To many, the answer is obvious. If home prices suddenly fall, then we’re all poorer, and we’re all spend less money, resulting in a recession. Empirically, this is in fact what tends to happen. But as this interesting comment from some anonymous economist explains, the actual reason why is considerably more complicated:
Though it’s difficult, let me try to explain why this is wrong. Roughly speaking, your spending in a year is a combination of (1) your income and (2) the change in your asset position. When the value of your assets suddenly declines, what are the first-order effects *going forward*? How does the sum of (1) and (2) change? There is no immediate effect on your labor income — surely as the economy finds a new equilibrium, there will be some changes in wages, but there is no clear movement here for most people (except those involved in industries related to the specific assets that declined). So (1) isn’t the important part.
As a matter of arithmetic, therefore, the change really has to be in (2). But changes in your asset position are inherently related to intertemporal substitution. Maybe you were counting on your asset stock to last you through retirement, and now you need to save more to achieve a certain net worth by age 65. But, of course, this decision depends on the interest rate. In a completely real economy, your savings will be channeled into investment (or dissaving by other households) because the real interest rate will adjust until the market clears. Maybe aggregate investment will go up and aggregate consumption will go down, but there isn’t some obvious first-order effect on GDP. Indeed, the classic “income” effect from a decline in asset prices would be an INCREASE in labor effort.
In an economy where the Fed targets the nominal interest rate, however, it’s not quite so simple, unless we’re in an environment where inflation immediately adjusts so that the real interest rate goes to its equilibrium value. (We clearly do not live in this world!)
By failing to cut nominal rates (and/or encourage inflation, by altering the expected future trajectory of the nominal rate) so that the real interest rate goes to its equilibrium value, the Fed effectively forces the economy to take some other path toward equilibrium. Generally this involves a massive decline in output.
The important thing to note here is that the rates that matter are the real (i.e., inflation adjusted) ones while the rates the Fed targets are nominal. Since nominal rates can’t go below zero, you need to change inflation expectations to avoid the output collapse. Similarly, letting inflation expectations collapse when nominal rates are already low will cause the real rates to become perilously high. All this is a reason to think central banks were flying too close to the sun with their pre-recession inflation targets below 2 percent. This leaves you dangerously exposed to very high real rates if there are any panics in asset markets.
The other thing is that if you imagine a future where we don’t have paper money, I think this problem goes away. In an all-electronic currency, you could have negative nominal rates so a central bank should never have a problem targeting whatever real interest rate it wants to target.