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Rising house prices do not lead to increasing consumption

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It is unlikely that households perceive apparent wealth gains from rising house prices as actual wealth gains. People increase their consumption when their earnings prospects improve.

Almost all Western economies have been hit by the crisis where household consumption and house prices have fallen. The question is how to lift the economy out of the slump. Might the solution lie in the housing market? If the housing market drives the slump then governments and central banks should adopt policies to stimulate the housing market. In fact, many governments and central banks pay close attention to how consumption tracks house price because they believe that house prices drive aggregate demand and inflation.

It is a fact that house prices and household consumption move in tandem, but there is more to this connection than meets the eye, and economists disagree about the causes of this link. One camp argues that home owners think of their house as any other financial asset and even relatively small movements in house prices can have significant impacts on household wealth since for most home owners this is their most important financial asset. When prices go up it is like winning the lottery and 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. They argue that what is important are peoples earnings prospects. 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 then so does the possibility to get credit based on the equity kept in the house, and therefore consumption tracks house prices.

Explaining the connection between house prices and household consumption is important. Martin Browning from Oxford, and Mette Gørtz and I provide a new answer. The key is to look at the behavior of individual households as the different explanations for the synchronization of house prices and consumption behavior are relevant for different types of house owners. If the house is considered as asset alongside all other financial assets then one would expect older home owners 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 house owners adjust their consumption the most.

The researchers turn to Danish tax-administration data with information about some 90,000 individual households and almost 400,000 observations for the period 1987-1996 because these data contain just the information needed to sort out the competing explanations. The data set is created from Danish tax records that combine information about income, wealth and saving as well as information about home ownership, age, education and family composition. The researchers consider this period because it exposed house owners to a house price 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 house owners to use the house as security for consumption loans before 1992, and this enables the researchers to establish how households take out consumption loans based on their housing equity when such loans were introduced. They find that old house owners did not respond to house prices changes, but that young house owners who are short of finances exploited the opportunity to take out additional consumption loans when this opportunity was introduced.

The study shows that it is unlikely that households perceive apparent wealth gains following changes in house prices as actual wealth gains. This result has important implications. Central banks and policy makers should think twice before designing policies targeting the housing market when trying to stimulate household demand in order to lift the economy out of the crisis. Of course, households knew this all along.

Published: Browning, M., Gørtz, M., and Leth-Petersen, S. (2013), Housing Wealth and Consumption: A Micro Panel Study, Economic Journal 123 (568), 401−428.

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