October 30, 2007
Housing wealth isn’t wealth
Introduction
Falling house prices are viewed by many as a major contributor to the economic slowdown in the US. In Europe, a long run of years characterised by rapidly rising house prices appears to have come to and end in Ireland, Spain and in the UK. Lower house prices affect aggregate demand through two channels - investment in housing and private consumption demand. This blog deals with the effect of changes in housing wealth on private consumption. It uses a little algebraic notation as part of a scientific experiment to determine the impact of symbol use on blog readership.
The effect of changes in the prices of existing homes on investment in home improvements and on the construction of new homes is not considered, except for noting the differences between the current size of the residential construction sectors across the four countries just mentioned. In the US, construction accounted for about 5.0 percent of GDP in 2006. The corresponding 2006 figures for Ireland, Spain and the UK were, respectively, 9.9 percent, 12.2 percent and 5.4 percent of GDP.
On average, you live in the house you own
The bold statement that is the title of this blog was put to me about ten years ago by Mervyn King, now Governor of the Bank of England, then Chief Economist of the Bank of England, shortly after I joined the Monetary Policy Committee of the Bank of England as an External Member in June 1997. Like most bold statements, the assertion in the title of this blog is not literally correct, although the pithy statement trumps the literal truth as a vehicle for getting the message across. A more precise statement would be that an increase in house prices does not make you better off. The argument is simple and applies to any consumer durable.
Let’s consider coconuts instead of houses. When does an increase in the price of coconuts make you better off? Answer: when you are a net exporter of coconuts, that is, when your endowment of coconuts, E, say, exceeds your consumption of coconuts, C, say. If P is the price of a coconut, the amount, G, by which you are better off when the price of coconuts increases by an amount ΔP, is given by
G = (E – C) x ΔP .
A net exporter of coconuts is better off when the price of coconuts increases, a net importer of coconuts is worse off. Someone who is just self-sufficient in coconuts is neither worse off nor better off.
Houses are no different from coconuts in this regard. Assume for the moment that the price of a house (strictly of a unit of housing) equals its fundamental value, F - the present discounted value of the future rents it generates. These rents can either be the market rents earned by a commercial owner of property-to-let, or the imputed rental value of owner-occupied housing. So we have:
P = F .
The consumption value of a unit of housing is also the present discounted value of current and future rents. When the price of residential property increases, households-consumers whose endowment of housing exceeds their consumption of housing are better off. Those for whom the endowment of housing is less than their consumption are worse off. The next step is the assertion that, for a typical household-consumer, the endowment of housing equals the consumption of housing:
E = C .
It follows that, since the representative household-consumer is self-sufficient in housing, a change in home prices does not make it better or worse off:
G = 0 .
As long as your endowment is positive, your wealth obviously increases when the house price increases. However, an increase in house prices means that the present discounted value of future rents has increased. As a consumer of housing services, now and in the future, you are therefore worse off. On average, in a country like the UK, people consume the housing services they own. Hence an increase in house prices does not make them better off. For financial assets like equity there is no corresponding “present discounted value of future equity services consumption” whose cost increases whenever the value of equity goes up. An increase in stock market values therefore unambiguously makes you better off.
But as regards house prices, regardless of whether a change in price is due to a change in risk-free discount rates, in risk premia or in expected future rents, you are neither better off nor worse off as a result of that price change, if you consume, now and in the future, the same contingent sequence of housing services whose present discounted value is part of the wealth you own. In that case, despite the increase in your housing wealth, once you have paid for the consumption of your initial contingent sequence of housing services, there will be nothing left to spend on anything else.
Qualifications
Bubbles
Instead of the price a house, P, equalling its fundamental value, it could be equal to the sum of its fundamental value, F, and the value contributed by a speculative bubble, B:
P = F + B .
The consumption value of the house, PC continues to be equal to the present discounted value of current and future rents, that is,
PC = F .
It follows that the net financial benefit or gain you have from a change in house prices can be written as
G = (E – C) x ΔF + E x ΔB .
So, making again the assumption that E = C, the net gain from an increase in house prices is given by
G = E x ΔB .
