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trade deficit, excessive household indebtedness and the low national saving rate), monetary and fiscal policy can be used aggressively at that point in time to remedy the problem. There is no need to act now to prevent some irreversible or even just costly-to-reverse catastrophy from occurring. Boosting demand through expansionary monetary and fiscal policy is not hard. It is indeed far too easy. We are also not buying time to uncover some new scientific fact that will allow us to improve the short-run inflation-unemployment trade off or to boost the resilience of the economy to future disinflationary policies. Cutting rates to support demand does not create or preserve option value.
If anything, the (weak) logic of the PP points to giving priority to fighting inflation rather than to preventing a sharp contraction of demand and output. Output contractions can be reversed easily through expansionary policies. High inflation, once it becomes embedded in inflationary expectations, may take a long time to squeeze out of the system again. Is the sacrifice ratio is at all unfriendly, the cumulative unemployment or output cost of achieving a sustained reduction in inflation could be large. The irreversibility argument (strictly, the costly reversal argument) supports erring on the side of caution by not letting inflation and inflationary expectations rise.
‘Fat tails’ and other decision theory jargon should only be arbitraged into the area of monetary policy if the substantive conditions are satisfied. They are not.19 With existing policy tools, we can address a disastrous collapse in activity if, as and when it occurs. There is no need for preventive or precautionary action.
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June 1997. Like most bold statements, the assertion is not quite correct; the correct statement is that a decline in house prices does not make you worse off, that is, it does not create a pure wealth effect on consumer demand.
The argument is elementary and applies to coconuts as well as to houses. When does a fall in the price of coconuts make you worse off? Answer: when you are a net exporter of coconuts, that is, when your endowment of coconuts exceeds your consumption of coconuts.
A net importer of coconuts is better off when the price of coconuts falls. Someone who is just self-sufficient in coconuts is neither worse off nor better off.
Houses are no different from durable coconuts in this regard. The fundamental value of a house is the present discounted value of its current and future rentals, actual or imputed.
Anyone who is ‘long’ housing, that is, anyone for whom the value of his home exceeds the present discounted value of the housing services he plans to consume over his remaining lifetime will be made worse off by a decline in house prices. Anyone ‘short’ housing will be better off. So the young and all those planning to trade up in the housing market are made better off by a decline in house prices. The old and all those planning to trade down in the housing market will be worse off.
Another way to put this is that landlords are worse off as a result of a decline in house prices, while current and future tenants are better off. On average, the inhabitants of a country own the houses they live in; on average, every tenant is his own landlord and vice versa. So there is no net housing wealth effect. You have to make a distributional argument to get an aggregate pure net wealth effect from a change in house prices. A formal statement of the proposition that a change in house prices has no wealth effect on private consumption demand can be found in Buiter (2008b,c). Informal statements abound (see e.g. Buchanan and Fiotakis (2004)).
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Most econometric or calibrated numerical models I am familiar with treat housing wealth like the value of stocks and shares as a determinant of household consumption. They forget that households consume housing services (for which they pay or impute rent) but not stock services. An example is the FRB/US model. It is used frequently by participants in the debate on the implication of developments in the US housing market for US consumer demand. A recent example is Frederic S. Mishkin’s (2007) paper “Housing and the Monetary Transmission Mechanism”. The version of the FRB/US model Miskin uses a-priori constrains the wealth effects of housing wealth and other financial wealth to be the same. The long-run marginal propensity to consume out of non-human wealth (including housing wealth) is 0.038, that is, 3.8 percent. In several simulations, Mishkin increases the value of the long-run marginal propensity to consume out of housing wealth to 0.076, that is, 7.6 percent, while keeping the long-run marginal propensity to consume out of non-housing financial wealth at 0.038.
The argument for an effect of housing wealth on consumption other than the pure wealth effect, is that housing wealth is collateralisable. Households-consumers can borrow against the equity in their homes and use this to finance consumption. It is much more costly and indeed often impossible, to borrow against your expected future labour income. If households are credit-constrained, a boost to housing wealth would relax the credit constraint and temporarily boost consumption spending. The argument makes sense and is empirically supported (see e.g. Edelstein and Lum (2004)). Of course, the increased debt will have to be serviced, and eventually consumption will have to be brought down below the level it would have been at in the absence of the mortgage equity withdrawal. At market interest rates, the present value of current and future consumption will not be affected by the MEW channel. 20
20 In the previous statement I hold constant (independent of the individual household’s consumption vs. saving decision) the future expected and actual sequence of after-tax labour income, profits, interest rates and asset prices. In a Keynesian, demand-constrained equilibrium, the aggregation of the individual consumption choices,
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Ben Bernanke (2008), Don Kohn (2008), Fredric Mishkin (2007), Randall Kroszner (2007) and Charles Plosser (2007) all have made statements to the effect that the credit, MEW or collateral channel through which house prices affect consumer demand is on top of the normal (pure) wealth effect. This is incorrect. The benchmark should be that the credit, MEW or collateral effect is instead of the normal (pure) wealth effect. By overestimating the contractionary effect on consumer demand of the decline in house prices, the Fed may have been induced to cut rates too fast and too far.
There are channels other than private consumption through which a change in house prices affects aggregate demand. One obvious and empirically important one is household investment, including residential construction. A reduction in house prices that reflects the bursting of a bubble rather than a lower fundamental value of the property also produces a pure wealth effect (Buiter (2008b,c)). My criticism of the Fed’s overestimation of the effect of house price changes on aggregate demand relates only to the pure wealth effect on consumption demand, not to the ‘Tobin’s q’ effect of house prices on residential construction.