In responding to Kevin Drum, Ryan Avent wants to know the channels in which falling house prices could cause a deeper recession. Shouldn’t it net balance out?
Well, first off falling house prices de facto increase the leverage of households and, as the Eggertsson/Krugman model shows, the effect of the following deleveraging shocks are to push interest rates further negative.
But I’m going to try and build this up because this story is important. There’s three steps to approaching this: balance sheet effects, asset fire sales, and then putting them together into a model with asset market feedbacks.
Let’s say I try to keep a consistent net worth and a consistent leverage ratio at all times. As an example, let’s say I have a house worth $100 and I keep a leverage ratio of 3.
Assets = 100. Debt = 75. Equity = 25.
Now let’s say that the value of my house drops $10. Now I have:
Assets = 90. Debt = 75. Equity = 15.
My leverage ratio has now increase from 3 to 5 (75/15), meaning I have much more leverage than I did before. I can’t function that way so I need to cut my debt load down to 45. I do this by consuming less and deleveraging for a period. I can also do this by selling off units of the asset, which is housing. I would have to sell $30 of housing in this example to get back to my ratio. Notice how leverage can cause major swings in these examples.
(Since it’s going to hang over the rest of this, the first complication is why assume a consistent leverage ratio/net worth for households? Corporate Finance theory can get us to arguments about why keeping a consistent net worth for entrepreneurs is optimal for investors; arguments like this can be generalizable to households on the part of their access to credit. The Eggertsson/Krugman paper does a similar move: “We will assume, however, that there is a limit on the amount of debt any individual can run up. Implicitly, we think of this limit as being the result of some kind of incentive constraint; however, for the purposes of this paper we take the debt limit as exogenous.”)
The next problem is the problem of fire sales. If there is a positive correlation of distress between buyers and sellers of a good then assets will sell at a discount relative to value. In English, if you are selling your home because you are unemployed and/or overlevered, and unemployment and overleverage is not just an individual phenomenon but characteristic of the economy as a whole, potential buyers are also likely to have weak earnings, worries about employment, constrained access to credit markets and worries about net worth. As such the home will sell at a large discount. You are currently seeing things like recoveries of 40-60% in foreclosure, gigantic haircuts on foreclosed properties, so this is happening. However this drives down the value of housing…
Asset Market Feedback
What happens when you put the balance sheet mechanism together with the fire sale mechanism? You get the Kiyotaki-Moore model from their paper Credit Cycles (1997).
Notice the overlap. Declining value puts pressures on balance sheets which puts selling pressure on assets, which if sold at fire-sale values marks down the net worth of assets, which increases the leverage of other homeowners that they see their property is worth less, which puts pressures on balance sheets, etc.
Which they describe as:
The transmission mechanism works as follows. Consider an economy in which land is used to secure loans as well as to produce output, and the total supply of land is ﬁxed. Some ﬁrms are credit constrained, and are highly levered in that they have borrowed heavily against the value of their landholdings, which are their major asset.
Other ﬁrms are not credit constrained. Suppose that in some period t the ﬁrms experience a temporary productivity shock that reduces their net worth. Being unable to borrow more, the credit-constrained ﬁrms are forced to cut back on their investment expenditure, including investment in land. This hurts them in the next period: they earn less revenue, their net worth falls, and, again because of credit constraints, they reduce investment. The knock-on effects continue…
For the market to clear in each of these periods, the demand for land by the unconstrained ﬁrms has to increase, which requires that their opportunity cost, or user cost, of holding land must fall…The fall in land price in period t has a signiﬁcant impact on the behavior of the constrained ﬁrms. They suffer a capital loss on their landholdings, which, because of the high leverage, causes their net worth to drop considerably. As a result, the ﬁrms have to make yet deeper cuts in their investment in land. There is an intertemporal multiplier process…
In fact, two kinds of multiplier process are exhibited in ﬁgure 1, and it is useful to distinguish between them. One is a within-period, or static, multiplier. Consider the left-hand column of ﬁgure 1, marked ‘‘date t ’’ (ignore any arrows to and from the future). The productivity shock reduces the net worth of the constrained ﬁrms, and forces them to cut back their demand for land; the user cost falls to clear the market; and the land price drops by the same amount (keeping the future constant), which lowers the value of the ﬁrms’ existing landholdings, and reduces their net worth still further. But this simple intuition misses the much more powerful intertemporal, or dynamic, multiplier. The future is not constant. As the arrows to the right of the date t column in ﬁgure 1 indicate, the overall drop in the land price is the cumulative fall in present and future user costs, stemming from the persistent reductions in the constrained ﬁrms’ net worth and land demand…
Land in that example is isn’t a house but “land”, something that is productive and can also function as collateral (think airplanes for airlines). This mechanism is important for the fire sale channel part of this – when an airline goes into crisis chances are other airlines are in crisis and the only buyers are unproductive users of the collateral, say someone who wants a private jet for fun (and will pay less because they’ll profit less from their use).
So is land being productive (an output), necessary for feedback from the future, a reasonable assumption? Well no, but we do see that high leverage is well-correlated with a general lack of demand, so mechanisms that produce higher leverage will feedback through weaker local economies, which will cause more fire sales, which will produce higher leverage and have potentials for spirals. Here’s Atif Mian and Amir Sufi on the link between leverage and weak demand. Here’s the graph for auto sales:
And employment growth:
Avent’s question assumes a frictionless market. What is necessary for these issues to complicate the picture? Credit frictions (our people can’t carry arbitrarily high leverage), debt which produces large swings, fire sales and low recoveries, those low recoveries being observed as as the value for the balance sheet and deleveraging causing unemployment.
Is it a slam dunk channel? No. But it does have me worried that a drop in housing will hit the economy hard. And it makes me think the lack of mechanisms to put some checks on firesales – say modification of mortgages in bankruptcy – and going with the “liquidate the homeowners” approach was a major mistake for the Obama administration.