[quote=jstoesz] But if prices drop 20% how will that contract the consumer demand for goods.
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You’re forgetting the psychological aspect of perceived wealth.

Lets say I bought a house for $100k. It goes up, on paper, to $500k. I feel 400k richer, even though my expenses are the same and my “wealth” is unrealized. Same with stocks.

People are more likely to spend what cash they have flowing, rather than allocate it towards savings, if they feel wealthy.

Same thing could happen if I’d bought 1000 shares of Google at $200/share. It’s over $600/share today. I’d feel $400k richer, even though it could go down to $200/share before I sell it.

The issue isn’t so much housing prices effecting the economy – it’s that our economy is far to reliant on consumer spending to drive it. When people feel poorer (even if their cash flow is the same) they don’t spend.