Ironically, an increase in house prices therefore only makes you better off if there is a (positive) bubble.
Distribution effects
Some households-consumers have an endowment of housing that is smaller than their consumption of housing (call them renters). Others own more housing than they consume (call them landlords). Clearly, landlords-homeowners are better off when the price of houses increases, while renters are worse off. If the marginal propensities to spend of these two categories of households-consumers are different, such a redistribution will not be neutral as regards its effect on aggregate consumption. I have no empirical information on whether renters have higher or lower marginal propensities to spend than landlords.
Likewise, some current home owners may be planning to ‘trade down’ later in life, for instance when the family home gets replaced by a smaller property when the children leave home, following retirement or following the death of one’s spouse. For them the fundamental value of their endowment exceeds the present discounted value of their current and future planned consumption of housing services. Against that, there are also persons planning to trade up in the housing market.
Foreign ownership
Residential property in a country could be owned by households-consumers not resident in the country, in which case the fundamental value of the housing stock located in the UK and owned by UK households-consumers is less than the present discounted value of future rents from the stock of houses located in the UK. An increase in the price of UK property would make UK households-consumers worse off in this case. I have no information on how much UK residential property is owned by foreign households-consumers.
Assorted irrationalities
Consumers of housing services may be more myopic and/or may discount future expenditure on rent at a higher rate that the discount rates that are reflected in house prices. Home owners may fail to recognize the opportunity cost of the owner-occupied housing services that they are consuming. There may be a variety of other irrationalities and behavioural idiosyncrasies causing the consumers of household services to respond differently from the owners of homes to changes in the present discounted value of current and future rents.
What do economic models assume about the effect of housing wealth on consumption demand?
Most econometric models I am familiar with treat housing wealth like equity as a determinant of household consumption. They forget to allow for the fact that households consume housing services (for which they pay or impute rent) and that with properly functioning markets, the value of housing wealth in the consumption function would be cancelled out exactly by the present discounted value of current and future rents.
An example is the FRB/US model. It is used frequently by participants in the debate on the implication of developments in the US housing market for US consumer demand. A recent example is Frederic S. Mishkin, a member of the Federal Reserve Board, in a paper “Housing and the Monetary Transmission Mechanism”, NBER Working Paper No. 13518, October 2007. The FRB/US model a-priori constrains the wealth effects of housing wealth and other financial wealth to be the same. The long-run marginal propensity to consume out of non-human wealth (including housing wealth) is 0.038, that is, 3.8 percent. In several simulations, Mishkin increases the value of the long-run marginal propensity to consume out of housing wealth to 0.076, that is, 7.6 percent, while keeping the long-run marginal propensity to consume out of non-housing financial wealth at 0.038.
The argument for an effect of housing wealth on consumption over and above the pure wealth effect, is that housing wealth is collateralisable. Households-consumers can borrow against the equity in their homes and use this to finance consumption. If they are otherwise liquidity-constrained or credit-constrained, a boost to housing wealth would boost consumption by more than the pure wealth effect.
Housing wealth is, however, not the only form of financial wealth that allows one to overcome liquidity constraints or credit constraints. Many other financial assets can be used as collateral. In fact, liquid financial assets like stocks and bonds tend to make better collateral than housing equity. Indeed, one can finance consumption spending simply by running down holdings of liquid financial assets; unlike illiquid housing wealth one does not have to use them as collateral for a loan in order to turn them into current spending power.
You can, of course, get a larger aggregate liquidity or collateral effect from housing wealth than from other financial wealth, if housing wealth is owned to a greater degree by liquidity-constrained households than other financial wealth. To the extent that the ‘other’ financial wealth is liquid, it is obviously true that the owners of this ‘other’ financial wealth cannot be more liquidity constrained than the owners of residential property. This, however, does not constitute evidence that owners of residential housing are liquidity constrained. It could be the case that neither the owners of residential property nor the owners of ‘other’ financial assets are liquidity-constrained. On balance, however, it seems likely that at least some owners of residential property are liquidity constrained while, almost by definition, no direct owners of liquid financial instruments are liquidity constrained.
