The house price fairy visited me last night. She offered me three choices: she would instantly double all house prices; she would instantly halve all house prices; or she would leave all house prices the same.
"You stupid fairy!" I replied. "Don't you know i already own this house, and I have no plans to sell it or to buy another? I need somewhere to live, and I've got it; I have already covered the short position in housing I was born with. I don't give a damn what you do with house prices; it won't make me richer or poorer or affect me in the slightest. That's why I own exactly one house, not two houses, and not zero houses, so I didn't have to care if house prices went up or down. Next time you wake me up, at least offer me something interesting to choose from!"
She looked at me reproachfully. "Nick, I expected better from you. Non-economists can only think of wealth (income) effects, and usually get them wrong too. You got the wealth effect right, but you ignored the substitution effect".
She was right. What should I have chosen? Or rather, which of the three choices should I not have chosen?
The vertical axis shows the quantity of housing I consume. An upward move means I live in a bigger and better house. The horizontal axis shows the quantity of all the other stuff I consume. The black line shows my budget constraint. If I want to live in a bigger and better house, I need to spend more of my income on housing, and have to consume less other stuff. That's why it slopes down, showing that trade-off. The blue curve is one of my indifference curves. Each indifference curve shows all combinations of housing and other stuff that give me a particular level of satisfaction. I've only drawn one indifference curve – the one I'm on. I choose to consume that combination of housing and other stuff where my black budget line is at a tangent to my blue indifference curve. That combination maximises my utility, given what I can afford.
Suppose house prices rise. My budget line now becomes the flatter, green line. I have to give up more other stuff to get less extra housing. Suppose house prices fall. My budget line now becomes the steeper, red line. I have to give up less other stuff to get more extra housing. But notice that the budget line always swivels around my current endowment point. I can just afford my current combination of housing and other stuff given my current income. And because I own my own house, I can still just afford it, whether house prices rise or fall.
If house prices rise, I could continue to do what I'm doing now, if I wanted to. But if my indifference curve looks like the one I've drawn, I won't want to. I could do better by moving to somewhere like point B, moving to a smaller worse house and consuming more other stuff.
If house prices fall, I could continue to do what I'm doing now, if I wanted to. But if my indifference curve looks like the one I've drawn, I won't want to. I could do better by moving to somewhere like point A, moving to a bigger better house and consuming less other stuff.
At either A or B, I'm on a higher indifference curve than where I am now. I can't say (without knowing where the other indifference curves are) which of A or B is better. But they are both better than where I am now. I will want the fairy to change house prices, whether double them or halve them, I'm not sure.
It's always got to be like that, unless I've got significant moving costs that would give me a weird budget line. Or unless I've got weird preferences, that have a kink at where I am right now. Otherwise, I could always do better, by moving either up or down the housing ladder.
And since for every landlord letting a house, there must be a tenant renting it, the average household owns one house, which they live in, just like me. I'm not special; I'm the representative household.
Of course, fairies aren't real. House prices don't just change; they change for a reason. Something caused supply or demand to change. Unless of course the fairy is Tinkerbell.
[By the way, my house price fairy problem is formally identical to the substitution bias in the CPI.]
Worthwhile Canadian Initiative 
JKH: What you say seems correct to me, subject to the careful qualifications you make. If all real investment is financed by debt and equity, and if debt and equity finance finances only real investment, and if we exclude (or carefully account for) all cases where individuals and firms both borrow and lend (act as financial intermediaries), Then total debt+equity equals wealth (but if we added in real assets as well we would be double-counting, of course).
But notice how your (very careful) conclusion leads to considering debt+equity as positive wealth. The normal meme is “shit! look at all that debt! we are really poor!”. It’s treated as negative wealth.
The “horizontal duplication” seems important to me. It seems to be pro-cyclical. That leads people to falsely conclude “It’s all a mirage! We just thought we were rich, because we had all borrowed so much to buy stuff with!”
But trying to clear up this conceptual mess, as you are doing, is a Herculean task. Key TooMuchFed in 3,2,1.. 😉
Phil: “It seems there ought to be a narrow, technical refutation. But I have to admit, I can’t spot it.”
Well, it’s because the fairy only comes to me, and she must be messing with everyone else’s demand or supply curves to get the change in house prices, but she doesn’t mess with mine. It’s an individual, not a general equilibrium experiment.
To convert it into a GE experiment, you could think of immigration as the exogenous factor that changes prices, and the preferences drawn in my diagram are those of the native born. The fairy could then either suddenly bring in a wave of immigrants, raising prices, or suddenly deport previous immigrants, lowering prices. Either way, the native born would gain on the housing market. (I think I’ve got that right).
