According to the Census, the current rate of home ownership in the United States is nearly 65%. Not only is the home a widely held asset, but it also represents the largest asset category in household balance sheets, accounting for about 45% of the median household wealth. Given these numbers, policy makers have considerable interest in understanding and quantifying how household spending responds to large house price fluctuations like those observed in the past decade. These responses matter because they have the potential to exacerbate booms and busts in the economy: windfall gains in the housing market may lead to spending increases, possibly contributing to bubbles in that market, while unexpected falls in house values may cause spending reductions, adding to the deflationary forces responsible for the decline in house prices.
There are several mechanisms through which the link between housing market cycles and household spending may arise. Individuals may use their growing housing wealth to boost their spending, by effectively letting their homes do the saving for them. Increasing house prices can make people feel richer. For instance, they know that they can downsize and cash out to finance retirement and that their house will eventually constitute a larger bequest. As a result, they may save less and increase their spending. People do not need to sell their home to reap the benefits of rising house prices since home equity extraction via re-mortgage and/or home equity line of credit has become relatively common. Clearly, the opposite is true when homes lose their values. Owners feel the pain of declining house values even if their place is not on the market: when house rates are on the fall, refinancing becomes more problematic and lenders are more reluctant to offer credit.
The Great Recession of the last decade offers a unique opportunity to assess the extent to which household spending responds to changes in house values. Between 2007 and 2009, house prices plummeted by 30% nationwide, but with enormous differences across states and local markets. Using data from before, during and after the recession, we compare spending behaviors of households across states — where housing markets behaved very differently — to estimate the response of consumption to sudden and large changes in housing wealth (interested readers can take a look at the full set of results here). We focus on the population over the age of 50, amongst whom home ownership rate is above 70% and home equity represents around 60% of median wealth. Middle-age and older households are more likely to downsize (or to consider downsizing) to finance their retirement and to have some bequest intentions. Because of that, they may be more sensitive to changes in the values of their homes. Moreover, since they are mostly in retirement or on the verge of it, they are less affected by labor market turmoil than younger persons. This is an important aspect to consider for our analysis as in some states large house price drops were coupled with unemployment hikes, which may, in turn, have affected consumption decisions.
We carry out our analysis in two steps. In the first, we compare spending of homeowners in states with small, modest and large house price swings over the period 2003-2011. We find that homeowners living in states with the largest house price declines during the Great Recession reduced their spending by 10 percentage points more than those in states with the smallest house price declines and by 5 percentage points more than those in states with modest house price declines. We make sure that these results are not driven by individuals in states with the largest house price declines experiencing more unemployment or suffering greater earnings reductions than those in other states. When we repeat the same analysis for non-homeowners, we do not find significant differences in spending across states with different levels of house price declines. This suggests that the observed differences for homeowners are indeed the result of different changes in house values across states.
In the second step, we quantify the response of household spending to the unexpected changes in house values brought about by the economic crisis. We estimate that for every $100 loss in housing wealth, spending is reduced by $7. During the recession, losses in housing wealth of $100,000 were not unusual in states like California or Florida. That would have caused a reduction in spending of $7,000, a large drop that may have contributed to the instability of the economy in those states. Notably, the reduction in spending following a loss in housing wealth appears to be bigger for more leveraged households. These may have relied more heavily on equity extraction during the boom and suffered more severe consequences when this source of credit dried up after the bust.
Based on the results of our exercise, can we expect in future crises a similar drop in consumption as the one observed during the Great Recession? The answer is yes if the economic turmoil means big drops in house prices; if homeowners base their spending decisions on excessively optimistic expectations about house value appreciation; and if they can comfortably extract equity from their homes to fuel their consumption. Perhaps the Great Recession has taught everyone a lesson about the danger of letting the house do the saving for us and making available easy ways to turn home equity into cash. As for now, house prices are on the rise and the holiday season is around the corner…
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