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Why the Country's Top Economists Keep Making Wildly Stupid Claims

Underwater homeowners can't explain the weak recovery. It's reduced demand and wiped out housing wealth.

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Anyone wanting to learn about the economy who talked to the nation's top economists in 2006 would have been wasting their time. Almost none of them had any clue that the collapse of the $8 trillion housing bubble was going to wreck the economy. This presumably reflects a rigid dogmatism and conformity on the part of these economists, since it should have been both very easy to recognize an unprecedented run-up in house prices as a bubble and also to understand that the collapse of the bubble, which was quite evidently driving growth, would lead to a severe downturn.

Remarkably, it seems from a Washington Post article that attributes the continuing weakness of the economy to the indebtedness of underwater homeowners, that many of the country's top economists have no better understanding of the economy today than in 2006.The claim is the dropoff in consumption due to the debt burden of these homeowners explains the weakness of the recovery.

Some simple arithmetic shows the absurdity of this view. The amount of underwater equity is estimated at between $700 billion (Core Logic) and $1.1 trillion (Zilliow). Suppose that we can disappear this debt through some decree, how much additional consumption would we see? If we assume that these households spend an incredibly large share of this increase in their net wealth, say 15 cents on the dollar, this would imply additional consumption of between $105 billion (Core Logic estimate) and $165 billion a year (Zillow estimate).

However we would have also destroyed the wealth of the mortgage holders. Let's assume that they just spend 2 cents on the dollar of their wealth. This would imply a net boost to demand of $91 billion to $143 billion. While this would be a helpful boost to the economy, equivalent to a government stimulus program of this size, this would hardly be sufficent to make up a shortfall in annual output that the Congressional Budget Office puts at close to $1 trillion.

Furthermore, even this gain is almost certainly a huge exaggeration of the actual effect. With 11 million homeowners underwater, the above calculaton implies an increase in average annual consumption of between $9,500 and $15,000 a year. The median homeowner has an income of less than $70,000 a year. It doesn't seem likely that such a family would either have this amount of savings each year that they could instead decide to consume if they were no longer underwater in their mortgage or that they could borrow this amount on any sort of sustained basis. In short, the numbers in my calculation above almost certainly hugely overstate the economic impact of eliminating underwater mortgage debt.

In fact, there is no need to turn to implausible underwater mortgage debt explanations for the weakness of the economy. The economy is acting exactly as those who warned of the bubble predicted. We saw a sharp falloff of residential construction as we went from a near record boom, with construction exceeding more than 6.0 percent of GDP at the 2005 peak, to a bust where it fell below 2.0 percent of GDP. This meant a loss in annual demand of more than $600 billion a year.

We also saw a large falloff in consumption due to the loss of $8 trillion in housing wealth. The housing wealth effect is one of the oldest and most widely accepted concepts in economics. It is generally estimated people spend between 5 and 7 cents each year per dollar of housing wealth. This means that the collapse of the bubble would be expected to cost the economy between $400 billion and $560 billion in annual demand.