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We Will All Be Better Off with Falling House Prices
  (Paul Tolnai, June 9, 2008)

The Mainstream Media, Reuters, is reporting that “Housing Price Decreases Means a $4 Trillion Capital Loss.”

Ok, what is that about and is it even true? I don’t think so! Let’s define some terms.

Savings: are residual resources left over from consuming less than you produce. These residual resources, that are not consumed, can be applied toward activity that has future, versus immediate, utility. That is to say they can be invested. Immediate utility is just consumption. These physical resources can be denominated in some common unit of measure, but it is the physical resources that are the savings that will be invested, however denominated. (Not necessarily tangible resources, for example education is a saving that results in human capital. But it is not necessary to over complicate things here).

Capital: is just savings. Why the different names? Because each of them may be associated with different actors. Clearly it is the producer who saves. This individual may or may not invest his savings himself. He may trust his savings with people with special skills. For example, by buying stock in a company one hands over one’s savings to that company. The company did not do the savings that it will invest, say in plant and materials, so the savings that the company has to invest is referred to as capital.

It is the same physical resource, but is associated with different actors. (Not really redundant terms. For example, it is unlikely that individuals will pool their savings to buy a Gulfstream jet so somebody else doesn’t have to wait in line to board first class, but it is possible for some corporate manager to invest his capital, savings entrusted to him, to think to do so).

Prices: represent the ratio of exchange between two different articles being exchanged. They have nothing to do with savings, hence capital. A bushel of corn may be exchanged for half a bushel of cherries. Two suits for an ounce of gold, and so forth. The price of a suit can be written as “1 Suit – ˝ oz gold”. Also, let’s say that one can exchange a suit for 10 bushels of corn. Then the implied price for cherries in terms of gold would be 10 bushels of cherries for an oz. of gold, or 1 bushel cherries costs 0.10 oz. gold.

Now if gold could be exchanged for scripts of paper, which we’ll call a “buck”, at a ratio of 1000 bucks per oz. of gold, then the price of a bushel of cherries would be 100 bucks. So price is nothing more than an exchange ratio. It has nothing to do with savings or investing. Now changes in prices may impact the level of savings , but that is so only because of changes in human behavior, not because of a change in price per se. Prices exist only within a framework of trade and trade operates at the margins of each trader’s diminishing marginal utility, and these are constantly in flux and prices are merely signaling devices wherein these values of diminishing marginal utilities find expression. As a general rule, the lower the relative prices, that is relative to income, the lower percentage of income that one must give up to acquire things that one wants, the wealthier one is. The more your dollar buys, the wealthier you are.

Now a house can be bought with past savings, the promise of future savings, or a combination of the two. In the recent bubble, people simply promised to pay the increasing price of a house by committing more future savings towards the house. Now as prices fall, people need to commit fewer future resources towards the purchase. This would tend to increase, not decrease the amount of savings that would be available in the future to otherwise invest.

So where is Reuters coming from? How do they figure that a decrease in housing costs means less capital availability. Well, clearly Reuters is referring to home equity and treating it as capital, that is savings available to invest. But is it? If an individual buys a house for $100K with a $80K mortgage, he has committed $80K of his future savings towards the extinguishment of that debt. If the price that the home will fetch, at some later point in time, goes to $200K, that is the new buyer will agree to pay more of his current savings, or future savings, to the current owner, the current owner may be richer – that is have an ownership claim to more savings than he had before, but the buyer will have a corresponding lesser claim to savings as he now has. The seller will be able to buy more of other things, the buyer less – be that bushels of cherries, corn, or whatever. Price changes have no direct effect on savings. The only thing that has changed in the above transaction is that the level of debt has increased. Before, the claim to future savings was $80K, after the purchase, the claim on future savings was, say, $160K or $190K.

The important point to keep in mind here is that this transaction involved a GIVEN physical resource which neither physically increased or decreased. Recall, savings, and hence capital, are physical resources that can be applied for future gain.

So where then is the change in capital that Reuters is referring to. Well, instead of wealth equaling savings, Reuters implies that wealth equals debt! The only thing that increased in the example above is the level of debt – that is the pledging of future savings. (Should the seller, the recipient of the increased savings stay pat, then there will be no net change in the overall savings. But realistically, a bank will have monetized those future promised savings for him, and given our cultural values, at least a part of it will be spent. Hence more consumption now and more net debt). So, if housing prices goes down, then the amount of debt that needs to be pledged goes down, so given Reuter’s point of view that wealth equals debt, they conclude that capital has decreased.

Indeed, this is exactly the problem the country is facing. Go shopping has been the country’s motto. The more you spend the more you save. This conception of wealth is akin to a teenage valley girl at a mall who has, not 1, not 2, but, yes, 3 credit cards available to her. Does she feel wealthy or what?! Take one of those credit cards (a claim on future savings) away from her, and Reuters concludes that she would now have less “capital” available to her and hence she is less wealthy! Go figure!

But debt is not wealth and we have pledged too much of our future savings towards the wrong objective. Reorienting our future savings towards more promising investment objectives will result in the seller above, or the intermediary that cashed him out, not receiving those promised savings as they will be applied instead to other areas of the economy. It is nothing more than Ricardo’s creative destruction of capital at work as the respective hurdle rates for each of the respective investments compete for those future savings. As interest rates rise, that is the price for savings, housing will simply not be able to provide the prospective return and will lose out in the race for a claim to those savings to other better prospects.

That process should not be interfered with, whether via “Friends of Angelo” programs or otherwise.

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