What this implies is that the ‘collateral’ or ‘liquidity’ effect of a change in house prices on consumer demand is likely to be larger than the ‘collateral’ or ‘liquidity’ effect of a change in other financial asset prices of equal magnitude. This does not mean, however, that the total effect on consumption demand of a change in house prices will be larger than that of an equal change in the value of other financial assets. This is because the total effect is the sum of the pure wealth effect and the liquidity/collateral effect, and the pure wealth effect of a change in house prices on consumption demand is zero.
If the argument in this blog is correct, the FRB/US model’s approach to the consumption effect of housing wealth is questionable. The pure wealth effect of housing wealth on consumption is zero (not 0.038). Mishkin then makes the further, untested, assumption, that the collateral or liquidity effect of housing wealth on consumption is greater (0.038) than the collateral or liquidity effect of ‘other’ financial wealth (0.000).
Conclusion
The arguments of this blog lead to the conclusion that the proposition that consumption is affected more by changes in housing wealth than by changes in other financial wealth is questionable, and that there is a distinct possibility that the net effect of changes in housing wealth on private consumption may be small or even negligible (if home owners are not liquidity- or collateral-constrained).
So, when considering the impact of housing price declines on aggregate demand, focus on the investment and home-improvement side, not on the consumption effects.
Like most economic theory this assumes people are rational beings. This is patently incorrect. The economic formula needs modification to take account of the “feelgood factor” that increased housing prices give to homeowners and mortgage payers.
Posted by: Chris Cherrington | October 30th, 2007 at 10:00 am | Report this commentThe leverage now being permitted/encouraged/ against housing collateral is not accessible to most in other assets.
A belief in a government/central bank prop that will prevent house price falls.
Housing equity tax advantages.
Posted by: Kartsen | October 30th, 2007 at 11:19 am | Report this commentAs Chris mentions in his comments, people can withdrawn money from they house wealth through equity withdrawal products. These are very common and allowed (acording to various media) to release billions of dollars and pounds that were mostly use for personal consumption.
So there you have it: a situation where an increase in house prices directly increases personal consumption.
Posted by: Hugo | October 30th, 2007 at 11:23 am | Report this commentI have long thought that what you call “housing wealth”, which is really a function of house prices over time and their rate of increase, is a reflection of credit availibility and its cost.
Once liquidity begins to tighten and its cost increases, it has a whole range of effects, one of which shows up in reduced housing “wealth” effects.
That does not, however mean it is unimportant to the mindset of the average person. Nor, in countries where the consumer constitutes a major source of economic activity, can it be said to be insignificant.
Posted by: Antonio | October 30th, 2007 at 1:11 pm | Report this commentGood post!
Posted by: Nick Rowe | October 30th, 2007 at 3:37 pm | Report this commentOne more qualification:
Suppose people have finite lives (in an overlapping generations model), but houses have infinite lives (or, at least, the house or land on which it is built lives longer than the householder). The present value of the rents the house will earn is therefore greater than the present value of the rents the average householder will pay (since the house will continue to earn rents after the householder is dead). Then a rise in house prices will increase net wealth and consumption of the present generation. To say the same thing a different way, if the average householder will sell his house and die in (say) 30 years time, then a $100 increase in the value of his house (expected to be permanent) will increase his current wealth by the present value of getting $100 30 years in the future (which is about $25 at a 4% real interest rate). Of course, if people care about their children, and the average householder bequeathes his house to his descendants, then this qualification is irrelevant
Interesting idea - would suggest the following amendments.
G = (E-C) x (ρΔP – M) + (ρΔP-M)
Where ΔP = (ΔF+B) [Price change = fair value change + bubble]
M is the mortgaged amount, and ρ is a probability factor relating to local markets and surveyors valuations at a time you wish to withdraw equity.
.. and it assumes that if you have a surplus of property, you still have one you own and live in.
Posted by: Matty | October 30th, 2007 at 4:40 pm | Report this commentErm, are you seriously telling me that people don’t feel wealthier despite house prices having trebled and on the back of this many homeowners have made huge leveraged gains in the last 10 years? There is economics and there is the real world.
Posted by: super siv | October 30th, 2007 at 5:37 pm | Report this commentThe discussion of liquidity does not take into account the credit wedge.
