Thursday, April 26, 2012

Economic Theory and Durable Goods

Sexy title, no?

A strict consumable good is one that will be consumed (used up) in this period. A durable is something that will last many periods, although you can think of a fraction of it being used up per period. So a new roof is a durable, you'll need to replace it again in 30 years, but 15 years from now you will not have half a roof, you will just have a roof with 15 years left of life.

Megan's blog runs the standard story on durables:
Normal economics has two pieces of advice about how to buy consumer durables:
1.  Buy them when interest rates are low (cheaper to borrow the money; and you weren't going to earn anything at the bank anyway).  
2.  Don't buy them when your income takes a one-time hit (if the 'crops' have been bad the last few years--like they've been since the Great Recession--it's best to focus on buying things that get used up: food, haircuts, doctor visits; you can keep driving the Corolla). 
Recessions are times when 1 and 2 usually push in opposite directions, but in practice 2 wins the battle: Durable purchases collapse in a recession
 Well, yes and no.

The main durable in the household sector is housing. The price of housing is very much determined by the price of financing -- when financing is cheap housing prices go up, and when financing is expensive, housing prices go down. In other words, housing is an asset for which the levered and unlevered prices are very different.

Therefore, housing, a durable, is a terrible thing to buy when interest rates are low because that means financing is cheap and therefore housing will be expensive. Better to buy a house with a high interest rate loan, for a lower price, and then refinance into lower interest rate loans when rates fall.

But, people buy when money is cheap. If Monetarists want a mechanism by which interest rates impact the economy, this would be it. Low interest rates encourage consumer spending via horizontal credit expansion beacause they use the money to buy housing. That increase in AD then brings the economy into full employment.

However, when the fall in AD is caused by over-consumption of housing due to cheap money, offering more cheap money to buy those assets at their fully leveraged priced is truly pushing on a string. Even more than ZIRP.


Blogger Ralph Musgrave said...

Agreed. Apart from the fact that low interest rates don’t actually work, the AMOUNTS borrowed prior to the crunch were well and truly into “irresponsible” territory: e.g. NINJA mortgages. So how do the idiots and buffoons running Western economies respond? They cut interest rates so as to encourage more irresponsibility.

You just couldn’t make it up.

10:32 PM  
Blogger The Arthurian said...

Interesting post.

Ralph, the "idiots and buffoons" are doing the same thing again and expecting different results.

5:11 AM  
Blogger Greg said...

This is exactly the point Mike Sankowski, formerly of Traders Crucible currently one of the MMR team, has been making for quite a while. Monetary policy is designed to work through the real estate lending channel.

As I see it banks want to lend as much as they can and most people take their largest loan out for a house. Its also a good that people need so they will try to make that payment at the expense of other frills for quite a while. Its only the people who are buying a second, third or seventh home that will walk away from an upside down situation without much angst. The idea that some people have seems to be that there are people walking away from their primary residences just to screw banks and the rest of us.... and we should heap scorn on these destroyers of our financial edifice. I know I would not take lightly the decision to leave my primary residence. I might do it (certainly WOULD do it if my debt/income situation deteriorated enough) but it would not be a decision I make blithely.

However a home in the mountains or at the beach could easily be dispatched if need be.

Is it fair to say Winterspeak that much of our accounting/econ blindspots come from differing notions of durables as investments?

9:25 AM  

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