The Bennett Newsletter
Households and House Prices
What drives consumption in New Zealand? Why do we “flash the plastic’? The Reserve Bank has posted a discussion paper which examines the relationship between household spending and house prices over 40 years, which singles out the wealth effect as the dominant driver. It is a very worthwhile theme, and very well researched.
Why is the theme important? It is important because household consumption is an important part of GDP, and could be an increasing part if government spending slows, and business investment declines. If household consumption increases its share of GDP, our economy could, potentially, become more volatile. We also need to know how consumption fares in recessions.
If we were to get a dinner party together, and throw in the question:” What makes you spend more or less?” you are bound to get a lot of valid responses. Some people are planning a big world-tour on their retirement, others are doing up their house in order to sell, some are traveling to see their grand children; many are updating their car, TV or other appliance. Some are taking courses to improve their employment prospects; some are having Botox. Many are spending heavily on their children or aged relatives.
You go deeper and ask “why are you spending now?” Most will point to necessity. The washing machine is stuffed; the carpet needs renewing, the kids have a school camp. Other say the time is ripe. They had always planned to go on a trip when Jack was 65. Others say holidays have never been cheaper and you can ‘grab a seat' to Bali for practically nothing. So some demand is forced by the things wearing out, some is opportunistic, and much is social—going out to dinner. The reasons are plentiful. Some may be due to media manipulation: "because you are worth it”.
There are always a lot of variables and the list could be almost endlessly extended but that is not the point of academic research. It tends towards the use of models which exclude as many variables as possible. This allows an intense focus on the selected trends. Let’s accept this simplification and study the argument: - for it is interesting.
There is existing research of the NZ housing sector 1980-2006 that would determined a permanent increase of $1 in real per capita of housing wealth is associated with a 0.19% increase in consumption in the long-run. So if a single person’s house increases in value by $100, consumption will increase by an average of $19. Another study of the1972-2000 came up with different figures: it concluded that consumption rose 6%-7% of the real increase in housing wealth.
The value of houses has, of course, fluctuated. There have been notable booms as in 1973-74, 1984, 1995, 2005 but sharp corrections have followed. Figure 1 in the following link to Mark Smith is very graphic http://www.rbnz.govt.nz/research/discusspapers/dp10_01.pdf
. Moreover, if increases in real house prices and real consumption are plotted on the same graph there is a close correlation. Somewhat surprisingly, there has not been research examining household consumption patterns and real house prices. There are different explanations of the correlation between house price movements and consumption:
Wealth effects. The hypothesis is that rising house prices improve household balance sheets which leads to either reducing the amount they save or withdrawing equity. If it is correct, we would expect to see homeowners increase expenditure when house prices are rising. Older householders would in theory increase consumption more than younger households because they have built up more equity in their property and they can realize equity by trading down, or utilise reverse mortgages
• Easing collateral restraints. Housing is collateral which can be used to increase borrowing. Some people might use their better credit rating to borrow in order to increase their consumption. This could be young people borrowing for furnishings etc and even older people borrowing for a new car or holidays.
• Common influences. Perhaps house prices and consumer spending expand or decline in response to common influences. For example, when the economy picks up, house prices could increase because everyone expects better future income. Consumer might anticipate better prospects.
Mark Smith’s purpose is to take a household perspective in examining the influences of consumption growth over the 1984-2007 period. This leads to some testing of his hypotheses. It could provide valuable service in what happens to consumption when house prices decline.
Much of the paper will be hard reading for the average reader. But for economists there is a full discussion of the data. It is very comprehensive, with snapshots on tenure and other things including educational qualifications and outstanding mortgages. There is an attempt to query the possibility that Auckland expenditures are different from other regions.
Some interesting points emerge from equations: expenditure is positively related to disposable income and house price levels but negatively to real effective mortgage interest rates. In short, households struggle when real interest rates on mortgages are high. Moreover, householders with mortgages spend more than other households, possibly because they have better credit. Householders with two properties, spend 20% more than other households. The behaviour of regional house prices can be significant in explaining consumption.
The sensitivity of expenditure to house prices varies with age. Mortgage free householders and mid-age people with mortgages are inclined to spend more than others.
But when real effective interest rates on mortgages rise by 1%, core household expenditure fall by 0.4%. This is especially true of younger and mid-age households. The aged increase expenditure, presumably because they are mortgage free and have other high yield investments.
On average, real house prices increased by nearly 4% p.a. from 1983 to mid-2007. But household expectations have varied, and there have been differences between actual and expected property rises. The recent rise (post 2003) was higher than expected, for example.
Key conclusions are:
• Household expenditures, by both owners and tenants, are closely related to real house prices.
• The responsiveness grows with age
• The most responsive are mortgage free
• Auckland is very responsive
• Expenditures are high for people who have recently moved
• Householders increased equity in the boom: this may sustain spending in the downturn
• There is weak evidence that expenditure is more sensitive to interest rates than the wealth effect.
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