One intended goal of the federal reserve’s bond buying is to induce a “wealth effect” in homeowners by inflating the perceived value of their home. By artificially suppressing mortgage rates, houses become easier to buy, demand for houses increases accordingly, and prices go up. You see the higher listings in your neighborhood, and you see the estimates for your house on Zillow and Trulia increasing, so you decide that you can afford a new flat screen TV and maybe a kitchen remodeling. Presto! Perceived wealth has transformed into real wealth, given our consumption-driven economy. Or at least that’s how it’s supposed to work.
Amir Sufi and Atif Mianis, professors at Chicago and Princeton respectively, authored an interesting little article yesterday that shows the downside of housing’s wealth effect: “Why the Housing Bubble Tanked the Economy and the Tech Bubble Didn’t.”
Sufi and Mianis don’t focus on quantitative easing. Rather, they just try to make the simple but important point that the relative distribution of wealth and debt across society matters. They observe that although the nominal loss of wealth in the tech crash in 2000 and the housing crash in 2008-2009 was about the same, the housing crash almost destroyed the economy while the tech crash produced only a mild recession. The reason for the difference, they suggest, is that the average person, and especially poorer homeowners, have most of their net worth tied up in the home they own. The deflating of the tech bubble hurt primarily the investment portfolios of the relatively rich, who could afford to keep on spending as they did before, in spite of their loss. The housing crash, by contrast, decimated the finances of myriad homeowners, especially since they owned their homes with highly-leveraged loans. Wealth people own their homes with relatively less leverage, so they are to that degree insulated from feeling the effects of housing price declines.
Although there are prominent sectors of the stock market that are greatly overvalued right now (e.g., internet stocks, biotech), we’re probably not in the midst of another general stock bubble that’s equivalent to the tech or housing bubble. But if the market as a whole does inflate a speculative bubble, then here’s a reason for thinking that it will be even more socially destructive than the housing crash when it pops. This is because the Federal Reserve hasn’t just tried to inflate housing prices, but financial assets generally. In particular, it has tried to force investors into riskier assets by suppressing fixed-income yields. The poor and the lower middle class tend to have a much smaller percentage of their net worth in financial assets. For this reason, those assets they do have tend to be conservative: CDs, money market accounts, investment-grade bonds. But the Fed has made these investments untenable, often with real negative yields. So mom and pop savers are being forced into riskier investments they could otherwise not afford to hold. The worry is that when the next big correction comes, it will punish a whole new class of poor and middle class investor, who is least prepared and least able to bear it. The reason why so many people owned homes with highly leveraged mortgages was because of government support for the home lending market. Similarly, the reason why more investors are being goaded out of fixed-income into stocks (and into exotic, risky bonds: “Nontraditional Bond Funds Raise Concerns,” Wall Street Journal) is because of government support for the bond market.