Housing Prices and Consumption

The widespread and sharp rise in housing prices during the early part of this decade in the United States and many other countries is said to have contributed to the worldwide economic boom through wealth effects that induced greater consumption. Similarly, the still steeper fall in these prices during the past few years is supposed to have reduced world consumption and helped induce the sharp downturn in world economic activity. Yet even sharp rises and falls in housing prices are likely to produce only modest wealth effects on consumption to the extent that changes in interest rates are responsible for the housing price changes (I am indebted to Kevin M. Murphy for many discussions of the determinants of housing prices and their effects).

Both long term as well as short term interest rates have been low since most of the period after 2001 (whether due to a deliberate low interest rate policy of the Federal Reserve or large savings by China and other Asian countries is not crucial for my discussion). These low interest rates were an important, although not the only, force behind the boom in housing prices in the United States and many other countries-e.g., expectations about future housing prices were also important. The prices of durable assets like housing are negatively related to interest rates, as long as the service flows from the durables are unchanged. Families buy houses instead of renting space mainly because they believe that ownership is a better way to consume housing services than renting. Therefore, if housing services were unchanged, the flows of utilities to homeowners over time would also be unchanged.

The high and rising housing prices in United States are supposed to have produced a positive wealth effect to individuals who owned homes that increased their consumption and reduced the US savings rate. Similarly, the steep drop in housing prices since 2006 is often claimed to have induced a negative wealth effect that contributed to the drop in aggregate consumption and rise in the aggregate savings rate. This wealth "loss" comes to several trillion dollars. Although these effects seem obvious and important, a closer analysis raises serious questions about the magnitude of any wealth effect on consumption.

Consider a very simple lifecycle and bequest story to bring out the main points. Suppose there are two periods of adult life: young and old. All young individuals buy homes at a given price that is determined by the quality of the homes and interest rates. For simplicity, for the moment I assume only one type of house quality. Older adults live in their homes until they die, and they then bequeath these homes to their children. The children then live in their inherited houses until they die, and then bequeath them to their own children. In fact, houses are the main assets that most middle class US families bequeath to their children.

Now introduce an unexpected fall in interest rates that increases the price of houses. Everyone who owns a home gets a windfall increase in their wealth because their homes are now more valuable. However, if they still want to bequeath their homes to their children, their opportunities to consume would not become more favorable, as long as other opportunities are not affected by the fall in interest rates. Their children in turn inherit a more valuable asset, but that asset does not bring any more housing services than before the price increase. Hence, children's consumption would also be unaffected since they simply hold their houses until they bequeath them to their children in the succeeding generation.

This example with inheritance of homes brings out the essentials most clearly, but the basic analysis would be unchanged if young adults were unrelated to older ones, or if they received no bequests from their parents. While older adults would then get a windfall when interest rates go down, they still have no extra resources to increase their consumption of other goods, if they want to consume the same amount of housing services. The only elderly gaining from higher home prices are those who want to downside their living space. Younger adults find housing services more expensive, so if anything they are made worse off by the higher housing prices. Yet as with older adults, the apparent change in the position of the young is largely illusionary since their houses would also be worth more after they own them.

More complicated analyses might produce larger wealth effects of higher housing prices due to lower interest rates. For example, higher house prices may give owners the opportunity to take out larger mortgages that help them finance purchases of other durables, including education for children. At the same time, however, higher prices make it more difficult for young persons to afford housing. Recent media reports suggest that first time homebuyers are taking advantage of the fall in housing prices to buy foreclosed and other cheaper property. Higher house prices due to lower interest rates may induce some people to substitute toward larger homes, as happened during the housing boom, and toward reduced consumption of other goods. This is because higher prices induce additional construction of houses that lowers the cost of housing services. Yet even with a substitution toward larger homes, total consumption may not change, but only its composition between housing and other services.

Lower interest rates may have other effects on the tradeoff between present and future consumption that do not come from the housing market. These effects would closely depend on what caused interest rates to fall. To discuss these causes would take me far beyond an analysis of the wealth effects of changes in housing prices.

The message of my discussion is not that higher housing prices have no wealth effects, but rather that any such effects are likely in the aggregate to be much smaller than what is often claimed. Perhaps this explains why empirical estimates of the housing wealth effect often differ greatly. It also suggests that while the rapid declines of house prices during the past few years may have had large effects on apparent wealth, it probably was not much of a drag on aggregate consumption, nor much of a stimulus to the savings rate.