Over the past few months, stock prices of real estate companies have fallen by almost 50% and interest rates on EMIs are rising. There is strong evidence of a bubble in Indian real estate markets. There is a natural parallel to be drawn to the US scenario, as housing prices in the US have been on a steady decline since the real estate bubble burst in early 2006.

One key difference is that in the US, due to the linking of mortgage payments with complex financial instruments like CDOs and derivatives, this real estate crash is having a tremendous impact on the financial sector. This is the ?subprime effect?.

However, there is also a conventional transmission channel from the bursting of the real estate bubble onto the rest of the economy. This has more implications for the Indian case. Casey Mulligan and Luke Threinen explore this channel in a 2008 National Bureau of Economic Research working paper entitled ?Market responses to the panic of 2008?. They identify two distinct effects?wealth effect and substitution effect?of the real estate crisis, and find that the breadth and impact of these two effects cannot be ignored, especially when considered in consonance with subprime effects.

The wealth effect is fairly intuitive. Housing demand rose quickly because of promises of appreciation and low mortgages. This created an artificial increase in housing supply at a similar fast rate, and houses were being sold for much higher than the construction costs. The fall in prices has broken this spiral of ?buying high and selling higher?, leaving people with very high debts on houses that have significantly lower relative worth on the market. The quick increase in supply has also led to construction costs that are higher than builders could afford, and builders now remain holding expensive debt and houses that they have no buyers for. Using two alternative indices of housing prices in the US, Mulligan and Threinen estimate that wealth effects add up to a loss of $4.5 trillion from the ?buy high and sell higher? argument, and around $1 trillion from construction costs of building houses too quickly, for the US as a whole.

The substitution effect is a little more complex. As house-building slows down, capital from the real estate sectors is released to the rest of the economy. This drives down the value of capital in all other sectors, as capital becomes more abundant there. While there will be a slight increase in investment in the non-residential sector due to this release of resources?and in fact, it has moved up to 4.64% of the capital stock in 2008Q3 (at current prices), as compared to 4.55% in 2007?this is not estimated to be persistent, especially since subprime effects are resulting in a virtual drying up of credit availability.

Both these effects transmit themselves into the real economy. Wealth effects force consumers to seek and find more work than usual. This exerts a downward pressure on wages, and they estimate that this could raise unemployment by around three percentage points. Substitution effects exert a downward pressure on the value of capital.

Interestingly, Mulligan and Threinen also find a redistributive impact of the bursting of the asset bubble?away from families near retirement age and large families towards younger people and smaller nuclear families. They conclude that an improper allocation of capital between residential and non-residential sectors combined with capital immobility led to a situation where pre-existing non-residential capital lost market value because of the residential price crash.

Interesting comparisons with India can be made. Even though we do not have an explicit subprime channel, the traditional channel alone has significant wealth and welfare costs. In India households often have the bulk of their savings in houses, and increasingly, are financing their homes via mortgages with flexible EMIs. Restructuring mortgages as is being done by public and private entities in the US is one policy option, but this paper points towards other structural deficiencies that need to be tackled in parallel.

?The author is consultant, NIPFP. These are her personal views