Monday, April 16, 2012

How do House Prices Impact GDP?

Why are the US economy and stock markets are doing reasonably well, while housing prices are doing poorly? Something here feels "amiss."

Housing prices are currently declining in most areas of the United States, in Australia and New Zealand, in select Chinese cities and in southern Europe. Spain's house prices are forecasted to decline a further 20% after falling by 20% from their peak in 2007. This has lead Citigroup chief economist Willem Buiter to label in early April 2012 the economic situation in Spain as "dire." The forecast for housing prices is uncertain, with Goldman Sachs revising in January 2012 their estimate for the return of appreciating house prices from mid 2012 to the end of 2013.

Review of Existing Approaches to Modeling House Prices and GDP:

Economists have re answered the question of house prices and the economy by correlating house prices with consumer spending, by regression analysis through estimates of the wealth effect. In these models, increases in housing prices make the home owner feel more wealthy, thereby impelling the home owner will spend more of this wealth per year. The increase in consumption per year per dollar of increases in home prices is estimated by several economists (from Cambell and Cocco, Federal Reserve, 2011 to Case, Quigly and Shiller, 2003, among others) to between 3.5 cents to up to 18 cents per year per $1 of house price appreciation\, based on regression analysis of housing wealth to consumption over varying time periods.

Can one say, that with a 30% decline in house prices in the United States from their peak in 2006, consumption would be approximately 8% lower due to a 10% tendency per dollar of house price change? (peak housing wealth of approximately $28Trillion, loss of approximately $9Trillion of housing wealth, 10% lower per dollar of consumption). The results of the economists cited above would appear to say yes, with several caveats:
--> The data only shows past data in which house prices went up unabated for 60 or more years, therefore the models may break down in periods of lower year on year house prices.
--> Further the exact mechanism of house prices on consumption and the economy is not stated in detail: housing is treated as a normal asset without unusual attributes, even as housing comprises approximately two-thirds of the median American's net worth.
--> Lastly, the additional consumption due to housing is treated as the excess of consumption year to year over net disposable income in several models, even as increased spending from housing would result in higher income so would be difficult to separate out: as people spend more due to higher housing prices, this higher spending becomes other businesses' net income, leading to higher disposable income through a multiplier effect, making the cause and effect of higher disposable income due to higher consumer spending from higher house prices difficult to determine.

Home Ownership as a For-Profit Business:

A way to model house price declines on the economy and stock market is proposed here: home ownership in the economy allows individuals to become, in effect, "business owners to themselves." This is to say, appreciating house prices allow home-owning individuals to become successful profit owners (or "capitalists" in a traditional economic sense). Instead of rent paid to another property owner, rent and debt repayment are effectively repaid for a homeowner to himself or herself, with the home price appreciation as a "profit." An unusual situation indeed, but consider: an appreciating home allows individuals to realize gains on their home owning "business" over time, while a declining home market reverses this situation, and in effect produces a loss-making enterprise on home owning individuals.

For further background on this idea, consider that Net National Income -- which according to GDP accounting must approximately equal Gross Domestic Product -- without government and net exports consists of salaries and wages plus corporate profits. For money spend on goods or services, the company or individual selling the service or product must pay for materials, energy, transport, etc - which goes as costs to other companies if the costs are materials -- or to workers if the costs are salaries. This series of payments goes on until all income from sales can ultimately be divided into either wages and salaries or profits. Note that corporate profits have traditionally stayed around one-third of net national income.

Housing ownership moves most home owning wages and salaried individuals from being fully in the category of a) deriving income from mainly salaries and wages to ---> b) deriving income from in part from salaries and wages and in part from "corporate" (sole-proprietorship home ownership) profits.

Appreciating house prices mean that home-owning individuals have a substantial, profitable business supplementing their salaried income, while declining house prices means that individuals have a loss-making enterprise, subtracting from their income.

