How Should We Think About the Destruction of Housing Wealth?

by Reihan Salam

It is widely understood that a sharp decline in home prices is terrible news. But is it really? Lower home prices mean more affordable housing, for current homeowners as well as renters looking to buy. John Cochrane and Benn Steil recently had an interesting exchange on this theme:

John: If you can afford to buy the same basket of goods, you have the same standard of living.

Basically, it’s deflation. The deflation is not yet recorded in statistics because they use the rental equivalent measure of housing costs. If your net worth goes from $100,000 to $10,000 but there is a 90% deflation you are exactly as before.

As an extreme, suppose technical improvement makes housing free – we figure out how to grow houses from chia pets in a week. The price of existing houses goes to zero. There are winners and losers here too. But obviously as a society we are much better off.

Benn: If I lose 90% on a stock am I no worse off because the broader index is also down 90%?

John: You don’t live in stocks…

So, yes. If you lose 90% on a stock, but the stream of dividends is completely unchanged, then yes, you’re just as well off as before. If before you were planning to live off that stream of dividends, you can still do so. If before you were going to exchange the stock for a different one that gave a similar stream of dividends, you can still do so.

The key difference: Stocks typically fall when there is a big bad shift to the expected stream of dividends. When your house price falls, there is absolutely no effect whatsoever on its value to you as living space.

Cochrane offers caveats and provisos, but his basic point is an important one. He also discusses the notion that housing wealth allows households to borrow more:

Remember though that borrowing has to be paid back. So you bought a $100,000 house in 2005 with $10,000 down, and $1,000 per month mortgage. It goes up to $200,000. Great! Now you can refinance and take an extra $90,000 out of the house and go on that round the world cruise you had been hoping for. (Or start a business, or whatever.)

Whoops. Except now you have to pay the loan back. You have to pay $2,000 per month on your bigger mortgage. As long as you want to live in the house – or another one of the same size – you didn’t get any more wealth. “Removing a borrowing constraint” is different from “having more wealth.”

So you are better off, but only if you knew you were going to get a big raise, so that you wanted to borrow a lot of money but the bank wouldn’t let you. That might be true for a lot of people. On the other hand, we are perhaps becoming skeptical that it is such a great idea for young people to pile on a huge amount of debt, so perhaps not such a social tragedy that they can’t do it as easily any more.

But don’t confuse the size of a possible borrowing / collateral constraint with “wealth.”

That’s part of the transfer question. Those who rented did worse when house prices went up, and do better when house prices go down. There’s no question that it’s better to be a renter if you know prices are going down and vice versa. Just as it’s better to be out of the stock market when prices are going down.

The fact that a majority of the electorate lives in owner-occupied housing is a big part of why the fate of housing wealth is being treated as an urgent policy matter while, say, the unfavorable tax treatment of renters is largely ignored.