Wealth Effect

I seldom agree with Dean Baker, but here he has a good point.

This is truly incredible. Homeowners have lost more than $5 trillion in housing wealth. There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption. This implies that the loss of wealth to date would cause consumption to fall by $250 billion to $300 billion annually (1.7 percent to 2.0 percent of GDP). If you add in the loss of around $6 trillion in stock wealth, with an estimated wealth effect of 3-4 cents on the dollar, then you get an additional decline of $180 billion to $240 billion in annual consumption (1.2 percent to 1.6 percent of GDP).

These are huge falls in consumption that would lead to a very serious recession, like the one we are seeing. This would be predicted even if all our banks were fully solvent and in top flight financial shape. Even the soundest bank does not make loans to borrowers who it does not think can pay the loans back (except during times of irrational exuberance).