Financial Times Blog on recessions and consumption

Willem Buiter writes:

The impact on annual consumption of the 5 percent decline in house prices would then be $38 billion. With a $ 12 trillion annual GDP, this is a decline in demand of just over 0.31 percent of GDP – not quite the stuff recessions are made off. Even if, over the next three years, house prices were to continue to decline at a 5 percent rate, this would give us a further cumulative decline in demand of just over 0.9 percent GDP.

The sub-prime crisis, like any financial crisis, is first and foremost a distributional question

The sub-prime crisis, the write-downs by commercial banks and investment banks of CDO and other ABS exposures, the ABCP meltdown and related financial kerfuffles are first and foremost a redistribution of financial wealth from creditors to debtors. All these derivative claims are ‘inside’ financial claims – for every creditor there is a matching debtor. These write downs and write-offs do not in and of themselves destroy any net wealth.

(what the author does not address is the effects of the delta creating REAL losses in the market participants, who are forced to deal with mark to market questions)

All other financial instruments, including sub-prime mortgages, ABCP and all asset-backed securities are inside instruments for which changes in valuation do not change aggregate wealth but just redistribute it. That does not mean that such changes (and the precise circumstances under which they occur) don’t matter for aggregate demand or supply. In general they will not be neutral. But it is important to recognise that for every unhappy banker who writes off $200,000 of mortgage debt, there is one happy mortgage borrower who now will no longer have to service that debt.

A single foreclosure on a sub-prime mortgage has been estimated to cost as much as $50,000. With as many as 2.2 million families with a subprime loan made from 1998 through 2006 who expected to lose their home to foreclosure in the next few years, a real resource cost of $110 billion will be incurred.

How much of the almost $1.3 trillion of subprime lending during these three years is covered by the value of the properties held as collateral is unknown, as there is no prior experience of lending to such a large subprime population. A loss of $150 bn would be just be under 12 percent; that seems low, and one could easily conceive of it being as high as 20 or 25 percent. In addition, losses will be made on subprime loans made before 2004 and after 2006, and on higher-rate loans, including Alt-A and prime loans. A $250bn to $300bn eventual loss on all mortgage-related exposure would seem to be in the ball park.
It is therefore not surprising that the growth rate of real exports has been pretty spectacular recently (9.6 percent in 2007 Q3 on a year earlier). There is no doubt that, if the dollar stays weak (let alone weakens further) and if global growth slows down only modestly, the growth of export demand can easily more than compensate for the decline in residential investment.
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