by Calculated Risk on 8/19/2007 11:21:00 PM

From the NYTimes: Debt and Spending May Slow as Housing Falters, Fed Suggests

A new research paper co-written by the vice chairman of the Federal Reserve says that ... consumer spending may slow down over the next few years.

The paper will be presented this morning by [Fed Vice Chairman] Donald L. Kohn ...

[Fed economist] Ms. Dynan and Mr. Kohn say that higher housing prices made many homeowners feel wealthier and more willing to take on debt, which they then used to finance more spending. This spending helped to keep the economy growing at a healthy pace since the last recession ended in 2001.

But the increase in debt “is not likely to be repeated,” ...

The Fed’s study, which has been in the works for months, helps highlight some of the difficulties that policy makers are facing.
...
In some cases, the authors said, homeowner families might have taken on more debt than was wise, out of a misplaced belief that the rise in prices would continue for years.

The Fed’s analysis is noteworthy because consumer spending has been arguably the economy’s biggest strength since 2000.

Update: Some excerpts:

"... substantial evidence suggests that households are not always fully rational when making financial decisions (Campbell, 2006). One can imagine a variety of reasons why households might take on more debt than is rationally appropriate. For example, a rise in house prices might make households feel wealthier than they are, perhaps because they do not recognize the increase in the cost of housing services; as a result, they might borrow too much and be left underprepared for retirement. Alternatively, households may suffer self-control problems so that a relaxation of borrowing constraints spurs borrowing that, in the long run, lowers rather than raises utility. Or households might mistakenly extrapolate recent run-ups in house or equity prices and take on too much debt to finance investment in these assets." emphasis added

On the danger of so much debt:

"... household spending is probably more sensitive to unexpected asset-price movements than previously. A higher wealthto-income ratio naturally amplifies the effects of a given percentage change in asset prices on spending. Further, financial innovation has facilitated households’ ability to allow current consumption to be influenced by expected future asset values. When those expectations are revised, easier access to credit could well induce consumption to react more quickly and strongly than previously. In addition, to the extent that households were counting on borrowing against a rising collateral value to allow them to smooth future spending, an unexpected leveling out or decline in that value could have a more marked effect on consumption by, in effect, raising the cost or reducing the availability of credit."