Crash Course In The Relationship Between Housing Prices, Consumer Spending and The Economy
In its recently released Summer 2008 Review, the Bank of Canada (
click here to download the entire report ) opines about a number of topics such as the Canadian Debt-Strategy Model and China’s Integration into the Global Financial System but in this instance I shall deviate from my normal blogging focus and highlight their thoughts on House Prices and Consumer Spending.
“House prices influence consumer spending through two main channels: a direct housing wealth effect and a collateral effect.”
"In a study of 16 countries belonging to the Organisation for Economic Co-operation and Development (OECD), Girouard et al. (2006) find that, since 2000, 13 countries
experienced a real increase in house prices that exceeded 25 per cent. Substantial increases in existing house prices occurred in Ireland, the United Kingdom, Spain, France, Australia, the United States, and Canada."
"Notably, the countries recently experiencing strong appreciation in house prices have also experienced robust growth in consumer spending, raising the possibility that higher home equity is a key channel stimulating consumer spending."
"More recently, the global pace of appreciation in existing house prices has slowed, or reversed. In the United States, the slowdown began in mid-2005, and real house prices have fallen since mid-2007."
"Signs are also emerging of a cooling in European housing markets, with growth in prices moderating in most countries. In Ireland and, more recently, the United Kingdom and Spain, prices have begun to fall; the International Monetary Fund (IMF 2008a) expects further declines in house prices in these countries over 2008–2009. In Canada, the growth in house prices is expected to moderate, since affordability has deteriorated and economic growth is expected to slow. With few signs of excess supply at the national level, the growth in prices is expected to remain positive (Bank of Canada 2008)."
"A recent IMF study (2008c) finds that, in many advanced countries, a large proportion of the house price increases over 1997 to 2007 does not seem to be accounted for by changes in fundamentals, such as affordability, growth in real disposable income, and real interest rates. Housing prices appear to be most overvalued in Ireland and the United Kingdom, where they are estimated to be about 30per cent higher than can be justified by fundamentals."
"The deregulation of housing finance systems has led to significant heterogeneity in the institutional characteristics of national mortgage markets across advanced economies that could affect the magnitude of the observed housing wealth and collateral effects. Such institutional characteristics include the typical duration of mortgage contracts, the required levels of down payment, the existence of equity-release products such as home-equity lines of credit, and the interest rate structure of mortgage contracts. Across countries, there is a high degree of dispersion in all the indicators considered in Table 2 (pictured above). The ratio of mortgage debt to gross domestic product (GDP) varies from a low of 32.2 per cent in France and 45.3 per cent in Canada to a high of 98.4 per cent in the Netherlands. Refinancing (fee-free prepayment) is easily available in some countries, but is either unavailable or its availability is limited in others, including Canada. Likewise, in some countries (e.g., Canada, the United States, and the United Kingdom), households can easily access their housing equity through homeequity
borrowing products, while in others (e.g., Japan) these products do not exist or have limited availability. There is also a large degree of dispersion across the average term of mortgage loans, which range from 15 years in France to 30 years in the United States."
"The mortgage market in the United States generally consists of fixed-rate loans with long maturity and prepayment options. These characteristics may lead households to underestimate the long-term risks, resulting in overborrowing. Access to financing is more limited in France and Germany. Moreover, the marginal propensity to consume (MPC) out of housing wealth is generally found to be higher for countries with more-developed mortgage markets, as measured by higher values of the mortgage market index; Japan, however, is a notable outlier."
"The collateral effect on consumer spending is likely to be the largest in countries with a high loan-to-value (LTV) ratio, such as the United States, which also have
more-developed subprime mortgage markets. As suggested by Iacoviello and Neri (2008), a higher LTV ratio increases the maximum borrowing capacity of households (measured by the expected present value of their home multiplied by the LTV ratio). At the same time, a higher LTV ratio has been found to decrease the share of credit-constrained consumers in an economy (Japelli and Pagano 1989). Therefore, the larger the LTV ratio, the higher the liquidity of housing wealth and the larger the effect of housing collateral on consumption."
Conclusion
"From reviewing a broad spectrum of literature, we find that house prices play an important role in household spending decisions for several countries. This link is stronger in countries like Australia, Canada, the United States, and the United Kingdom, which have more-developed mortgage markets, than it is in countries like Spain and France, which have lessdeveloped mortgage markets. These results suggest that, in the event of a major global correction in house prices, the link between house prices and consumer spending can pose serious challenges for policy-makers. In particular, rapid decreases in the price of housing can have serious implications for aggregate output and should help to contain inflation, particularly if a house price correction is followed by a significant downturn in consumption expenditures. Furthermore, the negative consequences associated with a general decline in global house prices would be expected to be greatest for those countries where house prices are seriously overvalued and where consumption expenditures and house prices are closely linked (e.g., the United States, the United Kingdom, the Netherlands, and Australia)."
References Cited
Girouard, N., M. Kennedy, P. van den Noord, and C. André. 2006. “Recent House Price Developments: The Role of Fundamentals.” OECD Economics Department Working Paper No. 475.
International Monetary Fund. 2008a. “Assessing Risks to Global Financial Stability.” Global Financial Stability Report: Containing Systemic Risks and Restoring
Financial Soundness (April): 1–53.
Bank of Canada. 2008. “Recent Developments in House Prices.” Monetary Policy Report (April): 27.
International Monetary Fund. 2008c. “Assessing Vulnerabilities to Housing Market Corrections.” Box 3.1 in World Economic Outlook (April).
Iacoviello, M. and S. Neri. 2008. “Housing Market Spillovers: Evidence from an Estimated DSGE Model.” Banca d’Italia Working Paper No. 659.
Jappelli, T. and M. Pagano. 1989. “Consumption and Capital Market Imperfections: An International Comparison.” American Economic Review 79 (5): 1088–1105.
