Sunday, May 10, 2009

Wealth and bubbles

Benjamin M. Friedman (who really should know better) said in the New York Review of Books (via Matthew Yglesias ):

Another fundamental issue that the current discussion has overlooked almost entirely is the distinction between the losses to banks and other lenders that reflect genuine losses of wealth to the economy, and other losses that don't. When the value of your house falls, that's a loss of wealth to the economy as a whole. If you keep paying your mortgage, you bear the loss yourself: your net worth is diminished by the amount of the decline in the home's price. ...

This is dangerously wrong. The increase of house prices in a bubble does not represent a genuine gain of wealth to the economy as a whole and the decrease in prices when the bubble pops does not reflect a genuine loss of wealth to the economy as a whole. If you sell your house at an inflated price then you gain wealth and the person who buys the house loses wealth. The gain and loss offset but bubbles are in fact bad overall because the mispricing causes misallocation of resources such as building too many houses. This misallocation does represent a real loss of potential wealth. So artificially propping up housing prices won't prevent a loss of wealth to the economy as a whole instead it will encourage further misallocation of resources thereby decreasing future wealth.

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