Greenspan Speaks on US Housing Equity Withdrawal....

The United States has enjoyed high growth rates compared with most other developed countries in recent years. In part, this has been due to rapidly increasing property prices fuelling increased consumption. Household consumption has grown based on home owners withdrawing equity from their homes (by taking out larger mortgages, for example), and spending part of this withdrawn equity on consumption.

In the long run, this behaviour may generate risks for the economy, as the ability of households to continue to withdraw equity depends on continued increases in the price of houses.

In a recent paper by the former Chairman of the US Federal Reserve, Alan Greenspan (and co-author James Kennedy) carefully calculate how large a share of consumption in recent years was due to home owners extracting equity from their homes. I find the results somewhat alarming.

Consider the following figure from their paper. US households have been spending approximately 1% more than they earn for the past two years (fat solid line). But if we subtract consumption and repayment of non-mortgage debt that is financed by equity withdrawal from their spending, they are in fact living within their means, with a savings rate of just over 1% (thin solid line). The difference between these lines may be interpreted as the extent to which the housing market has fuelled consumption demand.

To try to see how this has affected Real GDP growth in the US, I've reproduced the offical GDP numbers for the US, adjusted by the difference between the two lines. The first figure below is in terms of levels, while the second is in terms of growth rates. (The correction for 2006 is based on the average for the first three quarters only, the latest figures contained in the paper).

Taken at face value, the effects don't look too alarming. Even thought most economists would agree that the growing difference between these lines is unsustainable, it is small, at about 2.3% of GDP in levels in 2006. Under normal circumstances, we might expect that households would slowly reduce their equity withdrawals over time, which would slow GDP growth a little, but probably not by enough to cause a recession.

The problem comes if the correction is forced to occur more quickly. Now that house prices are actually falling in the United States, the ability of households to extract equity has effectively evaporated in most areas. If consumption were to fully drop by the amount of the equity withdrawals, then it is likely that the resulting 2.3% drop in real GDP would more than offset any increases in other sectors of the economy, and so cause a recession.

The problem may also be further compounded:

1) If house prices were to continue to fall, we could see equity withdrawal go into reverse: households reduce consumption by more than 2.3% to try to increase savings to offset their loss of wealth.

2) Other components of the economy are dependent on housing and consumption. It is likely that investment spending would also decline significantly in response to a major fall in consumption.

Only time will tell if this is correct, but I remain pessimistic.

For my earlier views on the US economy and the role of housing see here and here.