On asset prices and savings

Now that home prices are falling, you don't hear too many economist talking about how "savings" should be redefined to include home equity wealth. That was all the rage at the height of the housing bubble when dimwitted economists would eye the near-zero bottom line of income minus spending and figure that the calculation needed to be changed.

Here's a good example from a year ago - Unmeasured Savings - where the words of Nobel Laureate Edward Prescott looks quite foolish after the events of 2007:

Myth No. 3: Americans don't save. This is a persistent misconception owing to a misunderstanding of what it means to save. To get a complete picture of savings we need to investigate economic wealth relative to income. Our traditional measures of savings and investment, the national accounts, do not include savings associated with tangible investments made by businesses and funded by retained earning, government investments (like roads and schools) and business intangible investments.

If we want to know how much people are saving, we need to look at how much wealth they have. People invest themselves in many and varied ways beyond their traditional savings accounts. Viewing the full picture -- economic wealth -- Americans save as much as they always have; otherwise, their wealth relative to income would fall. We're saving the right amount.

It is reminiscent of the paper from the Federal Reserve Bank of Chicago that characterized mortgage lending innovations as "Wealth Creation Technology" - you don't hear those terms tossed around too much anymore.

One economist who has consistently made sense over the last few years (except for his horrible call on the bursting of a commodities bubble, which, of course, was noted here) is Stephen Roach, Morgan Stanley's chief economist who now works in Asia.

In a recent piece in the Financial Times, he argues that savings (calculated the old-fashioned way) is the root cause of the current economic problems in the U.S. and that asset prices must come down in order for order to be restored.

America's aversion toward saving did not appear out of thin air. Waves of asset appreciation - first equities and, more recently, residential property - convinced citizens that a new era was at hand. Reinforced by a monstrous bubble of cheap credit, there was little perceived need to save the old-fashioned way - out of income. Assets became the preferred vehicle of choice.

With one bubble begetting another, America's imbalances rose to epic proportions. Despite generally subpar income generation, private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.

None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.
...
As home prices move into a protracted period of decline, consumers will finally recognise the perils of bubble-distorted saving strategies. Financially battered households will respond by rebuilding income-based saving balances. That means the consumption share of gross domestic product will fall and the US economy will most likely tumble into recession.

As additional proof that, at least to some degree, all economists are naive, Mr. Roach goes on to argue that policy makers should just stand back and let the process play out rather than looking for quick fixes that will only prolong the inevitable.

In an election year?

Yeah, right.