JKH,
I’m not sure I understand your example. Since all corporations are owned by households then we can say that debt instruments cancel out, the households that own the corporation that issues debt are the ultimate borrowers and the households that buy the bonds the lenders. Lenders have a positive D associated with them, borrowers get negative number -D so the net value of debt in the economy is zero.
How does equity cancel? Holders of equity have a positive value of E, which households have a negative value of E?
David: we need to be careful in defining “optimist” and “pessimist”. It’s expectations about future prices, but compared to what? If it’s compared to current prices, then we always have 50% optimists and 50% pessimists at equilibrium (otherwise prices would be higher). If it’s compared to some fundamental value, then you are right. A bubble has 100% optimists. (I’m speaking loosely, of course.)
Adam: if you think of equity as shares, and shares as just debt with slightly funny state-contingent dividends, then the parallel is clearer. Shares are a liability of the corporation that issues them to borrow money.
Phil: here’s a better though-experiment: the fairy either builds lots of new houses (with her magic wand) and sells them in the market, lowering prices. Or else buys lots of houses with other stuff she created with her magic wand, and destroys them, raising prices.
Nick, shares may be viewed as a liability of the corporation but the corporation is owned by households.
Debt cancels out becuase you can “look through” the corporate structure and say that there are households who have borrowed D (owners of the issuing corporation) and other households who have lent D.
You can view equity as a type of debt that the corporation owes to the households that own the corporation, so the owners of the companies are long an amount E of equity claims. But which housholds are short E?
JKH is most definitely wrong when he says that “your theme applies to both debt and equity claims, since both cancel themselves out respectively as financial assets and liabilities”.
Debt is zero net supply, equity is in positive net supply. In the example D = 0 and E = R, after netting out.
Dammit! The fairy in that second thought experiment is just like that free trade example. We can load corn onto ships, sail it out to see and by magic it gets converted into cars on the return journey. Or vice versa. And we always gain, either way, unless the Japanese have exactly the same relative price of corn and cars as us.
Adam: we are agreed that (given JKH’s assumptions) Net wealth = R = D+E.
Now if someone says that wealth = R+D+E. Or Wealth = R-D+E, or Wealth =R-D-E, in other words, if someone insists that R and D and E all belong in the formula, we reply “No, R belongs, as an asset of the corporation, or of the household that owns the corporation, but not both, but net D is zero, and net E is zero, because they are both assets of the household an liabilities of the corporartion
We agree that R = D + E.
I claim that also R = E. Do you agree?
Adam P,
Households have net worth (right hand side of the balance sheet), but do not issue equity claims against it.
Households may hold equity claims (left hand side of the household balance sheet), which are effectively liabilities of corporations.
Equity claims net to zero, like debt claims.
There’s no difference in the zero netting characteristics of financial assets in general – debt, equity, pension liabilities, etc.
On the other hand household net worth, which is not represented by equity claims, does not net to zero.
“David Friedman has “prior art” on this one: “Application: Housing Prices–A Paradox” in this micro textbook: http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_3/PThy_Chapter_3.html”
I might be the first one to have published the argument, but I didn’t invent it. It was put to me as a puzzle at a party at UCLA about thirty years ago by one of my colleagues there.
David Friedman
David: (Wow, and David Friedman actually reads my stuff! Though someone must have tipped him off.)
I thought it was a really great example of applied basic micro for your textbook. You gave a really clean presentation (but you missed out on the fairy!). It shows how much mileage you can get out of really basic micro.
Now, I vaguely remember Milton Friedman saying something relevant to this, as well. On what you hold constant when you draw a Marshallian demand curve, and about income effects of price changes not being really there. Something like that. Do you, or does anyone else, remember the article I have in mind?
JKH,
Take the situation just as you’ve just described and to simplify aggregate the household sector into one big household.
Now assume the coporation issues new debt D1 to finance a new investment that makes real asset worth R1. Now, now worth must be R + R1. Where does the increase show up?
Well, befoe R1 has appeared the household debt holdings have increased from D to D+D1, but household net worth is still R. E has fallen by an amount D1.
After R1 has been built new worth has increased to R+R1, the increase is entirely reflected in the value of E.
This was true from the first issuance of any claim, in this economy net debt D = 0 and equity E = R.
Adam P.,
Original example:
R = D + E = household net worth, where households hold all D and E
The capital structure of firms is D + E
D and E are both financial claims
They both represent a claim on corporate cash flow
They are just ranked by priority of claim on cash flow
Both net to zero when considered as claims issued and claims held
Nick’s theme applies to all financial claims, not just debt
JKH: “Nick’s theme applies to all financial claims, not just debt”
Yep. With the exception of financial claims like money, only if they are issued by some monopoly issuer. But let’s not go there now.
