Deflation of the Asset Bubble and Consumer Dissaving

During the second quarter of 2005, Canadians spent $756b. on personal consumption. Personal disposable income was $770b [from various tables at this site]. In other words, Canadians were saving virtually nothing. In fact some reports that I have seen said that consumer spending had out-stripped disposable income (but, alas, I can no longer find the references, and the Sadistics Canada Website is anything but user friendly).

What are consumers doing? How are they paying for all this consumption?

They are drawing down their savings and borrowing a truckload. Unfortunately, the basis for much of this borrowing is inflated asset values, especially housing but possibly equities and maybe bonds, too.

Suppose that most pundits are correct and that major housing markets have been experiencing a bubble. The growth of home-owners' debt based on these inflated housing values to fund consumption spending has played a major role in the continued growth of aggregate demand. Once the housing bubble bursts, this dissaving will have to stop. And once consumption demand falls off, so will aggregate demand.

That is the essence of this piece by Nouriel Roubini, in which he quotes Fed Chairman, Alan Greenspan:

Recently, Greenspan and other Fed officials (see Greenspan (2005a) and Kohn (2005)) have expressed greater concern about such a housing bubble and on its effects on the national savings rate and the U.S. current account balance: "Nearer term, the housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home price increases will slow and prices could even decrease. As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures. The estimates of how much differ widely. "

... Fed practice over the last two decades of not reacting to rising asset bubbles (the tech stock bubble of the late 1990s and the housing bubble of the last few years) while aggressively countering bursting bubbles and episodes of systemic risk (as the Fed did in 1987, 1998, 2000 and 2001) may have contributed to the asset bubbles and economic imbalances (low savings rate and large current account deficit) that make the U.S. economy highly vulnerable to investors' shifts in the their assessment of risk and to negative developments in global economic conditions. That is why a Fed reassessment of its approach to asset bubbles is seriously warranted.

As housing prices cool off, there are some important questions:

1. How much are housing prices going to cool off? Will they merely stop rising so quickly or will they actually decline? and by how much?
2. As the housing market cools off, what will be the impact on aggregate demand? If much consumer demand has been based on inflated housing values, then aggregate demand could end up taking a big hit, and we would face a serious recession.

My own best guess is that (generally speaking -- there will be regional exceptions) housing markets will cool off gradually; there will be no gigantic, economy-wide blood-letting. The result will be less-than-catastrophic reductions in aggregate demand.

But what if I am wrong? [See here for a confession that I have, in fact, gone more liquid to hedge against this possibility.] Then macro policy makers in general and central bankers in particular should do two things: First they should be prepared to bump up aggregate demand in the near future. Second, they should take a lesson from Roubini and put the dampers on asset bubbles before they get out of hand.

The problem is that bumping up aggregate demand will not do much to restore savings incentives, which are so necessary for longer-term economic growth.

On a related topic: The Governor of the Bank of Canada warns about imbalances between countries that save and those that do not [h/t to Sean]:

"The United States faces a large and growing current account deficit, which reflects an excess of investment spending relative to domestic savings," David Dodge told a round-table discussion of central bankers Friday in Calgary.

He said the spiralling U.S. deficit was being matched by growing current account surpluses in Asia, in oil-exporting countries, and in some other economies around the world.

Dodge said if these imbalances continue to grow, it will slow the global economy.

"And hence we will be in a position where we will not have the growth to keep incomes rising as the population ages - that's the dilemma."

Dodge said in Canada this situation would create higher unemployment and lower investment.