Today I came across a link to what looks like a good FAQ on the crisis by Ivo Welch of Brown University. One of the first questions he asks and answers is, "The houses are still here, so how can we be poorer?".
I've been wondering the same thing for sometime now. Since I haven't come across this question in the any of the writing on the crisis I've read previously (and often read that the crisis has caused a destruction of wealth), I'm kind of embarrassed to admit that I just don't get it.
I've been wondering the same thing for sometime now. Since I haven't come across this question in the any of the writing on the crisis I've read previously (and often read that the crisis has caused a destruction of wealth), I'm kind of embarrassed to admit that I just don't get it.
I can see how we could have had more wealth now. Resources were
invested in housing that should have been invested elsewhere. Got it.
But those investments were made years ago. The real resources were misallocated during the time home prices were increasing far above the rental cost of housing. What's happened now is that prices have come to reflect that misallocation. That is, we're just as poor now as we were in 2005, we just didn't realize it before.
Welch's answer is:
"It's like finding out that you built a house in a place where you can no longer find work at the same pay rate as before or elsewhere. The house is still there, but it is less valuable to you. As an economy, we have deployed our wealth in a way that with 20/20 hindsight was not the best we could have done."
This mostly sounds like what I'm saying above- i.e. resources could have been put to better use and that this was discovered recently. In other words, we could have more wealth and we do, but we didn't just lose that potential wealth, it was lost when we allocated resources in the past. But in a question that immediately precedes that above here asks: "Has the economic crisis made us collectively poorer?". His answer to this is "Yes".
I guess I still don't get it. To me, it was the over-investment in housing that has made us poorer, not the fall in the prices of those homes*. I appreciate any comments that point me in the right direction.
*Note that there is a separate channel in which the crisis has made us poorer. Because credit markets are not working well (because of the solvency issues facing financial institutions), we are not able to efficiently and effectively allocate resources now. Real things (buildings, machines, factories) will not be built because of tight credit markets- and that affects the creation of wealth. This will be reflected in our future indicators of real economic activity (GDP, employment, etc). I'm of the belief that adding up the fall in home or equity prices is not going to give one the amount by which the crisis has made us poorer, but only give us some idea of the amount of resources that were misallocated before the crisis.
In short: The misallocation of resources has resulted us in being poorer now that we might otherwise have been. The financial crisis was caused by the realization of the wealth lost due to this misallocation. There is some additional wealth being lost because the crisis has affected the availability of credit. It is not that this crisis has caused us to lose wealth that we actually had, but it will slow the creation of more wealth in the future).
But those investments were made years ago. The real resources were misallocated during the time home prices were increasing far above the rental cost of housing. What's happened now is that prices have come to reflect that misallocation. That is, we're just as poor now as we were in 2005, we just didn't realize it before.
Welch's answer is:
"It's like finding out that you built a house in a place where you can no longer find work at the same pay rate as before or elsewhere. The house is still there, but it is less valuable to you. As an economy, we have deployed our wealth in a way that with 20/20 hindsight was not the best we could have done."
This mostly sounds like what I'm saying above- i.e. resources could have been put to better use and that this was discovered recently. In other words, we could have more wealth and we do, but we didn't just lose that potential wealth, it was lost when we allocated resources in the past. But in a question that immediately precedes that above here asks: "Has the economic crisis made us collectively poorer?". His answer to this is "Yes".
I guess I still don't get it. To me, it was the over-investment in housing that has made us poorer, not the fall in the prices of those homes*. I appreciate any comments that point me in the right direction.
*Note that there is a separate channel in which the crisis has made us poorer. Because credit markets are not working well (because of the solvency issues facing financial institutions), we are not able to efficiently and effectively allocate resources now. Real things (buildings, machines, factories) will not be built because of tight credit markets- and that affects the creation of wealth. This will be reflected in our future indicators of real economic activity (GDP, employment, etc). I'm of the belief that adding up the fall in home or equity prices is not going to give one the amount by which the crisis has made us poorer, but only give us some idea of the amount of resources that were misallocated before the crisis.
In short: The misallocation of resources has resulted us in being poorer now that we might otherwise have been. The financial crisis was caused by the realization of the wealth lost due to this misallocation. There is some additional wealth being lost because the crisis has affected the availability of credit. It is not that this crisis has caused us to lose wealth that we actually had, but it will slow the creation of more wealth in the future).
We are definitely poorer for the simple reason that resources were misallocated. Scarce credit was given to borrowers who could not effectively employ it, at the expense of more efficient uses. Lending constraints, and therefore borrowing constraints, eventually bind.
Regarding the over investment of houses, the misallocation in resources toward housing created two problems--one transitory and the other permanent. The transitory problem is that wealth was created artificially in the house price run up, and then taken away as prices declined. I think of this as a nominal problem.
The second problem is much more severe as it is a real problem that will persist for a long time. Real houses were built based on projections of increasing incomes and home prices at trajectories never seen before. Many communities now have a large percentage of homes that are vacant. This oversupply of homes is not going away anytime soon unless we have a government policy of bulldozing them. What's more, not only do their values as well as their neighbors' home values decline, but the vacant homes are providing no housing services.
I know that part of the imputed values in GDP are housing services, but I wonder if the BEA incorporates vacancy rates into those computations. If not, GDP will be overstated by quite a large amount. That is another "real" negative sign for the economy that might be worth a separate post.
Good way to break down the effects into transitory and permanent effects. This is what I was going for- my note is what I think of as the transitory effect. My argument is that there is no permanent effect in the sense you are talking about.
In my view, home prices falling has nothing to do with real wealth. That lost wealth was gone the second we built homes that "shouldn't" have been built.
Are you suggesting bulldozing homes? This would increase GDP, but is one reason why GDP is not a good measure of well being and definitely a case of the Broken Window Fallacy... More homes mean more services- they are only vacant at a given price- in equilibrium prices fall until all homes are occupied. They are only vacant now to the extent it takes time for prices to fall (Incidentally, Merlo and Rust have a neat working paper on this).
Regarding the BEA's accounting, I'm not sure how they actually do it, but
this document says the following:
"That imputation is made so that the treatment of owner-occupied housing in the GDP is comparable to that of tenant-occupied housing, which is valued by rent paid."
And later:
"From 1996 to 2006, the share of GDP accounted for by the imputation for owner-occupied housing increased from 6.0 percent to 6.2 percent."
These statements suggest that the services are more likely to reflect rental rates (which hadn't been increasing) than home prices and thus that GDP was not over stated by much (and certainly not overstated by the many trillions that home prices are going to fall). But you are right, this could be interesting if one wants to get their hands dirty...