That is, it seems that you assume housing as collateral is important because it can be used to increase consumption through borrowing. However, there is a potentially more important effect and that is the shrinking of the credit wedge.
In short the expected interest rate the lender is willing to accept is less than the interest rate paid by households because there is some risk of unrecoverable default.
This drives a wedge between lenders and borrowers that not only destroys some transactions but leaves the remaining ones more expensive. Households benefit because their financing costs decline.
Of course, this is simply a transfer, however, if there are
A) Distributional effects that lead to positive consumption
or perhaps more importantly
B) The nation is as a whole a net debtor,
then these effects can effect consumer spending. In the case of the United States the net external debt is quite substantial. If improvements in interest rates are borne in the form of lower returns for foreigners then there can be real increases wealth.
Posted by: Karl Smith | October 30th, 2007 at 6:57 pm | Report this commentAesthetically appealing. Reminds me of Ricardian Equivalence:
http://en.wikipedia.org/wiki/Ricardian_equivalence
I’ll take this opportunity to add that your previous post on ‘Lessons from the financial crisis; part I’ was very illuminating - for some reason I couldn’t post there my comment.
Posted by: Ron Cohen-Seban | October 30th, 2007 at 8:30 pm | Report this commentI’m confused about the financial difference between housing and stocks.
A house is an asset that entitles you to a stream of future actual or imputed rents. A stock is an asset that entitles you to a stream of future dividends. If either one appreciates in price, you can sell it and pocket the capital gains.
How is it then the case that housing wealth is different from stock wealth?
Sincerely,
Posted by: Mr. Noah | October 30th, 2007 at 10:46 pm | Report this commentNoah Smith
Econ PhD student, University of Michigan
Noah,
A house has an opportunity cost which is equal to the benefits it generates: if you leave your house in order to sell it or rent, because the higher price has enticed you to do so, you will find the same rise in price for the alternative house you buy or rent. But if you sell your stocks in order to realise any capital gains, you do not need to reinvest in new stocks — in fact you could buy a house to live in!
Best,
Posted by: Ron Cohen-Seban | October 31st, 2007 at 4:29 am | Report this commentRCS
Registered Land Valuer
Israel
The easy availability of credit, especially “equity release” (UK) and “home equity” (US) loans, the latter bearing in most cases tax-deductible interest, mean that an increase in house prices does yield spendable income.
And of course those who have buy-to-let properties ARE like the trader in coconuts. Plus, owners of second homes can sell them and spend the gain, as can those who downsize their primary residence and (in the UK and within the limit of $250k or $500k in the USA) take their gain tax-free.
Recent liquidation of gains in housing through equity-release mortgage schemes and remortgaging, and the spending of the proceeds is self-evident. One has only to look through the statistics of foreclosures and bankruptcies. Since at least the 1970s house prices have been an important, if not the main, element of party chatter in major cities of the UK and US (and, for at least a while, in Florida and Las Vegas).
The point of “housing wealth” is that more than any other kind of investment it is leveraged, the property is bought on margin.
Switzerland today (within limits) and Canada years ago and perhaps other countries imposed income tax on the implicit rent of owner-occupied dwellings. That might make the author’s theory more accurate. But there is a political decision behind tax-deductible interest (as there was with MIRAS), and it is to create this sort of wealth, and concomitant spending.
Posted by: Punktlich | October 31st, 2007 at 7:55 am | Report this commentOne’s consumption preferences are subject to change. For example. I am a producer of 10 coconuts. I normally like to consume 5 and export 5. If coconut prices go to the moon, I mostly likely would a/ try to produce more coconuts for export, and b/ consume less coconuts so that I have more coconuts for export.
Posted by: Ly | October 31st, 2007 at 10:52 am | Report this commentI am not an economist but as a housing researcher have done some work over the past few years on the private rental sector that has also brought me into contact with the investment market (city centre flats etc). What fascinates me is that the economic thinking about house prices and values is all predicated upon household consumption. This is why Mervyn King could say 18 months ago that prices couldn’t rise much more because they were becoming distant from household earnings.
