Muellbauer_0415_Password_Removed.docx

Housing, Credit and Consumer Expenditure John N. Muellbauer 1. Introduction One important channel by which developments in housing mar- kets affect the macro-economy is through changes in consumer be- haviour. More favourable access to credit has raised household debt levels in many countries and house price appreciation has led to in- creased household wealth. Several factors underlie the improved ac- cess to credit, including changes in prudential and wider capital mar- ket regulations, technological change and reductions in the cost of information technology, developments in the sharing of information on credit histories, and the deepening of markets for securitized con- tracts and derivatives. The increased ability of households to extract or borrow against their home equity has altered consumer spending and saving behaviour in many countries. New types of mortgage con- tracts have made housing more affordable at given home prices; but while lenders have often succeeded in spreading their risks through the financial system, the risks for many borrowers have increased. The aim of this paper is to discuss housing wealth and other asset effects in the context of lifecycle consumption theory, augmented for credit channel effects and taking account of credit market liberaliza- tion. In Section 2, it is argued that there is some justification from simple lifecycle permanent income theory for the Bank of England s 267 268 John N. Muellbauer view that there is no effect on consumption from a permanent in- crease in house prices. However, as soon as credit constraints based on asymmetric information between borrowers and lenders enter the picture, the implications for consumption alter dramatically. Where mortgage credit markets are poorly developed, potential first-time buyers have to save a significant fraction of their income for a hous- ing deposit, while existing owners have limited access to home eq- uity loans. When house prices rise, potential first-time buyers have to save yet harder, while the owners do not increase their spending much given limited access to the extra collateral. The overall effect of the rise in prices is then to reduce consumption. However, lib- eralization and improvements in the efficiency of mortgage credit markets change both dimensions: The young save less and housing equity becomes more collateralizable. When house prices rise, there is then only a small negative effect on the spending of potential first- time buyers, and a larger positive effect on that of existing owners as their collateral values increase. In Section 2, the consequences of institutional differences in credit markets for consumer behaviour through time and in comparisons between countries are discussed. Various nuances of credit market and other institutional differences are explored. In practice, there is widespread disagreement about the role of housing wealth in explaining consumption. Much of the empirical literature (briefly reviewed in Section 3) is marred by omitted con- trols for the common drivers both of house prices and consumption, including income, income growth expectations, interest rates, credit supply conditions, other assets and indicators of income uncertainty (such as changes in the unemployment rate). Omitted controls are likely to be correlated with house prices, thereby making estimated wealth or collateral effects liable to bias. For instance, while the easing of credit supply conditions is usually followed by a house price boom, failure to control for the direct effect of credit liberalization on con- sumption can overestimate the effect of housing wealth or collateral on consumption. Further, models formulated entirely in quarterly differences, as some are, may not well measure long-run responses. Housing, Credit and Consumer Expenditure 269 This paper explores the consequences of credit market liberalization through the lens of a modern version of the Friedman-Ando-Mo- digliani solved out consumption function. An extended framework for modelling the consumption effects of housing wealth, collateral and credit is presented in Section 4, encompassing traditional fea- tures of lifecycle theory such as income growth expectations, but building in the main elements of the household credit channel. This gives rise to an empirical model that allows the consequences of shifts in credit supply conditions for consumer spending to be tested, as well as checking for differences in the marginal propensity to con- sume out of different types of assets. It takes account of the long- run information in data on consumption, income, assets and debt which is thrown away in the alternative (differenced) Euler equation approach. The model is also more robust than the Euler approach to deviations from the latter s extreme assumptions about household rationality and information processing capacity. This extended model has been applied in the UK, the US and other countries, including South Africa and Japan, though the results for the US and Japan are still preliminary.1 The results are discussed in Section 5. Key to this work is the development of an indicator of the shift in credit market supply conditions. For the UK, we have a so- phisticated index developed in Fernandez-Corugedo and Muellbauer (2006), consistent with a large credit market liberalization beginning in 1980. Liberalization significantly raised the consumption-to-income ratio and significantly altered the response of consumption to several drivers, most importantly to housing wealth. The evidence is that before 1980, there was no housing wealth effect on consumption, but that this effect now somewhat exceeds the effect on consumption of illiquid financial wealth. Evidence also points very strongly to a larger marginal propensity to consume out of liquid assets (minus debt) than that of all other assets. Further, in a separate model, the Bank of England s estimates of housing equity withdrawal are well explained by this credit conditions index and its interaction with housing wealth. However, housing equity withdrawal has no explanatory power in our extended consumption function. 270 John N. Muellbauer For the US, we use a proxy for credit supply conditions based on the Federal Reserve s Senior Loan Officer Survey question on banks willingness to make consumer loans for durables purchases. To en- sure robustness to the possible omission of long-run influences on consumption coming from demography, rising inequality and other factors, the consumption model includes a smooth stochastic trend. The key findings are the same as for the UK: The easing of credit market conditions has caused a significant rise in the consumption- to-income ratio and a positive shift in the housing collateral effect. As in the UK, we find a higher marginal propensity to consume out of liquid assets minus debt than out of illiquid financial assets. How- ever, our preliminary evidence points to the US housing collateral ef- fect now being larger than in the UK and significantly exceeding the illiquid financial wealth effect. For the US, this supports the claims of the widely cited paper by Case et al. (2005) and research by Car- roll et al. (2006) among others. Further support for these findings and the extended consumption model comes from work on South Africa, with large wealth and col- lateral effects. South Africa has long had a