One can only blame bad economics for the confusion about the current state and direction of the US economy. Because the economic commentariat have swallowed the fallacy that consumption is what really drives an economy they treat consumer spending much the same way that ancient seers treated the entails of goats, and with just as much success.

If these modern-day seers are correct then consumer spending would be dropping and those companies at the consumption end of the production structure would be contacting. Yet consumer spending is still holding its own once we subtract the fall in spending on new cars. Cars are like houses* in that they are very expensive goods. Few people ever pay for their house or car outright. This means that these goods will be sensitive to changes in interest rates.

Let us assume an interest rate of 4 per cent. This would amount to $4,000 on a $100,000 loan for a year. It is obvious that if the interest drops to 3 per cent then the borrower would save $1,000. What is not so obvious is the fact that if the 4 per cent rate limited the borrower to $100,000 then the new rate would raise his limit to $133,000. Therefore a 25 per cent drop in the interest rate raised his borrowing capacity by 33 per cent. The point of this exercise is to show why the demand for houses and cars responds quickly to changes in interest rates.

We have also been visited by the inverse 'wealth effect' idea, according to which rising house prices will lead to more consumer spending because the owners will now borrow against the value of their houses. There is an awful lot wrong with this thesis. That it has any legs left at all is an intellectual disgrace. To begin with few people increase their demand for consumer goods on the basis of the value of their home. In fact, most people have only a vague idea how much their house is worth. What they borrow for consumption will be largely determined by interest rates and their expectations of their future income.

Gerard Jackson
BrookesNews.com

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© 2008 Gerard Jackson

ABOUT THE AUTHOR

Gerard Jackson is an economics editor at BrookesNews.com.

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