March 12, 2013
Feeling Poorer? Blame the House!
The American psyche gets a lot of credit for fueling the boom in U.S. home prices, which ended in 2006. As houses increased in value, homeowners felt richer, and they spent more. Similarly, falling house prices led to declines in consumer spending as households found themselves poorer and less able to access credit, according to a new paper, “Wealth Effects Revisited: 1975-2012,” by economists Karl Case, the late John Quigley and Robert Shiller.
In this interview, Case explains this “wealth effect.”
Q: Why were our spending decisions influenced by our psychology during the housing boom?
Case: The increase in house prices was like magic. They went from the 1950s until 2006 without ever falling nationally. The numbers are astonishing. If you look at the Federal Reserve’s Flow of Funds Accounts, the value of the owner-occupied housing stock in the United States increased from $14 trillion to $24 trillion. All of a sudden the collective balance sheet of U.S. households had $10 trillion worth of assets that it didn’t have before. That’s a very big number.
The first thing I asked myself is, How did I behave? I bought a house in Wellesley [Massachusetts] for $56,000 in 1976. When I sold it in 1991, it was a $240,000 asset. I know my behavior changed. I was in my 40s, and I found myself with a quarter million dollars that I didn’t know I had. It made me feel wealthier, and I spent more and saved less than I otherwise would have. Home equity loans and second mortgages made it possible for homeowners to withdraw their newly acquired equity to finance a higher level of spending and/or a new or bigger home.
Q: How do we decide we’re feeling richer?
Case: Household wealth is made of many things: houses, cars, and financial assets. The value of any asset, including housing, is determined by what people are willing to pay for it. What determines that? Our expectation of whether it will go up in the future. If you have a house I think is going to go up 10 percent per year, I’m willing to pay more for it than if I think it’s not going up at all. That’s how psychology drives the housing market.
In annual surveys for another paper, we asked 5,000 people going forward 10 years, what do you expect the average annual increase to be in the value of your house? They said 8-10-12 percent per year. They were feeling better because their house was worth more. That leads to more spending.
Q: Is it fair to say the housing market was one of the primary influences on the economy?
Case: Absolutely. Our finding has been very controversial. Some people say housing’s wealth effect doesn’t exist. Our own earlier work suggested that it works when the housing market is on the way up but not on the way down. We now have evidence that it works in both directions.
Housing has been the driver that got us out of recessions for 40 years. Every recession was cured by increasing housing starts and house prices. The reason this is important is that it’s something we counted on back in the 1970s all the way through the 1990s. Housing did what you wanted it to do: create more spending in a stagnant economy and also slow spending in a strong economy.
And the impact on the downside is even bigger.
Q: You found that house prices plunged more than 30 percent nationally from 2005 through 2009. How did this affect our psyches?
Case: In earlier decades, house prices had fallen in Texas. They also fell in New England and California – all at different times. But the aggregate national price level had never declined, and when it did, starting in the fall of 2005, the credit market that had supported it collapsed.
Two things about the last downturn impacted people. First, they found themselves not having the wealth they thought they had. And their leverage multiplied the downside risk: if you put 10 percent down on a house and borrowed the rest, and it increases 10 percent in value, you’ve doubled your money. But on the way down it works badly, because if you only put up 10 percent and the house price falls by 10 percent, you’re under water, and you can’t spend.
Second, there had been a tremendous drawdown in housing wealth during the boom through home equity loans, second mortgages and the like. The impact of the bust on behavior was psychological. People felt poorer. The losses were beyond anything that we could imagine – $7 trillion – and we’re still trying to figure out who’s suffered those losses. It’s going on in litigation and bankruptcies and short sales. I bought a house in upstate New York for $180,000, and it might be worth $100,000. But I bought the one I live in in Wellesley for $392,000, and it’s worth over $1 million. The lord giveth. The lord taketh away – but not until 2006.
Q: In the past, the wealth effect was mostly associated with the stock market, but you find it at work in the housing market?
Case: Yes. Researchers have looked at the effect of the stock market on household spending but have not until recent years looked at the separate effects of different types of assets on spending. That’s what this paper does, and the result was surprising. We’ve captured the impact of the stock market on behavior, but housing is the largest asset for most households. Clearly, during the boom years it had a very large effect on the economy.
Q: How is the wealth effect in housing different, though, than it is in stocks?
Case: Stock market wealth is a form of financial wealth. We buy and sell common stocks to earn a rate of return that comes in the form of dividends and capital gains. Housing is a durable good. We buy and own a home to enjoy living in it. It provides a yield in the form of housing services, which have a market value. Homeowners also realize that housing is an investment. When it goes up in value it acts just like shares of stock that go up in value.
Even though the returns are subjective and not just in money form, both serve as a way to hold your wealth. And whether it is a house or shares of stock, when they appreciate you are more wealthy, and you tend to spend more.
Q: Can you quantify how much the wealth effect contributed to Americans’ buying power and the economy?
Case: If you had a 10 percent increase in the value of housing, it would lead to a 1 percent change in the level of consumer spending. But a decline of 35 percent in housing wealth would lower consumer spending by 3.5 percent. Consumption is about $10 trillion per year, and that, in turn, implies a decline in consumption of about $350 billion annually.
Q: So where are we in 2013?
Case: House prices started rising in the early part of last year, and a serious headwind for the economy has turned into a tailwind. House prices are up, and they’re creating wealth. In February, jobs were up about 240,000, which is huge, and one of the biggest components was a large increase in employment in the construction sector. They’re building houses for the first time. New home construction is like the little engine that could, but it is going up the hill.