Headline: Housing May Rescue Economy From Wilting Wealth Effect

Source: New York Times, 15 August 2001

URL: http://www.nytimes.com/2001/08/15/business/16CND-PORT.html

As the American economy struggles to avoid recession and begin a rebound from the sharp slowdown of the last 13 months, that roof over your head is more important than you may have thought.

With the stock market well off its record highs and showing no sign of getting back on track, the stimulus that has helped keep consumer spending alive — and the economy above water — is the old family home. If the technology-led stock market boom produced a New Economy wealth effect that ramped up consumer spending, then the rising equity in American's homes is providing an Old Economy bulwark against a persistent slide.

The wealth effect has been debated incessantly since the Federal Reserve began trying to slow economic growth when it started raising interest rates in June 1999. At the time, Americans were feeling richer as stock prices continued to rise, and they kept buying at such a rapid pace that it was difficult for the central bank to restrain growth.

But now the wealth effect is being refocused on housing, the traditional source of the feeling of increased wealth that can spur spending. And to the surprise of some, the continued strength in housing seems to be offsetting part of the negative wealth effect from declining stocks, as consumers refinance their mortgages, lower their monthly payments and borrow against the rising value of their homes.

Alan Greenspan, the chairman of the Federal Reserve, is well aware of this and, in fact, seems to be depending on housing as his buffer against recession. Housing appears to be Mr. Greenspan's bridge to that time when companies, which have slashed their capital spending, start to invest again while others begin to rebuild their depleted inventories.

"Greenspan is bound and determined that he is going to nurse this thing along by creating a positive wealth effect for housing," said Paul A. McCulley, a portfolio manager at the Pacific Investment Management Company, a bond powerhouse in Newport Beach, Calif. And this means, Mr. McCulley said, that interest rates should move lower and, more importantly, stay lower longer than many analysts now expect. "Alan Greenspan has raised interest rates for the last time," he said. Mr. Greenspan's term as Fed chairman is not up until June 2004.

While Mr. Greenspan has mentioned the importance of the housing market in noting how much better than expected the economy has held up this year, his focus on housing is really seen in some answers to questions when he appeared before the Senate Banking Committee on July 24.

"I think one of the things that's occurring in the country," Mr. Greenspan said, "is the evolution of housing into a very sophisticated, complex industry, in the sense that we not only have got standard home-building aspects of homeownership-related activities, but we're also beginning to find that as homeownership rises and as the market value of homes continues to rise, even in a period when stock prices are falling, we're observing a rather remarkable employment of that so-called home equity wealth in all sorts of household decisions."

He also said the borrowing against rising home prices was not a worrisome long-term trend. "If unrealized capital gains were declining, which is, of course, what happens when you extract equity from homes, yes it would be a problem," he said. "But there is no evidence of that. Instead, despite the fact of the significant extraction of home equity gains, the level of unrealized capital gains in homes continues to rise apace. So it is not a depleting asset, if I may put it that way. It could be, but fortunately it is not."

And pushing interest rates lower and keeping them there for some time should help housing to continue to maintain its value.

Now you may wonder about the negative wealth effect of the stock market. Since stocks went up so far for so long, shouldn't their decline offset any of the gains from the home wealth effect?

A recent study reported by the Federal Reserve Bank of New York says not to worry too much. It concludes that the popular conception that Americans had become aggressive stock investors in the 1990's as they chased Wall Street returns is off the mark.

The study shows that the increase in the stock portion of American portfolios was more modest than thought. It also argues that the main reason for this more modest increase in stock holdings was the rise in the value of the stocks themselves, not the wild pursuit of more stocks.

In other words, American investors, the study contends, were more passive investors than many thought. If correct, this means that as stocks fall, investors may remain passive. Then, the stock market decline would have less restraint on consumer spending than feared.

The study also shows that real estate — the home — is still the most significant portion of American portfolios, and this is a plus for Mr. Greenspan's strategy for limping through until the economy rebounds.

[ COMMENT:

However, there was an interesting article on the front page of the Wall Street Journal either Monday or Tuesday of this week raising questions about the way in which house assessments are made. The basic argument was that real estate assessors may be pressured to inflate values because banks want to give higher loans so they can make more money... and each time a house mortgage is refinanced, another assessment is done.

The implication, disputed by some of course, is that the "rising value" of houses is just another bubble... no surprise to readers of this forum, I hope. Despite the soothing words in the article above, I fear that a collapse of artificially high real estate prices would be the final straw in breaking the back of the U.S.', and hence the world’s, economy.

I am sorry I can’t link the WSJ article – it isn’t on the "free" MSNBC/Wall St Journal website, and I read it in the print edition only. But it’s worth taking a look. –Andre]

-- Andre Weltman (aweltman@state.pa.us), August 15, 2001