The Wealth Effect Shifts Into Reverse

Stripped of all the acronyms and economist-speak, government policy of the past few years has been simple: lower interest rates to push people out of cash (which yields nothing) and into stocks and houses. And then, when those assets go up enough to make their owners feel rich, hope that this paper wealth translates into a willingness to max out credit cards and take out car loans.

This propensity to borrow and spend more when your investments are rising is called the wealth effect, and by early 2013 it seemed to many that America’s “normal” debt-driven consumer society was reviving and that we might, after all, be able to maintain our military empire, welfare state, big houses, SUVs, massive banker year-end bonuses, easy incumbent reelections, etc, etc, without any prioritization or hard choices.

Nope. It turns out that the laws of economics can be bent but not broken. You can’t have a vibrant, growing economy AND interest rates near zero AND a stable currency at the same time. One of these has to give. And in the past month interest rates have started moving back towards historically normal levels.

Rising interest rates are incompatible with housing and equity bubbles, and the air is now leaking from both. As this is written, global stock markets are down big. And US housing, which in some markets was approaching 2007-esque levels of speculation, has hit a wall, at least based on mortgage applications:

Mortgage applications tumble as rates rise further: MBA

(Reuters) – Interest rates on home mortgages rose last week to hit their highest level in over a year, sapping demand from potential homeowners, data from an industry group showed on Wednesday.

Rates climbed 2 basis points to average 4.17 in the week ended June 14, according to the Mortgage Bankers Association. It was the highest level since March of last year.

After hovering around record lows, rates have surged for six weeks in a row, pushed higher by worries that the Federal Reserve could slow its stimulus program sooner than had been expected. Rates have accelerated by 58 basis points since the start of May.

The Fed’s bond purchases have kept borrowing rates, including mortgages, low. Though mortgage rates remain low by historical standards, the ultra-cheap mortgages have helped lure buyers back into the market and worries have crept in that higher rates could disrupt the still-young housing recovery.

The rise in rates appeared to hold back homebuyers as MBA’s seasonally adjusted index of loan requests for home purchases – a leading indicator of home sales – fell 3 percent. The gauge of refinancing applications slipped 3.4 percent, though the refinance share of total mortgage activity held steady at 69 percent of applications. The overall index of mortgage application activity, which includes both refinancing and home purchase demand, declined 3.3 percent.

And so the wealth effect shifts into reverse. Fewer people can afford mortgages, so home prices stop rising, making homeowners feel less rich. Stock prices stop rising (or, like today, start going down) and the record number of people who have been buying on margin see their exciting gains melt away. They feel both less rich and suddenly very stupid. Most of them will spend less, and the recovery will stop in its tracks.

Which means it’s time to think about the next big government plan to save us. Will it be a massive public works program? Expanded  QE? Maybe a major war? Whatever, it will have to be commensurate with the size of the now-global crisis. So, just a guess, but this time around it won’t be surprising to see a coordinated attack on deflation from Europe, the US and China. In other words, global Abenomics.

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