The Housing Market and Consumer Spending
We have been talking about the US housing slump for some time now and more specifically how the downward trend in housing prices would affect the degree of US consumer spending. In fact, the most gloomy pessimists are primarily pinning the opportunity of a US recession on the recent slump in the housing market. This seems to be a discourse carved in stone but let us shift gears for a moment and take a step back; because what is in in fact the link between fluctuations in the housing market (asset wealth accumulation) and consumer spending?
This weeks edition of The Economist takes on this subject in the Economics Focus column which sets up the debate between the optimists and pessimists concerning the US economy from the perspective of the housing market. Now, obviously there is a correlation between a rise in wealth and consumer spending. However, the crucial question is whether the link is extra strong when it comes to the housing markets, a conclusion which would support the pessimists' prediction of an impending recession in the US.
Today's debate is about the consequences [of the dropping house prices], particularly for consumers. Will Americans slow their spending gradually or suddenly, and by a little or a lot? At issue is whether people treat their housing wealth like a nest egg or like a cash card.
The optimists and pessismists ...
Optimists, Mr Bernanke among them, argue that the links between housing wealth and spending are much the same as for any other type of wealth, such as shares.
Nonsense, say the pessimists. Weaker house prices, they argue, will have a bigger and more immediate impact than the “wealth effect” suggests, because Americans have been paying for their spending binge by borrowing against the rising value of their homes'
In terms of economic theory The Economist concedes that first round goes to the optimists but then again the housing market might be a different beast entirely than other asset classes.
Economic theory tends to support the optimists. Rational consumers should adjust their long-term spending in response to changes in their wealth, not the ease with which they can tap it. But there are several reasons why the wealth effect from housing could differ from that of shares and bonds.
Hmm ok, what about if we make this an empirical excercise then? In that case it does seem that wealth accumulation in terms of rising property prices should display a more direct link with consumer spending than other asset classes and therefore greater volatility in terms of the transmission mechanism.
'(...) the latest research suggests that, in America at least, housing wealth has a bigger influence on consumption than financial assets, and the effect is increasing.
A new study [see list of papers below] by Christopher Carroll, Misuzu Otsuka and Jirka Slacalek estimates that an increase in housing wealth of $100 in America eventually boosts spending by $9. A similar increase in stockmarket wealth would produce only $4 more spending. That ties in with a new microeconomic analysis of individuals' wealth and spending habits by Raphael Bostic, Stuart Gabriel and Gary Painter, which estimates that the wealth effect from housing is around three times bigger than that of financial assets. A study by Karl Case, John Quigley and Robert Shiller also found the wealth effect from housing to be more significant than that from shares.'
In the end The Economist finds it hard to choose side here ...
All of which suggests that Wall Street's optimists may understate the impact of weaker home prices on spending. By the same token, however, the pessimists may exaggerate how much the recent rise in equity extraction has fuelled an unsustainable spending binge
Both sides can point to evidence supporting their cases. Optimists note that the housing slowdown has so far had scant impact on consumer spending. Pessimists say that is because the pace of active mortgage-equity extraction has not yet slowed. The truth, most probably, will lie somewhere in between.
Index of papers referred to by The Economist (taken from the article) ...
“How Large is the Housing Wealth Effect? A New Approach”, by Christopher D. Carroll, John Hopkins University; Misuzu Otsuka, Asian Development Bank; Jirka Slacalek, German Institute for Economic Research. October 2006
“What Drives Personal Consumption? The Role of Housing and Financial Wealth”, by Jirka Slacalek, German Institute for Economic Research. September 2006
"Housing Wealth, Financial Wealth, and Consumption: New Evidence From Microdata", by Raphael Bostic, Stuart Gabriel and Gary Painter, Lusk Center for Real Estate, University of Southern California. July 2006
“Comparing Wealth Effects: The Stock Market Versus The Housing Market”, by Karl E. Case, John M. Quigley and Robert J. Shiller, Advances in Macroeconomics, Berkeley Electronic Press, Vol 5 (1) 2005
“Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four Family Residences”, by Alan Greenspan and James Kennedy, Federal Reserve Board Finance and Economics Discussion Paper 2005-41