But this is precisiely what has happened. The “market” for housing is the % that changes hands in a period (not the stock being consumed at any one time). Government and CML data would indicate that investment is taking around 30% to 40% of transactions over the past few years and at very local levels even more than this. (I have interviewed residents in N Manchester who describe “landlords” buying ALL that comes on the market in their area and thus pricing them out of ownership).
There are a variety of ways in which investors cash in on this inflation but their ability to do so has been supported by Building Societies lending (perhaps irresponsibly) to prop up inflationary values. Their more cautious current lending practices may trigger the slowdown but, like Northern Rock, many of them may have lent substantial amounts against over valued stock and therefore want to keep the price up as the theoretical price is also their asset base. Finding the true clearing price (which would be consumption based) would be a disaster for them and for all the housiholds buying into this inflated market recently.
An additional quirk of this investor led market is that it has skewed new supply towards flats thus tightening the market for houses that most “consumers” want and again having an inflationary effect within that market niche. This has all been possible because of the imperfect nature of market knowledge. Investors in city centre flats don’t know they are buying at false values and that there is no second hand market for their assets for them to cash in on (see recent BBC reports). Lenders get sucked into the bubble psychology and even where they suspect a false market, they can’t afford not to be in it (see Shiller’s, Irrational Exuberance, 2006).
Fascinating stuff and very unpredictable but any formula needs to include international investor playground notations, resources and effects to fully capture the drivers of prices and the access to real wealth from theoretical housing wealth.
Posted by: Nigel Sprigings | October 31st, 2007 at 1:01 pm | Report this commentVery interesting. I’d consider breaking down the housing asset into two parts - the structure and the land. The structure is consumption. The land the structure sits on is investment. The coconut example doesn’t seem appropriate. What about the tree and the land it sits on.
Posted by: Marcel | October 31st, 2007 at 2:46 pm | Report this commentQuite interesting and enlightening! it´s just a simple model trying to explain the basic rationale behind housing wealth. Of course, it could be improved, but I think the main thing that can´t be explained is the behavioral part of it, innit?
Posted by: Joe Prairies & The Prairie Wallflowers | October 31st, 2007 at 5:55 pm | Report this commentQuite interesting and enlightening! it´s just a simple model trying to explain the basic rationale behind housing wealth. Of course, it could be improved, but I think the main thing that can´t be explained is the behavioral part of it, innit?
Posted by: Joe Prairies & The Prairie Wallflowers | October 31st, 2007 at 5:55 pm | Report this commentQuite interesting and enlightening! it´s just a simple model trying to explain the basic rationale behind housing wealth. Of course, it could be improved, but I think the main thing that can´t be explained is the behavioral part of it, innit?
Posted by: Joe Prairies & The Prairie Wallflowers | October 31st, 2007 at 5:55 pm | Report this commentI think the housing wealth is wealth as it says.
its nothing different in the fact that the price goes up and down by the amount of the invested capitals.
Our posseced assets have all price changes ,
the housing is one of the very different item though because often its price rises as time goes so that banks can allow increased loans by judging sdtandard on its market price.
Looking at Japan’s example ,
the real estate assets price bubbled up but in the end it has bursted ,
the investors lost a lot, it affected to the banks’ profit and finally influenced to the consumers purchasing power and market price -deflation.
Japanese believed real estate never falls down so a lot of investors flocked in
but when the bubble bursted ,everybody lost.
The risen value disappeared and went nowhere.
Posted by: sowmin | November 1st, 2007 at 9:21 am | Report this commentYou appear to have ignored completely any discussion of psychological effects of housing price declines.
Was this deliberate?
Posted by: dave | November 5th, 2007 at 4:04 pm | Report this comment[…] been a reduction in the value of this outside asset of, $2.3 trillion. I have argued elsewhere (http://blogs.ft.com/maverecon/2007/10/housing-wealth-html/; http://blogs.ft.com/maverecon/2007/10/ok-then-housinghtml/; […]
Posted by: FT.com | Willem Buiter’s Maverecon | Double Counting 101: Inside versus Outside Assets | March 11th, 2008 at 8:15 pm | Report this comment