The poverty effect

During the housing boom (or, as we now know, the housing bubble), many people felt richer than their incomes might have indicated because their house had increased so much in estimated value. They took out home equity loans and other loans to buy things they would not otherwise have considered buying. They felt that, if necessary, they could sell their house at such a profit as to be able to clear their debts and still leave enough to buy another house. Some people even made this a practice, buying a run-down house and refurbishing it and "flipping" it with a profitable resale.

Economic reporters called this feeling that a house was a storehouse of value that you could tap to improve your lifestyle, the wealth effect. It led people to buy more, spend more, and rack up more debts.

Now that we are in a recession, many of those people who enjoyed the wealth effect are suffering from the poverty effect. Some of them are really much poorer than they were, having lost their jobs, their health insurance, and their house to foreclosure.

The poverty effect, however, is spreading beyond this group. Many young people with good and stable jobs have looked at the falling values of their 401k's and gone into panic mode. The fear of losing your job is real; it is wise and reasonable to take precautions. It is wise to revisit your 401k and put whatever is left into more conservative investments for the time being. It is wise to increase savings and decrease waste in your daily expenses. It may be wise to postpone getting that new car or replacing your living room furniture until you are sure of your job situation.

But the poverty effect can lead to irrational behavior as much as the wealth effect. If you are in your 50's and your 401k had sunk like a rock, you are facing serious problems. But if you are in your 30's, you still have thirty more years of work and investment to repair that damage. You may never get back to where you appeared to be at the top of the boom, but you can reach a level of safety. And, in fact, you never really were as well off as you thought at the top of the boom: like the invisible assets of so many toxic bonds, you had imaginary wealth, like the imaginary food in old tales that seemed real, but evaporated when you swallowed it.

It is wise to postpone replacement of a good, reliable car. It is unwise to skimp on its maintenance to save money, or to hold on to it when it has become unsafe.

It is wise to try to take care of minor problems yourself. It is unwise to try to take care of things that are beyond your skill because plumbers or electricians are expensive. The fifty or one hundred dollars you might have saved is nothing to the result of a flooded house or one burned down by an electrical fire.

It is wise to cut back on luxuries, but homeowners and liability insurance is not a luxury. Yes, you've had your house for ten years and never needed it. But that is no guarantee; during Hurricane Floyd, part of North Carolina flooded that had not flooded since before the Civil War. You may be able to save on premiums by raising your deductible, but if you raise it to a point where you don't have the cash to cover it readily available, you are actually worse off than before.

Above all, we all need to remember that this is not going to last forever. We have gone through these situations before. The Great Depression was long and difficult, but it ended. The panics before it ended. The recessions since the Depression ended. And this will end.

I am not being Pollyanna. I know we are in trouble, and that closing our eyes and whistling "Happy Days Are Here Again" is not going to solve the problems we face.

But neither is panic and irrationalism.