How Economists Have Underestimated the Effect of Home Prices on Consumer Spending

When US consumers curtailed their spending during the 2008 recession, many people suggested plummeting housing prices contributed to the cutbacks. Now four economists have devised a theoretical rationale that supports the idea that this “housing wealth effect” is real.

The economists—Northwestern’s David Berger and Guido Lorenzoni and Chicago Booth’s Veronica Guerrieri and Joseph S. Vavra—were motivated by mounting evidence that suggests housing prices were a factor in the spending slowdown. “While a large and growing empirical literature documents strong responses of consumption to identified house price movements, a large theoretical literature argues that this response should be small,” they write.

Seeking a better theoretical understanding of what might drive the large response observed in the data, the researchers extended existing economic models to assess the role of liquidity constraints, housing’s role as collateral, and rental and mortgage markets. They argue that borrowing constraints play a crucial role in the large consumption responses.

In addition, they find that the size of the housing price effect can vary widely, and the amount of change in consumer spending can depend to a large extent on the economic conditions and household debt level at the beginning of a housing cycle. In looking at the dynamics of housing booms and busts, they find that “the increase in housing demand during the boom leads to increased leverage, and this contributes substantially to the consumption contraction caused in the bust.”

One takeaway: policy makers hoping to spur spending may want to consider how housing prices and debt levels could affect the success or failure of their proposed interventions.