Housing and the economy: How does it work?

Skimming Stuff this morning I noticed the headline: House price slump ‘drag on economy’.  I thought that it might be useful, or possibly even interesting to discuss how a cooling in the New Zealand housing market could weaken economic activity.

When thinking about this issue we gave to ask the following question – how does house price growth influence household/consumer behaviour? For people that own houses, higher house prices act as an increase in their level of wealth, and houses are an asset. If a households wealth level is higher then they are both willing, and more able, to borrow money now to fund consumption – given peoples incentive to smooth consumption over time.

In this sense a fall in house prices would have a ‘negative wealth effect‘ (and a liquidity effect) on households, which would lead to households tightening their belts and saving more. This (along with strong wage growth) is part of the reason that so many New Zealand forecasters expect private savings to increase (along with the impact of tax cuts).

However, something is missing here. Why does a reduction in house prices lead to less consumption activity if that dip in prices was anticipated?  If households (and banks) expect house prices to fall, consumption activity will weaken. As a result, it is not the actual fall in prices itself that impacts on consumption (unless it is unanticipated) but the expectation that the household will have a lower lifetime wealth position.

Households tend to use a mix of adaptive and forward looking expectations when forming their expectation regarding house prices. This implies that the actual value of house prices in the current and past periods is directly important for forming an idea of household wealth. However, if something moves to provide negative household sentiment, or house prices seem unrealistic for home owners, this will also impact on consumption activity.

Since about May 2007, growth in consumption activity in New Zealand has slowed significantly. However, house prices did not peak until May, and annual house price growth was still in double-digits by December. This indicates that households had already reacted to the expected fall in house prices and housing market activity before it occurred.

As a result we have to ask, if people are REALLY expecting house price falls of 10%, won’t households have already changed their consumption behaviour (expect for a little bit of habit formation that they will have to shake out). If people truly expect these falls (which is debatable), then even if we experience a slump in house prices we may not experience as significant a slump in underlying economic activity.