University of Chicago Booth School of Business: Questioning the Economic Effects of a Booming Real Estate Market
Strong house price growth fuels economic activity during expansions, and the ensuing slowdown in housing often precipitates severe crashes. Almost every severe economic downturn in advanced economies over the past 85 years was preceded by a real estate boom: Among them the Great Depression in the United States, the Lost Decades in Japan, and the current economic malaise that plagues Spain. Research, as summarised in our recently published book House of Debt, shows that this relation is causal: Movement in house prices affects real economic activity such as spending and employment.
Policy-makers throughout the world now recognize this fact, and many are paying close attention to housing markets. In Britain, house prices have risen sharply over the past 16 months, sparking worries of an unsustainable housing boom. The Bank of England, recognising the relation between such housing booms and subsequent economic catastrophe, has implemented restrictions on mortgage lending in an attempt to cool the market. Central banks in Israel and South Korea, among others, have also used limits on mortgage lending to cool housing markets in the past.
“While the fact that housing affects economic activity is clear, the underlying economics are not.”
While the fact that housing affects economic activity is clear, the underlying economics are not. An understanding of these economics is crucial as policy-makers increasingly target excessive mortgage lending during real estate booms.
Why should house prices drive economic activity? One reason is obvious: A rise in real estate values encourages the construction of new buildings and homes, which in turn contributes directly to economic growth. But in most advanced economies, residential investment is not a major component of economic growth. We need to look beyond construction to understand why housing affects the broader economy.
The other reason is more important, but also harder to explain: Movement in house prices have a strong effect on household spending. In 2005 and 2006, our research shows that house price growth in the United States increased household consumption by 1.3 per cent of GDP. The dramatic decline in spending when house prices crashed was instrumental in both the initiation and severity of the Great Recession .
Most call the influence house prices exert on spending the “wealth effect,” and a common estimate is that households spend about 4 to 7 cents out of every dollar of house price appreciation. Symmetrically, households cut spending by a similar amount when home values fall.
But this effect is theoretically puzzling. Why should people feel wealthier when their home values rise? A rise in the price of a home is also a rise in the cost of living. Consider, for example, a young couple that owns a small apartment but wants to buy a bigger home in the same neighbourhood. A rise in real estate prices is a bad thing for this couple – they now need to increase their spending on housing in the future. A higher price of housing makes them feel poorer rather than not richer. This is what makes housing different than stocks or bonds; housing is an asset we directly consume, and so a higher price also means a higher cost of consumption.
So how do we explain the empirically robust relation between home value changes and spending? Rising home values affect spending not because people feel richer, but because a higher home value facilitates borrowing by lower and middle income homeowners, who use the borrowed cash to spend. In our research on US house price growth from 2002 to 2006, we find that the effect of higher home values on spending was completely driven by lower and middle income homeowners . Among the rich, an increase in home values had no effect on spending.
Further, higher spending for lower income Americans was driven by borrowing. They borrowed heavily against their rising home value, as much as $0.25 for every dollar of price appreciation. All of the borrowed money was used for spending, and all of the effect of increased home values on spending was driven by borrowing. The housing wealth effect is really a housing borrowing effect, and it is driven completely by lower and middle income households. The average 4 to 7 cent spending effect cited above is misleading because it masks huge variation across the population.
These findings fit into a broader literature that consistently finds that lower income, lower net worth individuals have a much higher propensity to alter their spending dependent on income shocks. Research has confirmed this result in the context of fiscal stimulus rebate checks, auto loans, and credit card limits. Lower income households see their spending change dramatically when they experience a rise or fall in income or credit availability. Higher income households are far less responsive.
So what are the lessons for policy-makers in Britain today? An overarching theme from our research is that we must move beyond aggregate measures of house price growth, household debt, and spending. It is the distribution that matters, and we therefore must have more microeconomic data to understand the effects of the current boom on economic activity. If low income households in Britain are using higher home values to borrow and spend, then that suggests a warning flag. In contrast, if the gains to home values are primarily accruing to the very rich, then rising house prices may be having a minimal effect on household spending.
Here is a concrete example of how a singular focus on aggregate data can be misleading: Current measures of the aggregate household debt to income ratio in Britain suggest that there is no sharp rise in household leverage. But this fact alone provides only limited information. If the rise in income is driven by those at the top of the income distribution who carry very little debt, then it could still be the case that lower and middle income British households are seeing an unsustainable rise in leverage. Policy-makers need to know whether people in the middle and lower income part of the distribution are borrowing too much relative to their income.
We have historical precedent for such an error based on aggregate data. Many in the United States justified the rise in household leverage from 2000 to 2007 by pointing to higher aggregate productivity. But as we have shown in our research, the rise in productivity was not affecting the incomes of the low credit score individuals that were borrowing aggressively. Their income was actually falling. Microeconomic data would have shown this dangerous pattern, while the aggregate data did not.
The disparate effect of shocks to income on spending across the income distribution is also an important consideration when setting monetary policy. As the excellent report by the Resolution Foundation  points out, many lower and middle income British households are stretching to meet their mortgage payments; payments that will rise sharply if overall interest rates increase. In surveys, almost half of British households say they will have to cut spending, work longer hours, or renegotiate their mortgage if interest rates increase by just 2%. An increase in interest rates could have a significant effect on spending for lower and middle income homeowners with large mortgages.
Advances in computing power and data availability mean we can now measure the effects of house prices and other economic factors at a more disaggregated level than in the past. Our research suggests that house price growth has a very different effect on spending for low versus high income homeowners –we must measure who is affected to know how aggregate movements in real estate affect the broader economy.
 ‘Household Balance Sheets, Consumption, and the Economic Slump’ by Atif Mian, Kamalesh Rao, and Amir Sufi, The Quarterly Journal of Economics, Vol. 128, Issue 4, Pages 1687-1726.
 ‘House Price Gains and US Household Spending from 2002 to 2006’ by Atif Mian, Amir Sufi, May, 2014.
 ‘Hangover Cure: Dealing with the household debt overhang as interest rates rise’ of July 24, 2014.
Originally for “Financial World” and ifs University College.