Housing Wealth and Consumption –Revisiting Pigou

Dennis Wesselbaum, Senior Lecturer, University of Otago
Insights Newsletter
14 May, 2021

New Zealand’s housing shortage causes a lot of misery. An inflexible housing system makes it very hard for supply to respond to changes in demand. This affects the availability of housing, house prices, and rents.

At the same time, this also makes other policies more complicated, because of what economists call the Pigou Effect.

The Pigou effect is a wealth effect and postulates that the amount of real money people hold affects their consumption behaviour. Housing is a huge part of household wealth for those Kiwis who own homes.

What we should, therefore, consider is a Housing Pigou Effect: when house prices go up, people who own houses feel richer and, hence, change consumption.

While this “feeling” richer can be an illusion, because the housing wealth is illiquid and the capital gain can only be realised when the house is sold and one finds a cheaper (e.g. because of size, location, or quality) house to live in, it can still affect consumption and saving behaviour.

Reserve Bank research in 2008 showed that an increase in housing wealth increases consumption and that Kiwis treat changes in house prices as permanent, rather than temporary. Net financial wealth (gross financial wealth minus total household debt) can even decrease when house prices increase, because households borrow more against their house.

This has implications for monetary and financial stability policy.

Because housing supply has been very inflexible, changes in demand quickly affect house prices. Rising house prices then – via the Pigou effect – affect aggregate demand and the prices the Reserve Bank targets.

Borrowing against higher house prices can also drive up a household’s leverage, potentially increasing default risk. This could expose banks in the case of a sharp drop in house prices. This is important for macroprudential policies, such as loan-to-value ratios or countercyclical capital buffers.

It also has worrying implications for housing policy. If reforms that address underlying supply issues meant that house prices would fall, there would be flow-on implications for aggregate demand and inflation, because of the Pigou effect. This might create some resistance against fixing housing market problems.

Overall, economic policy making needs to consider these non-traditional factors. Policies such as KiwiBuild, the housing package introduced earlier this year, or recent changes to monetary policy making, should have been informed by research insights, such as the relevance of the Housing Pigou effect.

Understanding these driving forces of consumption and saving and how these change over the life-cycle is an important, policy relevant, and open research question.

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