Wealth Housing Market
Comparing Wealth Effects: The Housing Market versus the Stock Market
Introduction
Both economics and common sense would teach us that the value of household wealth should be related to consumer spending. Early academic work by Frank Modigliani (1963) suggested that a dollar increase in financial wealth (holding all other variables constant) would lead to an increase in consumer spending of 3-5 cents.
This link between stock market wealth and consumption had been widely accepted as the ‘wealth effect’, which had been of interest to economists for decades, but the late 1990s marked the beginning of a renewed interest in the literature (Martha Starr-McCluer 1998). This renewal of interest was sparked by the second half of the 1990s which recorded a dramatic increase in stock values. In the UK, the annual return to equity rose from an average 5.9 percent in the first half of the 1990s to an astonishing 18.9 percent average annual return from 1996 to 1999.
Over the same period the aggregate saving rate dropped from 17 to 14 percent in the UK. This has led to renewed policy and econometric interest in the effects of household wealth upon consumer spending. To the extent that the inflation of stock prices increased spending pressures, there were good reasons to fear that constant or declining share prices may depress consumption and exacerbate a slowdown in the economy.
The stock market decline of 2001 however did not depress expenditure as expected. The leading explanation for the limited impact of falling stock prices on aggregate demand is that of an offsetting housing wealth effect (Benjamin 2004). It was further stimulated by the appreciation and recent softening in house prices in the U.K. These recent developments in the housing market raise the question of how households view their housing wealth and how this may vary their consumption.
An explanation relies on that there may be differences in consumption responses to shocks to different types of wealth, many authors have recognised that overall wealth may not contain all the information useful for understanding the link between wealth and consumption spending. In particular, arguments have been made to separate wealth into financial and housing components (Case, Quigley and Shiller 2001).
As to the nature of the correlation between the wealth components and consumption, it would be tempting to attribute it to a direct wealth effect meaning an increase in the price of your home would increase household wealth, which in turn increases consumption. There are however several reasons not to make this attribution without further analysis, as there are alternative explanations for the correlation between the different wealth components and consumer spending.
The proposed project will contributes to the literature by analysing differences in the wealth effect out of financial and housing wealth using data from the UK. The project will begin with an overview of the existing empirical evidence and the theoretical background for our work.
From there we will validate our analysis by modelling an econometric model which will set out by regressing consumption to an exogenous variable of family income and using two endogenous variables of wealth which will be divided into liquid and illiquid for stock market wealth and using credit conditions alongside other controls to model the housing wealth effect.
This model will also include the error correction mechanism to represent the long run information. This information is crucial and needs to be included in the model because our focus is to build a model which fully explains consumption using our model over a period of time.
Literature Review
The literature on wealth effects has at its core the life‐cycle model of consumption developed by Albert Ando and Franco Modigliani (1963). From these papers, a standard approach to estimating the relationship between consumption and measures of real income and wealth was developed and is most common as a basic framework to begin with. Mishkin (1976) provided early evidence of the existence of a stock market wealth effect. Mishkin looked at the period of the Great depression following the stock-market crash of 1929 and argued that the decline in financial asset values affected consumption through liquidity effects.
In the past decade, several studies used macroeconomic data to assess the effect of housing and financial wealth on consumption. Some of those studies do suggest that consumption reacts differently to changes in the two types of wealth.
Case, Quigley and Shiller (2005) examined wealth effects, using a panel of 14 countries during 1975 to 1996. They compared their results using this data with a panel of US states for the period 1982 to 1999. They found that evidence for stock market wealth was insignificant compared to the results they found from housing wealth which delivered a significant wealth effect on consumption.
Case, Quigley and Shiller concluded from their data that a change in housing price will result in a more important impact than a change in stock market prices in influencing consumption, both in the United States and across their panel of developed countries. However, many authors believe that their model is simplistic and has resulted in omitted variables such as interest rates, the unemployment rate, and income growth expectations effects.
Also, for the OECD part of their study, pooling 14 countries denies the different situations between countries implied by their institutional differences. Shifts in credit conditions are also omitted from the OECD country data though, for example the UK went through revolutions in credit availability. The supposed housing wealth should have been larger for the OECD countries, where credit conditions went through larger changes than for US states.
