A trillion here, a trillion there…..pretty soon you’re talking real money

I’m old enough that a trillion is still a big number. In fact I’m old enough that I remember wondering what came after a billion. And in England a billion was a million million, not just a thousand million. A bit like pints, which are 20 ounces in England against 16 here. Well actually nothing like, but I still miss pints of bitter.

Back to real estate.

The value of homeowners’ equity in real estate peaked at $13.5 trillion in 2006, before falling to $6.6 trillion in 2011. That’s a loss of almost $7 trillion. Ouch! In the last year there has been an increase of $1.6 trillion to $8.2 trillion, according to the Federal Reserve.

Is there a wealth effect in real estate? I don’t think anybody would argue that as homeowners see the value of their equity increasing – and for most of us that is the main “wealth” item we possess – they feel more inclined to buy the new car to replace the ageing clunker, to take the first proper vacation in years, etc.

This is the consumer spending effect. Before the Great Recession conventional economic wisdom (an oxymoron?) was that rising prices had a wealth effect, but falling prices did not.

According to Prof. Karl Case: “Some people say housing’s wealth effect doesn’t exist. Our own earlier work suggested that it works when the housing market is on the way up but not on the way down. We now have evidence that it works in both directions.”

In his paper, Wealth Effects Revisited: 1975-2012, Case and his co-authors say a 10% increase in home prices causes a 1% increase in consumer spending, and a 10% drop in home prices causes a 1% drop in consumer spending. The approximately 35% decline in home prices during the Great Recession therefore caused a $350 billion drop in consumer spending.
To put that into perspective, the most widely used estimate is that consumer spending accounts for about 70% of GDP (which is about $15 trillion) or some $10.5 trillion..

Whatever the numbers I think it is clear that the wealth effect exists and there is an argument that, as and when homeowners and consumers are really confident that the economic recovery is going to continue and grow, it may even be felt more strongly than normal reflecting pent up demand.

Which brings me to the effect of the housing recovery on the economy. One of the factors in the record low recovery of the economy in recent years has been that housing, which usually leads the economy out of recession, has been a drag on growth. That changed in 2012 and will be an even more dramatic positive in 2013.

Let’s look at one example to see how this works. With the rising home market a homeowner decides this is the time to sell and downsize (the argument applies just as much in trading up situations). Prior to selling her house, our homeowner decides to hire a handyman to fix all the little things that she has been willing to live with; then a painter to make the new areas look crisp and new. The yard, of course, needs to be at its best so add a landscaper, who will suggest a visit to a nursery to buy plants. At some point a stager will come in to set up the house and then the photographer will be able to come and take photos.

Next will be the printer to have glossy brochures made. Now the house is ready and it sells! Great.The broker gets a commission, the attorney gets a fee, the city or town gets all sort of fees, and then the new owner moves in. And what does she do? Well, she decides the kitchen needs new appliances, the bathrooms updating, maybe a different color on the walls, hardwood floors to replace those carpets.

It doesn’t take much imagination to see (a) how much activity was lost during the housing slump, and (b) how much pent up demand there is, not just for houses themselves, but for all the related services and goods.

Another way rising home prices impact the economy is that it enables more homeowners to take out home equity loans, which are often used to finance home improvements and other expenditures. And then there is the huge impact of new construction.

Ok enough. My point is that the economic slowdown experienced in the last few years after a strong start to the year is less likely to happen in 2013 for two reasons: the strength of the housing market; and the fact that there are NO NATIONAL ELECTIONS! That last may not be good for the media industry who benefit from the cacophony of political advertising, but it is wonderful news for the rest of us.

At the beginning of this year I wrote that any surprise in housing in 2013 was likely to be on the upside. Housing may also provide upside surprise to the economy as a whole.