Belfast Telegraph

Friday 11 July 2014

Crystal ball is cloudy and the future a worry

First-time buyers — they primed the boom and are now in debt

Remember the 'wealth effect' during the boom? People were becoming more wealthy as the value of their houses and (particularly in the US) their shares, rose rapidly.

The question was to what extent this encouraged them to spend, thereby adding to the marvellous circle of growth.

The other, more troubling, question was what would happen to consumption if that wealth began to fall? If growing wealth added to personal spending and economic growth, it seemed logical that a decline would have the opposite reinforcing effect.

No one seemed terribly sure about the numbers. Some economists disputed whether there was much of a thing called the 'wealth effect' at all. This uncertainty was understandable. No one had ever seen such an increase in general household wealth before, and they would have to wait for a crash to get any data on the reverse effect. Well, now they have it.

Commonsense suggests that there must be some impact on people's behaviour from a fall in the the value of their assets. It is a critical question for Ireland where the rise and fall in wealth from the bubble and burst are among the most extreme recorded anywhere.

You may remember the headlines when an estimate from National Irish Bank (NIB) put household wealth in the Republic at one trillion euro. This was at the beginning of 2008 and represented an extreme way of marking the peak of the boom.

Of course, most of this value was in property.

The 'wealth effect' is psychological, and there is even some suggestion that changes in the value of a house may have more effect than that of financial assets. Nor are these all 'paper losses' in the way that gains in house prices were notional gains. In many cases there is a large amount of mortgage and other debt built up on the back of those heady gains in housing wealth.

The loss in the Republic is certainly astonishing. The folk in NIB think it is around €160bn, which is an average of more than €100,000 per household. If, as many believe, house prices still have further to fall, the final loss will be greater.

Those are figures for net worth - assets minus debts. The headline-grabbing trillion euro figure was assets alone, but one would expect net worth to be the main factor in any 'wealth effect' on consumption. Net wealth is down by about a third since 2007, leaving Irish households with an average of something less than €400,000, comprising debt of €130,000 and assets of more than €500,000 - including the value of houses.

So Irish households overall are not actually bankrupt. Averages, though, are not much use in this case. Young people who bought homes in the past six years are likely to be more heavily in debt, and to have negative net wealth where those debts exceed the value of the house and other assets.

This difference between the generations has been highlighted by several commentators, and is bound to shape the changes in consumption as younger people - the big spenders - respond to their loss of wealth or their descent into net debt.

Yet there has been considerable wealth destruction among older people as well, many of whom borrowed heavily to buy extra properties, or lost heavily on supposedly safe shares or pensions. It is not easy to distinguish 'wealth effects' from straightforward reductions in income. Clearly, people who lose their jobs will spend less. A rise in interest rates can knock as big a hole in purchasing power as contentious pay cuts. The wealth question asks how people react to the sight of other people losing their jobs, and the economy in general getting into trouble, as well as to their own financial situation.

If the present generation become more fearful, the crisis could mean a permanent loss in the Irish propensity to consume.

The genuine Celtic Tiger owed a lot to the dramatic fall in the numbers of dependent children, but the dependency ratio is going to rise over the next several decades as the population ages.

The 'wealth effect' means consumption cannot be the engine of recovery, but the alternative - investment - will be constrained by the very uncertainties caused by falling consumption.

The Great Man once again put it best. The factors influencing the rate of investment are most unreliable, he says, because they are "influenced by our views about the future about which we know so little".

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