By Pete Lester, Sr.
January 23, 2008
Where two or more economists are gathered, there will be an argument.
To any economic argument we bring basic economic facts and logic, but we also undoubtedly bring our perspectives and presuppositions.
A good, generally accepted definition of a recession includes something like: “an overall decline in a country’s gross domestic product or negative real economic growth for two or more successive quarters.”
In my prior business life, I was in commercial real estate. One lesson I learned in that industry was that regardless of how one defines a recession, the effect of a recession is that equity flows back to its rightful owners.
What does this mean to each of us in the current economic environment and how might it impact us?
For the last few years, those of us who own a home have enjoyed extraordinary increases in our property values. For the last few years, whenever we had a neighborhood party we would all scratch our heads as to “who were the people moving into the new houses being built in the back of the subdivision? How can they afford the homes at those prices?”
Truly, we all had experienced significant “paper wealth” from the appreciation of our homes. According to Robert Shiller of Yale University from 1998 to 2006, the US housing market gained 86% in real inflation-corrected value.
With the sub-prime lending problems and the tightening of credit for new home buyers, the housing market has not just cooled off, but some of that “paper equity” has eroded for all of us.
Its not just homeowners who are feeling the pinch, but to stay on this thread for another moment… the impact of this loss of equity is felt in several ways:
- Obviously, there is a loss of flexibility. People who were going to borrow against their home to start a business, send a child to college, or maybe simply improve the home are now more limited in what they can do.
- Psychologically, the impact runs a little deeper. Anytime a consumer takes a loss on an investment, it impacts their confidence. The more significant the loss, the more deeply confidence is impacted. I would venture further and state that because so many people are impacted by the decline in housing values, albeit by varying degrees, this is much more significant.
According to the Conference Board, the Consumer Confidence Index has been falling steadily since July. Confidence rebounded slightly in December. [1] And the numbers for January? Well, they have not been released yet.
But here is the point: the psychology of consumers is a key component to any turn in the economy, whether it is an expansionary turn or a recessionary one.
Exacerbating the situation is the specter of inflation. This too, can be psychologically based. For instance, if consumers expect the price of certain goods to rise, they will rush out and purchase, even hoard those goods. The rapid increase in demand leads to increased prices. Inflation becomes a self-fulfilling prophecy.
In the stock market there is an interesting Index that reflects the anxiety of investors. The VIX is the Chicago Board Options Exchange's Volatility Index. For the last few weeks, this index hovered around 24 to 25. Last week, it moved up 16% moving above 30 for the first time since November. During typically calmer periods, this index is somewhere South of 15. While this index is not an indicator of consumer confidence, it is an indicator or the current sentiment of active investors.
If there is a recession it could be complicated by rising oil prices, the tightening of lending standards, jittery investors, even poor political and fiscal policies, but ultimately, consumers will decide when it starts and when it ends.
[1] “The Conference Board Consumer Confidence Index Improves Moderately in December,” December 27, 2007, www.conference-board.org/economics .
QUESTIONS for STUDENTS of ECONOMICS:
1) Can you think of an instance where prices increased because of volatile or sudden increase in consumer demand? How did businesses respond after Katrina? What prices where impacted by increased demand for certain products after Katrina?
2) If you anticipated a slow down in the economy, how would it impact your decisions?
3) If you were a business owner, or thinking about starting a business, how would the increased likelihood of a recession impact your decisions?
2 comments:
Hi Pete,
Interesting commentary. many people fail to grasp how important confidence and expectations are to the macroeconomy.
I would bring up the question of what the government's role should have been in the subprime debacle. I had students 3 years ago who were assistants to mortgage brokers in Columbia telling me that mortgages were being made that were unsuitable and not understood by the borrowers. If they saw it a lot others saw it as well.
Unfortunately, real estate is illiquid which is one of the reasons it takes so long, and causes so much pain, when disequilibriums occur.
Bob,
Thanks for the comments... and you are right. Certainly lending requirements were relaxed and (my wife is an appraiser) there is plenty of blame to go around. Any time credit is too easy: when there is a falling out - it is rough on those who were last in, and should have not borrowed in the first place.
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