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Wealth Effects

By Matthew Yglesias on November 9, 2008 at 5:08 pm

"Wealth Effects"

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I don’t think I would agree with all the conclusions he draws from this, but Dean Baker makes the excellent point that there’s a lot more than a “credit crunch” going on to explain the onset of recession — the simple effect of asset prices tumbling is to make people reduce their spending and therefore the economy contracts:

This is truly incredible. Homeowners have lost more than $5 trillion in housing wealth. There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption. This implies that the loss of wealth to date would cause consumption to fall by $250 billion to $300 billion annually (1.7 percent to 2.0 percent of GDP). If you add in the loss of around $6 trillion in stock wealth, with an estimated wealth effect of 3-4 cents on the dollar, then you get an additional decline of $180 billion to $240 billion in annual consumption (1.2 percent to 1.6 percent of GDP).

These are huge falls in consumption that would lead to a very serious recession, like the one we are seeing. This would be predicted even if all our banks were fully solvent and in top flight financial shape. Even the soundest bank does not make loans to borrowers who it does not think can pay the loans back (except during times of irrational exuberance).

To argue from the personal case, as you may recall I bought a condo recently. Obviously, to make the downpayment and meet my closing costs I was going to need to liquidate some of my savings in the stock market. I had planned to sell more stock over and above that in order to get cash to buy furniture and other moving-related expenses. But because of what was happening in the stock market it was an inopportune time to be selling shares so I sold fewer than I’d planned and bought cheaper furniture, figuring I might just buy nicer stuff later on if at some future point the animal spirits of the market drove my net worth up. Thus someone missed the chance to sell me a coffee table (pictured above) that I liked very much but that cost a lot of money. Their loss was Ikea’s gain, but that kind of decision drives GDP down.

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