The increased value of housing and stock prices on paper makes consumers feel more confident in the economy’s prospects. Feeling more confident, they spend more and become more willing to buy goods and services by taking out more credit increasing their risk appetite. We have covered these concepts in a previous post.
Our financial system supports asset values by increasing credit creation over time. Each time a bank creates a loan, a corresponding deposit is created through the banking system, which adds to the money supply. Money is used to purchase goods and services and accumulate and save for a property. As the money supply grows, cash is devalued against assets (financial assets, real estate, commodities, art, etc.), causing nominal prices to rise. As a result, households feel like they have more wealth and believe as they are richer they may be able to spend more on luxuries such as new computers, the latest technology gadgets, vacations, additional cars, and homes increasing private demand through consumption and investment.
As home values rise, homeowners find it easier to borrow using their home value as security for either home renovations or consumption spending. If this ‘wealth effect’ is strong, it could leave the economy more vulnerable to adverse events, such as a large decline in house prices. We saw in the run-up to the 2007-2008 recession home equity extraction was potentially being used by households to finance spending in the U.S. The combination of the pullback in house prices and job loss reduced consumption significantly in 2007-2008. We saw in 2020-2021 a similar trend of housing/consumption moving together – well above trend. Historically, large price increases well above trend have resulted, in large declines, including a reduction in household spending. Hence too much reliance on residential real estate and the wealth effect/consumption could have issues for some countries’ financial sustainability going forward.
As a request from a subscriber, we have reviewed the Canadian housing/mortgage market below which complements our previous post.
