond to times of general prosperity, so it’s difficult to identify what’s really causing people to spend more, the fact that their assets increased in value or that their incomes increased.

Economists also observed that stock prices had little effect on people’s propensity to spend; however, house prices have a strong correlation to people’s spending habits. Why does real estate wealth cause people to spend more than stock wealth? Money is money, isn’t it?

The conventional interpretation is that rising house prices make people feel more confident than rising stock prices, so rising house prices has a greater impact on people’s desire to spend. The economist’s interpretation is partially true because prior to the housing bubble, house prices had never gone down while stock prices had crashed repeatedly. A rising house price appeared more stable; therefore, people were more confident in spending the gain. However, this explanation completely ignores the tangible micro-economic forces at work.

If stock prices go up, people don’t have ready access to that money. They would have to sell some of that stock (foregoing future gains) and pay taxes on the gains in order to obtain the money, two major disincentives to making this wealth liquid, disincentives that make the correlation between stock price gains and consumer spending weak (also, fewer people own stocks than houses).

If house prices go up, it’s a completely different story. When credit is loose, lenders will loan 100% of the value or more of a house with a HELOC or second mortgage. This gives homeowners immediate access to cash, it doesn’t have any tax implications, and they can keep the asset to enjoy future gains. The correlation between house price gains and spending is so strong because obtaining and spending that cash is quick and convenient.

Since lenders make it so easy to spend the gains from home price appreciation, people really, really want to own homes, particularly when prices rise rapidly and lending standards are loose. Since aspiring owners want the free money from home price appreciation, people strongly desire homes, and when lending standards are loose, this desire is translated to tangible demand in the marketplace. The buying causes prices to go up further, stoking even more demand: a mania ensues.

This mania quickly descends into a debt-fueled Ponzi scheme. The debt lenders provide to new buyers keeps pushing prices higher: higher prices justify even more debt, so everyone else in the neighborhood borrows and spends their new equity. The only justification for the high prices is the demand created by foolish lenders and greedy borrowers. The mania continues until the buyer pool is exhausted and the supply of greater fools runs out, at which point the Ponzi scheme collapses and house prices crash.

The euphemism, wealth effect, distracts economists 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.

The lure of mortgage equity withdrawal is seductive for both borrowers and politicians. The lure of free money for borrowing homeowners is obvious, and the economic growth that results from their profligate spending pleases politicians. If not for the billions of dollars in losses from when the Ponzi scheme implodes, it would be a panacea.

April 25, 2016, By Barry Ritholtz

The Federal Reserve Bank of Dallas in a recent report noted that several factors affect consumer spending: “Higher incomes and household wealth boost spending. Higher, real (inflation-adjusted) interest rates—which encourage consumers to save—reduce current spending.” (emphasis added). I emphasized “and household wealth” for a reason. Many of the Fed’s recent monetary policy decisions, including quantitative easing and zero interest rates, were driven by a belief in the so-called wealth effect. It is a notion, as noted before, that is very likely wrong. The discussion about the wealth effect above has real-life implications. Economists at the federal reserve genuinely do not understand what’s going on, and their policy decisions reflect this ignorance. Before I explain why this is much more likely a case of correlation than causation, a quick definition and background: The wealth effect is … the idea that rising asset prices — especially for housing — boost consumer confidence, which in turn leads to an increase in retail spending. … Once in motion, this virtuous cycle of higher prices leads to greater economic activity, more profits and still more positive sentiment. Repeat until recession or crisis interrupts. The rule of thumb has been that for every $1 increase in a household’s equity wealth, spending increased 2 cents to 4 cents. For residential real estate, the increase is even greater: Consumer spending increases 9 cents to 15 cents (depending upon the study you use) for every dollar of gain. The correlation is there; the problem is the lack of causation. What these observations attempt to capture is the relationship between increased spending and rising asset prices. Only it confuses which causes which. Indeed, the longstanding economic theory has the historical relationship exactly backward: more spending (and profits) cause higher asset prices and improved sentiment, not the other way around. … In the housing market, more spending (buying) causes higher prices, enabling everyone in the neighborhood to borrow more money. This in turn stimulates the economy as homeowners flush with equity converted to cash spend, and spend, and spend. The Fed … has a misplaced faith in how the wealth effect helps the average American. Maybe we can gain insight into where the Fed’s thinking goes astray by looking further at home prices and consumer spending. In the pre-crisis 2000s, it wasn’t rising home prices that led to greater economic activity. Instead, it was access to cheap credit on non-traditional terms, enabling a huge run up in consumer spending. Rather than praise the housing boom, the true engine of growth during that period was lax lending and easy credit. Since we all know how that turned out, I doubt we want to revisit that any time soon. … The fallout from the credit bubble — the ongoing deleveraging that is curtailing spending — is with us to this day and “still dominates the public mood three elections later,” as Bloomberg News reported. Unfortunately, the Fed seems committed to fight this drag on growth with policy remedies that are based upon what is probably a false economic belief.

You won’t hear any complaints from homeowners.

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