Is this all a rational reaction to falling household wealth

House prices in New Zealand have fallen 6.8% on a year earlier according toe QVNZ (for November). Given that inflation was running at somewhere around 4% during this time this implies that the real value of houses has fallen by around 11%.

Now, prior to the recent crisis, households based decisions on the (wrong) assumption that house prices would continue to appreciate. As a result, relative to what has happened, household have “over-borrowed”. The sharp pullback in consumption is their rational response to the sharp decline in households expected lifetime wealth.

This is consistent with David Rosenberg’s view of what is happening in the US economy. (here is a version of the report)

If this is the primary factor behind the sharp drop in economic activity then this implies two things:

  1. We can expect further drops in consumption as house prices moderate over 2009,
  2. This household rebalancing process has to occur (unless we expect expectations of household wealth to overshoot on the downside) and so there is nothing that the government can do to help us.

Thoughts?

  • CPW

    Even if the change in the economy to a new higher rate of savings is desirable, there’s no guarantee the transition path will be optimal. There could still be room for the government to stimulate aggregate demand in the meantime – we don’t want to try and move to the new savings position instantaneously.

  • “there’s no guarantee the transition path will be optimal”

    There is also no guarantee that government actions to change the path would be optimal. Furthermore – if the government isn’t willing to let us move to an equilibrium with higher savings now, is there an assurance they ever will?

    Ultimately, if households have realised that there expectations are out of whack and are responding then why is it optimal for the government to spend money now and then tax people more in the future?

  • Another way to put it is that the pain of a recession comes from two areas, a structural decline in activity and a misallocation of resources stemming from a lack of price adjustment.

    The government should help improve the speed with which resources are allocated to minimise the pain – it shouldn’t try to stop a structural adjustment.

  • CPW

    “Ultimately, if households have realised that there expectations are out of whack and are responding then why is it optimal for the government to spend money now and then tax people more in the future?”

    Because we can’t instantly switch everyone from producing consumption goods to capital goods, and if we try the result is a lot of intermediate unemployment. That’s the result we get if everyone tries to raise their savings level at the same time.

  • “Because we can’t instantly switch everyone from producing consumption goods to capital goods, and if we try the result is a lot of intermediate unemployment. That’s the result we get if everyone tries to raise their savings level at the same time.”

    Cool, so the problem stems from the lack of perfect substitutability – not from the fact that “savings are now too low”. As a result, government policy should be focused on improving workforce training and helping the macroeconomic adjustment along – rather than trying to prevent it happening.

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