sophisticated financial sys- tem and UK style mortgage markets, with credit market liberaliza- tion in the 1980s and 90s. In contrast, research on consumption in Japan points to very different conclusions. We find no evidence that there was any important easing of credit conditions for consumers between 1980 and 2000. Using residential land prices as a proxy for house prices, we find a negative effect from higher prices on con- sumption consistent with the view that the young save harder when prices rise, offsetting any wealth or collateral effects for existing own- ers. Since Japanese inheritance tax favours residential housing, there are good reasons why older households are less likely to downsize or withdraw equity. There are important implications, discussed in Section 6, for house- hold vulnerability of the high debt levels that have been reached in many countries. The evidence that many households have poor in- formation or understanding of financial matters suggests that, while most households have adequate net equity and cash flow cover for their debts, significant proportions could find themselves in difficulties in Housing, Credit and Consumer Expenditure 271 only somewhat less benign economic conditions. This has been exac- erbated by some poor lending practices that have come to light as the subprime loans crisis has unfolded. A recent OECD review by Gir- ouard et al. (2006) raises mild concerns about household vulnerability, but rather more disturbing is a study by Lunde (2007) using a remark- able micro data set for Denmark (the world champion for high levels of household debt). Section 7 concludes by discussing some of the implications of the analysis and empirical findings of this paper. It draws parallels be- tween the partial and temporary retreat from liberal credit conditions in the UK in the early 1990s and current prospects in the US. It examines implications for world growth of credit and house price de- velopments in emerging markets. It also discusses wider government policies to deal with some of the issues raised by credit and housing market developments. 2. Housing Wealth Effects and Credit Availability In this section, the housing wealth effects implied by the lifecycle/ permanent income theory of consumption, in the absence of a credit channel, are examined and shown to be small or even negative. How- ever, introducing credit constraints radically alters these conclusions. The implications of differences in credit and other institutions across countries and across time are explored. 2.1 Housing Wealth Effects Linguistic confusion abounds regarding housing wealth effects for consumption. We need to distinguish the effects of higher housing wealth due to fixed capital formation from those effects due to price rises. Given the focus in the literature on the role of house price rises, we examine here increases in real housing wealth resulting from a per- manent rise in the relative price of housing. It is important to make two further distinctions. We need to distinguish the classical wealth effect on consumption implied by lifecycle/permanent income theory where the channel credit is disregarded, from housing collateral effects via greater access to credit. We must also distinguish non-housing consumption from composite real consumption including imputed housing services. 272 John N. Muellbauer As we shall see, for the latter, there are good reasons to doubt any wealth effect stemming from a permanent relative price change. In lifecycle permanent income models, a permanent increase in the real price of housing has income, substitution and wealth effects. These can be analysed in the following simple model of consumer choice. In the model, c denotes non-housing consumption, p is the relative price of housing, H is the stock of housing, is the rate of de- terioration of housing, r is the real interest rate, y p is permanent real non property income, and A is real financial wealth. The consumer maximises lifecycle utility defined on the flows of c and on the stocks H, in each period. Assume that the consumer expects the future relative price of hous- ing to be constant. Then the multi-period inter-temporal optimiza- tion problem reduces to a two-good problem (by the Hicks aggrega- tion theorem, see Deaton and Muellbauer, p.121) with the following budget constraint for housing and non-housing consumption: c p(r )H y p r(A pH ) (2.1) 0 0 where r(A0+ pH0 ) effectively measures permanent property income. The standard view is that housing services are defined by (r+)H, and the real user cost is defined by p(r+), see Poterba (1984) or Deaton and Muellbauer (1980, pp.107, 348). The effect of a permanent rise in the relative price of housing on non-housing consumption is given by: c / p rH0 (r )H p(r )H / p rHo H (r )(1) (2.2) = wealth effect minus income and substitution effect Here represents the own-price elasticity of demand for housing. The value of is generally thought to be in the region of -0.5 to -0.7, moderately inelastic, see Meen (2001), Cameron et al. (2006). The overall effect of a price rise in housing could be positive or negative, but is more likely to be positive. For example with a real interest rate of 4 percent, a rate of deterioration, , of 2 percent, an elasticity, , of Housing, Credit and Consumer Expenditure 273 -0.7, and assuming H is approximately equal to H0, the overall effect on non-housing consumption is 0.04-0.06 x 0.3=0.022. However, we are more usually interested in the effect of a price- induced housing wealth increase on a constant-price index of ag- gregate consumption (including imputed consumption from housing services, h =(r+ )H ), than only on non-housing consumption. The effect on the index of total consumption2 from equation (2.1) is c / p p(r )H / p rH 0 (r )H (2.3) But with HH0, the right hand side of equation (2.3) is bound to be negative in this simple model, since is positive. In countries where the housing services are incorrectly measured as H, which omits the real interest cost, the effect would usually be positive. This is because one would expect the real interest rate generally to exceed the deterioration rate of housing. It is important to be cautious in these circumstances, for the finding of a positive housing wealth ef- fect might be due to the mis-measurement in the National Accounts of housing services. Even in the circumstances of a mis-measurement of housing services, the theory suggests that the housing wealth effect (r-) is smaller3 than the financial wealth effect (r). The above is a stylised model assuming an infinitely lived repre- sentative consumer. In finite life models, by contrast, one can argue about distributional effects, for example if the marginal propensities to consume out of wealth of older consumers downsizing to release housing equity are large compared to the income effects for younger consumers increasing their stake in housing.4 This analysis has also abstracted from taxes, and liquidity consid- erations due to transactions costs and capital uncertainty. The lower are transactions costs, which include some taxes, and the lower are the charges of real estate agents and lawyers, the more liquid and so potentially spendable, is housing wealth. The tax system can have other effects: For example, if housing is tax advantaged for inheri- tance tax (as is the case in Japan), older people will be less inclined to reduce their