Governments and central banks should think twice before designing policies aimed at the housing market in an effort to stimulate household demand and lift the economy out of the crisis. That is the implication of research by Professors Martin Browning, Mette Gørtz and Søren Leth-Petersen, which finds that it is unlikely that households perceive apparent wealth gains from rising house prices as actual wealth gains.
Their study, published in the May 2013 issue of the Economic Journal, provides a new explanation of the fact that house prices and household consumption tend to move in tandem. This is important because if, as many governments and central banks believe, house prices drive aggregate demand and inflation, then the answer to a slump in which household consumption and house prices have fallen is to adopt policies to stimulate the housing market.
But analysing data on the Danish housing market over an economic cycle, the research finds that homeowners do not respond to rising house prices by increasing their consumption. Rather, people increase their consumption when their earnings prospects improve – and people who expect higher earnings are also willing to pay more for houses, thereby pushing house prices higher.
The researchers note that economists have long disagreed about the causes of the link between house prices and household consumption. One camp argues that homeowners think of their house just like any other financial asset. If this is true, then even relatively small movements in house prices can have significant impacts on household wealth since for most homeowners, it is their most important financial asset: when prices go up, it''s like winning the lottery so why not spend some of it?
The other camp argues that a house is not just an asset. People have to have a place to live and as prices change, so does the cost of having a place to live. According to this view, people''s earnings prospects are what are important. When people expect their earnings to rise, then demand increases and so do house prices because people who expect higher earnings are also willing to pay more for houses. Another explanation is that as house prices change, so does the possibility of getting credit based on the equity in the house and, as a result, consumption tracks house prices.
The researchers argue that the key to sorting out competing explanations for the synchronisation of house prices and consumption behaviour is to look at the behaviour of individual households since different explanations are relevant for different types of homeowners.
If the house is considered as an asset alongside all other financial assets, then one would expect older homeowners to adjust their consumption the most when house prices change. If, instead, everything is driven by income prospects, then the data should reveal that young homeowners adjust their consumption the most.
The researchers analyse Danish tax administration data on around 90,000 individual households and almost 400,000 observations for the period 1987-96. The data set is created from Danish tax records that combine information about income, wealth and saving as well as home ownership, age, education and family composition.
The researchers analyse this period because it exposed homeowners to a cycle in which house prices declined from 1987 to 1992 and then increased from 1993 to 1996. The period is also interesting because it was not possible for homeowners to use the house as security for consumption loans before 1992. This enables the researchers to establish how households took out consumption loans based on their housing equity when such loans were introduced.
The results show that old homeowners did not respond to house prices changes. But when the opportunity to take out additional consumption loans was introduced, young homeowners, who are typically short of finances, exploited it.
''Housing Wealth and Consumption: A Micro Study'' by Martin Browning, Mette Gørtz and Søren Leth-Petersen is published in the May 2013 issue of the Economic Journal. Martin Browning is at the University of Oxford. Mette Gørtz and Søren Leth-Petersen are at the University of Copenhagen.
Professor at University of Copenhagen
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