Will Housing Save the Economy?

Don’t count on it, says a leading macroeconomist at the Booth School of Business at the University of Chicago. “We need to temper our optimism on what a housing recovery can do,” says Amir Sufi, professor of finance.

Thought leaders ranging from President Obama to Bill Dudley, the president of the Federal Reserve Bank of New York, have pinned the nation’s economic progress on the housing recovery, but the fact is that “we will not be returning to the boom years that preceded the Great Recession. The days when housing was the predominant force driving economic activity are gone, and I view that as a good thing,” says Sufi in an article in the fall issue of Capital Ideas, a Booth School publication.

However, the housing wealth effect is less than meets the eye and price growth owes as much to investors as to homeowners, which means home ownership won’t recover more to

“An increase in house prices drives economic activity in two ways. First, it induces investment in new residential construction. Second, it leads some households to spend, either for home improvement or consumption. The latter effect has generally been called a “housing wealth effect,” but in my view that’s the wrong way of thinking about it. Instead, the positive effect of house prices on household spending relies crucially on the degree to which a given household is constrained from spending as much as it would like in the short run, either because of borrowing constraints or behavioral biases.

But Sufi argues that spending as a response to an increase in house prices was not uniform, which is a critical point often neglected in the discussion of housing wealth effects. “In our study of the housing boom, we found enormous differences in the propensity of homeowners to extract equity from their home based on credit scores. Homeowners with the lowest credit scores were very aggressive, borrowing 40¢ against every dollar of increased home equity. Homeowners with the highest credit scores were almost completely passive, pulling almost no equity out of their homes when house prices increased,” said Sufi.

“In research with Kamalesh Rao of MasterCard Advisors, Mian and I also found the exact same relationship during the housing bust. For a given dollar decline in house prices, constrained borrowers cut back on spending much more dramatically than unconstrained households. The marginal propensity to consume out of housing wealth was three-to-four times larger for constrained versus unconstrained households.” wrote Sufi.

Today these constrained borrowers have been shut out of housing and mortgage markets, he said. ‘The only households that can buy a home or borrow against one are precisely the unconstrained households that are least likely to spend out of an increase in housing wealth. Therefore few homeowners are aggressively borrowing against their homes, precisely because they have high credit scores. If we take the results from our previous research, the housing wealth effect for these households may be close to zero, which would substantially dampen the effect of house prices on spending.”

Another way to measure the wealth effect is to look at home improvement, he said. Year-over-year spending on home improvement, appliances, and furniture was up 2.4% in January through March of 2013, while other retail spending was up 3.5%. Spending on home-related purchases remained weak even as house prices climbed. In contrast, during the 2002-06 boom, year-over-year spending on home improvement, appliances, and furniture outpaced other retail spending every single year.

“The nature of the housing recovery is quite different than what we’ve seen in the past. Up to this point, it appears to be driven in large part by investors and cash-buyers. The direction of causality is difficult to discern: investors may be responding to house price growth as much as driving it. But the recent growth should be understood in the context of the boom in investor activity,” he wrote. The most direct effect would be a permanent return to homeownership rates in the United States of 65% or perhaps even lower. Further, investors renting out apartments and single-family homes are likely to invest less in the homes than homeowners would. We still need good theory and data to back up this argument, but it seems to be accepted wisdom among professionals working in housing and durable goods markets. It does make intuitive sense. Landlords tolerate more depreciated washing machines and kitchen appliances, and more transient renters are less willing to pay the landlord for better equipment.

“We cannot rely on debt-fueled collateral-based consumption for economic growth. Easy credit-fueled house prices and consumption during the boom, and the collapse in spending, were exacerbated by excessive debt burdens and a failure to provide any relief to underwater homeowners. Fueling consumption through easy household credit may help in the short-run, but it inevitably has long-run painful consequences,” Sufi concluded.