This will very likely mean that consumer spending will contract, perhaps resulting in a much more sluggish economy and more unemployment.
The connection between falling home prices and consumer spending is abundantly clear. Just last month, Karl Case, Robert Shiller and John Quigley published a study that looked at housing markets and consumption over 31 years. They found that “variations in housing market wealth have important effects on consumption.” (And, yes, the first two authors are the "Case-Shiller" guys.)
Specifically, they found that there’s a “wealth effect” from housing.
When home prices rise, consumption rises, as well. When they fall, consumption falls. What’s more, this wealth effect is even more strongly pronounced for falling prices than it is for rising prices.
Apparently, fear is a greater motivator on the savings side than joy is on the spending side.
They estimate that for every dollar of lost housing wealth, consumer spending contracts somewhere between three cents and 18 cents—with eight cents in the middle of the range. With total consumption around $10 trillion, this means that for every one percent decline in home prices, consumers decrease their spending by somewhere between $3 billion and $18 billion.
This “wealth effect” is much stronger for housing than for other types of wealth. In fact, “financial wealth”—the rising or falling of the stock market—seems to have almost no impact on consumer spending.
Why is the wealth effect so pronounced for housing? The reasons aren’t quite clear. It may be rooted in psychology or perhaps in what economists call an “external finance premium”—basically, what a household has to pay to borrow. Or both: Rising prices make people feel better and also strengthen their financial positions, making it easier to borrow and spend.
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