OK then, housing wealth is wealth, but not NET wealth!

Yes housing wealth is wealth, but corresponding to the housing asset is a housing liability. Under certain conditions, not all of which are too unreasonable, the value of the housing liability exactly equals the value of the housing asset, so housing wealth isn’t net wealth.

The fundamental value of the housing asset, FA, say, is the present discounted value of current and anticipated future rents from the stock of residential homes in existence in a given economy (the UK, say) at a given point of time. The rents can either be the actual market rents paid by those living in rented accommodation or the imputed rental value of the housing services consumed by owner-occupiers. The fundamental value of the housing liability, FL, say, is the present discounted value of current and anticipated future rents that the current inhabitants of the economy expect to pay (or impute to themselves if they are owner-occupiers) over their lifetimes.

The strongest version of the proposition is that the fundamental value of the housing asset equals the fundamental value of the housing liability, that is,

FA= FL

Therefore, regardless of whether a change in house prices is due to a change in risk-free discount rates, in risk premia or in anticipated future rents, the housing liability changes in value by the same amount as the housing asset. So housing wealth isn’t net wealth. When the price of housing increases, when you have re-budgeted the increased cost of living in your now more valuable accommodation, you will have no money left to spend on anything else.

If the increase in house prices is due to an increase in current and expected future rents (holding constant the discount factors), you may choose to switch your spending more towards other goods and services, away from the now more expensive housing services. If the increase in house prices is due to lower risk-free discount rates or lower risk premia, there is no reason to expect any spillover into spending on non-housing goods and services.

There are a number of reasons why the proposition that housing wealth isn’t net wealth could fail to be true.

  • Reasons consistent with rationality.

(1) Overlapping generations. The future rents discounted in the price of an existing home are not just those paid (or imputed) by those currently alive, whose present discounted value I denote by FAA , but also those that will be paid (or imputed) by those yet to be born; the present discounted value of the rents that will be paid by the unborn is FAU. So, if there is a positive birth rate, FAU will be positive. It follows that

FA = FAA + FAU

Consumption today, of course, does not include the consumption of future housing services by the unborn, therefore

FL = FAA < FA

It follows that when the house prices rise, the value of housing as an asset goes up by more than the value of housing as a liability, so net housing wealth increases. This effect will be reinforced if there in net immigration into a country. If there is intergenerational caring, with bequests, and no-one dies childless, the consumption of the unborn is effectively internalised by those currently alive, and FL = FAA + FAU=FA.

(2) MEW. My earlier blog did discuss mortgage equity withdrawal (“Households-consumers can borrow against the equity in their homes and use this to finance consumption”), that is, using you home as collateral for consumption loans. This will boost consumption if and only if the homeowner is liquidity- and collateral- constrained. The boost to consumption is, of course, temporary, as the loan will have to be serviced and repaid; future consumption were therefore be lower in present value than it would have been without the MEW.

  • Reasons requiring irrationality.

1. “Feel good factor”. This is the argument that when house prices go up, home owners get a buzz, feel happy and go out and spend. It’s hard to know what to make of this. If there is a feel good factor for homeowners when house prices rise, there must be a feel bad factor for all those missing out on the capital gains because they do not own real estate – people for whom it may now have become harder to get a foot on the housing ladder. Also, does the feel good factor actually cause you to spend more? The feel good factor is not the same as consumer confidence, which is positively correlated with consumer spending. My wife spends more (mainly on shoes) when she feels bad – and she is a professor of economics.

2. Owner-occupiers don’t understand the concept of ‘opportunity cost’. Possible, but not likely. As soon as a the owner of a home that has gone up in price wants to cash in on this gain, he will find out that he will have to spend the entire sale price to purchase the right to equivalent housing services. If he is trading down, and the value of the house he is selling exceeds the present discounted value of the housing services he plans to consume over the remainder of his life, we are in the overlapping generations case discussed earlier, and there is no irrationality involved.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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