From 1992 to 2006, aggregate housing wealth in constant 2005 dollars increased from approximately $12.5 Trillion to $28.5 Trillion, accordi data from the federal reserve. The average yearly increase was therefore approximately $1.14 Trillion per year. The question is, how much of this increase contributed to consumption?

Table 1: Household Wealth, Consumption and Housing Price Appreciation in the United States from 1950 to 2008:

According to Haurin and Rosenthal of Ohio State University (2006), a survey of 4,000 home owners found that households took on an additional 15 cents of debt per dollar of home price appreciation to finance consumer expenditures. Assuming here a range of 10 to 25 cents per dollar of home price appreciation/depreciation leading to initial increases/declines in consumer spending, creased spending from housing contributed through a ripple-through effect (a spending multiplier of .10 based on a marginal propensity to consume of .90 - a savings rate of 10%) 11% to 29% of GDP.

If the spending multiplier says consistent through a housing downturn, a similar decline in GDP should have been experienced. The reasons why such a downturn did not occur is likely due to the unprecedented actions of the US Government through stimulus spending and actions on the part of the Federal Reserve to support asset markets.

Note that the loss' or gain's impact from home price appreciation/decline on GDP can be treated with the spending multiplier, if the income or income decline ripples through the economy. Other economists do not touch upon the multiplier, but as consumer spending from house price gains ends up as sales of products and services, which ends up as income for other business to be spent, and so on and so forth, likely there will be a ripple through effect from additional consumer spending.

So one could say, yes housing does impact the economy through consumer spending (as economists have traditionally modeled), but now we can make an estimate utilizing a profit/loss estimate from published data and a multiplier estimate (not solely relying on regressions of past data which could have flaws due to the fact that housing has appreciated for the past 70 years before 2007).

Secondary Effects of Home Price Declines:

Further, secondary effects of declining home prices means that non-real estate related businesses are impacted due to lower effective real income. In any community, a percentage of GDP is represented by local stores, grocery, automotive, convenience, clothing, food retail etc which depends on the consumer spending of the individuals living in that community. One could say that declining house prices can one of the following: produce either 1) a situation of a multiple equilibrium (where economic activity can stabilize at a significantly lower level that less income is available for purchase of goods and services). Oil markets, for example, are considered to have multiple equilibrium by several economists -- at $20 in the 1990's or near $100 per barrel currently -- due to he relative power of the oil producers with spare capacity (OPEC).

2) Declining home prices could produce a "vicious spiral" in which lower home prices continuously reinforce lower income (lower home prices --> lower consumer spending --> lower sales for community business --> lower income for workers in the community --> lower amount of money available for home mortgage payments --> lower home prices ---> etc) At one one economist (Mark Zandi) as expressed concern that declining home prices may be a downward spiral for economies.


If one models home ownership as a business with a certain level of profits or losses "marked to market" per year in an accounting sense, then with any level of spending multiplier it becomes clear that housing is a significant contributor to the US economy. It is estimated in this post that the contribution to GDP from housing is between 11% and 28% per annum of total GDP. This intuitively makes sense, in so far that housing represents approximately two thirds of the median household's net worth, and represents over $23 Trillion in aggregate value, in an economy with a GDP of approximately $14.5Trillion.

The impact of the decline of house prices - 30% from their peak over a 5 year period (with continued declines in the near future at least) -- could modeled as an approximate $1.8 Trillion loss of housing wealth per year in aggregate, which could be realized by home owners at between 10%-25% per year, with a multiplier of 10 would have resulted in a reduction of GDP of between 12% and 31%. So far, this reduction in GDP has not occurred, due to the unprecedented actions of the Federal Government and the Federal Reserve. However, if housing prices do not begin to recover before the end of current stimulus programs, it is possible GDP could once again decline due to the reduction of consumer spending and total income due to lower housing wealth.


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Aditi Jain said...

You know this is a very good post i hadent thought about this for quite a while and you have like sparked me to look into it further and re educate my self in the subject....thanks,hope to see more of your posts soon

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