Based on the life cycle hypothesis Donihue and Avramenko (2007) place their study between the boom burst cycle of 1990-2002. They decomposed wealth into three different forms: firstly, the fashionable housing wealth versus stock market wealth, the second model decomposed wealth into per capita household net worth into liquid versus illiquid components.
Thirdly, the most interesting model they delivered was the housing asset against stock market assets which was divided into liquid and illiquid. The results support the notion that housing has greater statistically significance over stock market wealth. Importantly increases in liquid stock assets had significant effect to short run consumption whilst illiquid stock wealth proved to be insignificant.
Ludwig and Slok (2004) investigate the relationship between stock prices, house prices and consumption using a panel of quarterly data for 16 OECD countries, over the period 1960—2000. Their results are estimated on whether a country’s credit market systems are bank-based or market-based. The authors caution that due to data limitations, their results are uncertain. However, the elasticity of consumption spending to stock market prices is found to be larger for market based rather than bank-based economies. Contrary to the findings of Case, Quigley, and Shiller (2005) and Donihue and Avrmenko (2007).
Using aggregate data or even regional data for studying the wealth effect can also be problematic, because movements in asset prices can be affected by many factors that also affect consumption decisions such as macroeconomic factors (Sierminska and Takhtamanova 2007).
There have been few studies using micro data to address the link between housing wealth and consumption. Most of them do not distinguish between different types of wealth, are single-country studies, and use different methodologies. In terms of the relative size of financial and housing wealth effects, a recent study by Sierminska and Takhtamanova (2007) updated previous econometric evidence and provides us with an estimate for two types of wealth on consumption, using micro data. Whilst they found a stronger elasticity for the housing wealth on consumption over stock market wealth this could be due to housing wealth acting as a proxy for permanent income.
Campbell and Cocco study micro data from the UK Family Expenditure Survey from 1988-2000, after credit market liberalization had largely occurred. They explain changes in consumption per head for different cohorts classified by region, controlling for income growth, regional unemployment, interest rates as well as housing tenure, mortgage debt and regional house prices.
They find that the largest house price effects are for the older homeowners and the lowest for renters. The fact that the national house prices affect the consumption of renters, clearly not a wealth effect, suggests that house prices contain a general ‘confidence’ or expectations effect.
Housing wealth in previous literature is married with different controls such as income, unemployment, interest rates and other assets. However, the failure to control for shifts in credit conditions is likely to be critical Aron, Muellbauer and Murphy (2005) study data for the UK and include a more complete set of controls than earlier studies. The shifts in credit conditions are substituted using an indicator derived from data on loan-to-value ratios for mortgages to first-time buyers.
They include interest rate and unemployment effects. Assets are aggregated into liquid and illiquid categories, where the latter includes housing wealth, and shifts in wealth effects with credit conditions are tested. They conclude that the housing wealth effect largely works through the ‘credit channel’ and shows a substantial elasticity when credit conditions are included.
Another study by Aron and Muellbauer (2006) is applied to modelling consumption in the UK. This paper incorporates methodological improvements in the measurement of credit conditions they distinguish theoretically and empirically among three types of effect of financial liberalisation on consumption. The first effect is that financial liberalisation reduces the credit constraints on households engaging in smoothing consumption when they expect significant income growth.
Secondly, it reduces deposits required of first-time buyers of housing and lastly, it increases the availability of collateral-backed loans for households which already possess collateral. Their empirical evidence supports these three features of financial liberalisation on consumption and suggests for the UK, that after credit market liberalisation, the marginal propensity to spend out of housing wealth is approximately the same as that out of illiquid financial wealth, but less than that out of net liquid assets (they designate that illiquid stock market wealth has a greater impact to consumption over liquid stock market wealth which is due to behavioural reasoning by consumers which goes against the literature published by Donhiue and Avramenko 2007).
In the UK the marginal propensity to spend out of housing wealth is likely to be smaller than from stock market wealth. The model that they use is well polished and delivers a good understanding of the wealth effects on consumption. However, their regression seems to be missing the long run information and therefore tells us nothing to say about whether the variables used and consumption have an the equilibrium relationship.
Bibliography
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