If you're an Average Joe or Josephine, you may skim reports of economic data and wonder about the tangential effect these statistics have on your everyday life. Measures of things like durable goods orders or the trade deficit may seem pretty distant from your personal budget.
That's no longer true with housing indicators, watched by many people for evidence of a precipitous slide in home prices. If you're interested in the current thinking among economists about how the changing housing prices may affect you and even change your behavior, consider this recent government report.
The Congressional Budget Office, a nonpartisan group of number crunchers who advise lawmakers, predicts that the slower growth of home prices will probably have a modestly negative effect on the economy this year. They foresee a slowdown in consumer spending, but their crystal ball doesn't show evidence of a major economic disruption.
What could happen? CBO economists estimated that home prices would have to rise 3% between the last quarter of 2006 and the last quarter of 2007 to prevent a decline in housing wealth when compared with disposable income. If, hypothetically, prices fell 2% during that time, people would feel their housing wealth shrink in relation to their disposable income.
What happens next? That depends in part on the strength of what's known as the wealth effect. Economic analysts believe that increased home values permanently increase consumer spending in future years by decreasing the amount of disposable income that homeowners feel they must save for the future. In other words, your assets grow and you save less; therefore, you spend more.
While economists mostly agree that consumers act on this wealth effect, their measurements of its magnitude vary. The CBO survey showed that most estimates fall within the range of between $0.02 and $0.07 of extra spending per dollar of housing wealth. All else being equal, the wealth effect would mean that a $1,000 increase in the price of your home this year would cause you to spend an extra $20 to $70 this year and in every future year.
Returning to our hypothetical example, if home prices fell 2% over a year, the CBO says the wealth effect would probably cause the savings rate to increase by between 0.2 percentage points and 0.7 percentage points. Said another way, consumer spending would continue to grow but at a slower rate. That would slow economic growth slightly.
The bottom line? Even if you factor in all the secondary effects of reduced consumer spending, that reduction in housing prices would not be enough to cause an economic recession.
What could cause a recession? Let's look at the worst-case scenario. (Economics has been called the "dismal science," after all.) Three variables could make a decline in housing prices have a much bigger negative effect on consumer spending: housing prices could fall by much more than 2% -- we'll just have to wait and see how that one turns out; homeowners could be basing their spending decisions on wildly optimistic expectations for the increase in their home's value; or consumers could suddenly all stop drawing on their home equity.
If all three of these things happened simultaneously, and it had a big enough effect on consumer spending, it could tip the economy into a recession, the CBO found. However, they also called that scenario "possible but unlikely."
What does this mean for real people and their real houses? We'll just have to wait and see what happens to put these economic predictions to the test. In the meantime, you may want to think a little bit about whether you're exhibiting some "irrational exuberance" when it comes to the wealth effect.
To gain some perspective, consider this: Housing prices have skyrocketed until just recently. The report calculated that between 2000 and mid-2006, the median sale price of existing single-family homes rose 7.7% per year. That's 5 percentage points faster than inflation. But, over the previous 32 years, the median home price rose by a more modest 1.8 percentage points faster than inflation.
For related Foolishness:
- Smaller House, Bigger Retirement
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Fool contributor Mary Dalrymple welcomes your feedback.