Monday, May 28, 2007

Back to Basics with Housing

The report last week on the positive increase in new home sales is misplaced. New home sales only tell us the quantity that is sold and not the price that cleared the markets. Of course these sales are related to demand but the important issue with housing for the US economy is the wealth effect, what is embedded in the price of the homes sold.

Prices for new and existing homes have fallen. Focusing only on the quantity side of the equation generates misinformation. The price determines whether there has been a profit generated from the construction and whether future building will be undertaken. The price, in the case of existing homes, determines whether there was any gain on the asset which can be used for other investing or consuming. Prices are more important than quantities.

The macroeconomic focus on housing has been twofold, the impact of new construction on the overall economy and the creation of wealth from investing in housing which drives consumption. The first impact is important but a localized sector effect. This sector effect is fairly easy to measure. The wealth effect is more complex and far-reaching. Wealth creation is a combination of financing or leverage and the price change for the investment. The transmission from wealth increase to consumption is difficult to measure because it is related to whether the home-owner believes the change in the value of his home is permanent or transitory. Consumption should not change significantly with transitory changes in wealth, but will change when the wealth adjustment is viewed as permanent. The economy is still working through this process and one month of greater sales will not move consumer expectations nor should be considered a trend.

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