Adam P.,
Again, household net worth is not a financial claim, and specifically it is not an equity financial claim.
If corporate assets increase by R1, and corporate liabilities by D1, and household assets by D1, then household net worth increases by R1 = D1.
Gross debt claims have increased by D1 and net debt claims by zero.
Gross equity claims have increased by zero, and net equity claims by zero.
Household net worth has increased by R1 = D1.
Nick,
“But let’s not go there now”
Right.
Also venturing perilously close to MMT “vertical” and “horizontal” distinctions – another stinky variation on the reasonably straight forward generality of the subject.
So let’s really not go there now.
Nick, JKH,
Imagine a world with no uncertainty and no assets. R = 0, the consumption good just appears but everyone’s endowment is know with certainty (to all agents) for all eternity. This implies that their is no default but there may be debt issuance for the purposes of consumption smoothing.
Their is also equity issuance although in this setup equity is indistinguishable from debt.
We have R = 0, D = 0 and E = 0 (all net numbers).
Now magically (the one unexpected thing, ever) a productive asset appears that has value of R.
Nobody’s debt is worth more than it was before, we still have D = 0.
The asset was given to a household who had, in the past issued equity. That equity is now worth R more than before to the holders.
Why? Well, when the equity was issued to raise an amount, say E0, it did not obligate the issuing household to pay anything back. However, it did entitle the equity holders to all of the consumption good that the issuing household has over an above it’s endowment. Of course, before the asset appeared this was just equal to E0 so the equity was indistinguishable form debt.
Now that the asset has appeared and produces extra consumption the household that owns the asset has an amount of consumption greater than its endowment but all of the excess is owned by the equity holders. This is not true of that household’s debt holders (its creditors).
Thus, once the asset has appeared the value of equity to it’s holders is now E0 + R. The issuing household didn’t pay for the asset though, in terms of the consumption good the equity issuing household still suffers -E0 less consumption going forward. The issuing household doesn’t lose any of its endowment.
To make this all consistent with JKH’s example rename the equity issuing household as a corporation.
The point is that when the asset of value R appeared the value of equity in the economy went up by R, the value of debt didn’t change. R = E and D = 0.
The reason is that equity isn’t just a claim junior to debt, equity is a claim to all the excess over what is owed to debt holders.
Adam P.,
“The asset was given to a household who had, in the past issued equity. That equity is now worth R more than before to the holders.”
Once again, households do not “issue” equity claims.
“To make this all consistent with JKH’s example rename the equity issuing household as a corporation. The point is that when the asset of value R appeared the value of equity in the economy went up by R, the value of debt didn’t change. R = E and D = 0.”
The institutional difference between households and non-households is critical to understanding the financial claims netting process. This difference doesn’t permit the assumption of mere “renaming” with any logical coherence.
Starting with your “renamed” entity, the household can’t realize that value without having a financial claim on it. The default claim is an equity claim. It doesn’t matter that the example includes no debt. In fact, it just reinforces the point that there is no difference between the notions of netting debt claims and equity claims.
By review:
I tend to distinguish between equity claims (issued by non-households) and household net worth (no claims issued).
Non-household equity claims and household net worth can also be grouped as equity more broadly.
I usually refer to household net worth as household equity in this sense.
This is partly definitional, but largely conceptual in that households do not issue equity claims on the household balance sheet.
You can think of household equity as residual equity in the economy, since all equity nets to zero before it hits the household balance sheet. The chain of equity in the economy stops at the household in that sense.
The net of all equity in the economy is household net worth or equity (apart from net foreign claims).
JKH, believe me I understand what you’re saying.
You’re basically saying that when you net out, the corporate sector nets to zero because corporate balance sheets have assets of total value R and liabilities of total value D + E.
Household balance sheets have asset side of D + E and no liability side. It follows that D + E = R.
“You can think of household equity as residual equity in the economy, since all equity nets to zero before it hits the household balance sheet. The chain of equity in the economy stops at the household in that sense.”
Yes, nothing I’ve said disagrees with that.
Your just making a semantic argument, fine. Everything you said in this last comment makes sense.
But you can’t have D = 0 and E = 0 but D + E > 0.
Adam P.,
That’s not what I’m saying at all, except for what you quoted.
But I’ll have to leave this for now, because of time – sorry.
Maybe Nick can add.
Nick
If one sells shares in a company which projects gains from a yet-to-be-discovered gold deposit, or sales on the internet which have yet to materialise, or anything similar, surely one has created a debt. But it seems to me to be stretching the definition to claim there is an “asset” to balance the debt – unless you count hope as an asset.