Robert Shiller answers critics of housing "wealth effect"

Posted by: Peter Coy on July 06

Guest blog from Economics Editor Peter Coy

Breaking a tidbit of economic news here: I just got off the phone with Yale’s Robert Shiller, who has some interesting responses to the posting this morning on by Charles Calomiris and others that questions the existence of a “wealth effect” from changes in home prices.

The wealth effect theory, which says that rising home prices stimulated Americans to spend more during the boom years, has been cited frequently by Federal Reserve Chairman Ben Bernanke, and it’s built into the Fed’s main macroeconomic forecasting model. The theory seemed to be corroborated in a 2005 paper by Karl Case of Wellesley and Shiller—the namesakes of the Case-Shiller home price indices, among other badges of honor—and John Quigley of Berkeley.

Today, on, there’s an important posting that denies the existence of the effect. It’s called “The (mythical?) housing wealth effect” and it’s by Charles Calomiris of Columbia and Stanley Longhofer and William Miles of Wichita State. It summarizes a June National Bureau of Economic Research working paper by the authors with the same title.

Calomiris et al. argue their case on both theoretical and factual grounds. In theory, they say, the only people who should be expected to experience a positive wealth effect from rising prices are those who expect to sell their houses soon to cash in. Renters who had hoped to buy should actually experience a negative wealth effect, as they realize they’ll need more money than ever to buy. And people in the middle—most of us—should be neutral. Furthermore, they say, it’s possible that even if consumption does rise when home prices go up, it doesn’t have to be a cause-and-effect relationship. It could be, for example, that both consumption and housing are rising in response to an increase in expectations for future incomes.

Digging into the data, Calomiris et al. reanalyze the Case-Quigley-Shiller data and conclude that there is in most cases no statistically significant effect on consumption from housing wealth once you control for other possible contributions to consumption changes. (The working paper explains how they did this using instrumental variables—read it for yourself if you’re interested.)

I was able to reach Shiller at his office at the height of summer vacation season and he had several top-of-the-head responses, which I will now relay pretty much unfiltered:

“I’m the most behavioral of the three authors on our paper, so this is me speaking: The effects of housing wealth operate through animal spirits rather than cold calculation. … It seems to me that part of the effect is through people’s general sense of the world.”

“This is the dismal law of economics, that it’s always difficult to disentangle the ultimate causes.”

“The whole view of the world is changing all the time. … I’m sorry to be pushing my book [“Animal Spirits”] but [Berkeley’s George] Akerlof and I say that the economy is driven by stories, and one of the prominent stories [during the boom] is the triumph of capitalism.”

In other words, it’s hard to disentangle the income-expectation effect from the housing-wealth effect.

The problem with running regressions, Shiller said, is that it “inherently takes the world as unchanging for long periods of time. … I can’t resist talking about what’s happening now.”

Shiller’s response is obviously a bit loosey-goosey, but he said he didn’t mind being quoted. I think he and Case and Quigley are likely to have a more formal response in the weeks or months ahead.

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Reader Comments

tim straus

July 6, 2009 02:38 PM

I have read neither the summary nor the full paper, yet. But I will say that, at first blush, the conclusions are irrelevant, if not totally absurd and a prime example of why the economics "profession" has come under a darker cloud than normal. Regardless of the "wealth effect" of rising or falling house "values" the fact remains that rising values and expectations of the continuations of trend ( a fault of what the behaviorist school would call excessive "positive reinforcement") the average home owner used his house appreciation as a piggybank to borrow and spend freely against--the direct correlation between MEW, consumer debt, consumption and US corporate profits during the housing boom--call it a massive unfundable debt hangover if you will, instead of a negative housing affect, but it is all pure semantics and exercises in mathematical regressions and other black board intellectual gymnastics is such a waste of bright minds--a problem in this country.

Brandon W

July 6, 2009 04:44 PM

I think Calomiris et al. have missed something entirely. Home prices exploding allowed people to borrow money against that illusory wealth which they then spent in the economy. Their argument, on the surface at least, only makes sense if people were unable to take out equity loans (and property taxes weren't based on that imagined wealth, as well).

I think Shiller is making an excellent point both here and potentially in his book. What economics massively underestimates (and fails to account for) is the role of human psychology in the economy and the markets. I love classic economics, but it's a field gone awry. Economics is a social science (a branch of sociology, in my opinion) that decided to make itself seem more relevant and prescriptivist by inventing woefully inadequate mathematical models that are about a trillion variables short of being worth much of anything.


July 6, 2009 05:14 PM

I have yet to read the source article, but it sounds like it dismisses the effect of people who did cash-out refis.

I think most people and banks who did cash-out refis believed, or at least hoped, the home underlying the loan would keep increasing in value, erasing the debt. That's a foolish notion to me, but I know plenty of people who did dumb things because banks would let them.

The wealth effect isn't only on Main Street. Banks were huge enablers so they could book big fees for loans they flipped.

It's the same mentality: I get something for free now, and skate later because the investment will make up for it.

Now I hear people (GAO?) saying the nation lost $1.3 trillion of wealth in the crash. That is proof enough of the "wealth effect" for me. That money never existed except on bank balance sheets. Until the bailouts started, of course, then the government printed it.


July 6, 2009 07:00 PM

A more interesting question is to what extent the rise in overall debt levels has contributed to the rise in house prices.

Our housing market in Australian has yet to collapse. As a result I live in a house (purchased in 1998) that I could not afford to buy now.

Unless this changes I can see my kids living at home for a very long time.

Whatever the negative wealth effect of falling house prices I am keen for it to happen!


July 6, 2009 08:25 PM

What should be and is are far different things. Much more convincing is detailed data analysis by Mian and Sufi,
that show, it was not a small effect at all but amounted to 25-30%. Shiller is right on target about the difference between now and forever.


July 7, 2009 07:29 AM

quote: "Renters who had hoped to buy should actually experience a negative wealth effect, as they realize they’ll need more money than ever to buy."

That was not at all the narrative. Sub-prime and interest only loans were marketed to those renters on the epectation that appreciation would solve all.


July 7, 2009 07:37 AM

There was definitely a wealth effect for me. I did not cash out excessive amounts of money from my house. However, I bought it as a fixer upper and was unable to generate enough cash flow to pay the ridiculous prices contractors were charging at the time without borrowing some against my house just to make it presentable.

At one point, I had $150,000 of home equity. Being in my early thirties, I figured that meant I didn't have to worry too much about saving for retirement because eventally I would just sell and downsize to something smaller and live off the remaining profits.

Well, that theory has now been blown out of the water and I have stopped virtually all discretionary spending. Furthermore, I am looking to downgrade to a cheaper house so that I can set more money aside for retirement. Now I know that a house is not a retirement fund.

Of course, none of this means that I went around charging up credit cards, but it does mean that I was willing to spend more and put less in savings. Everything has changed now for the American family.


July 7, 2009 08:22 AM

During the boom years I heard countless ads about using a home equity loan to put your idle home equity wealth to work. And I heard many people talk about taking out a home equity loan to do this or that spending. There is no doubt in my mind that many people felt free to spend more money because their house was rapidly increasing in value. As mentioned by another commenter, the idea was to take out a home equity loan to buy something, make loan payments for a few years, and then sell the house and have the appreciation pay the balance of the loan. Sure not everyone did it, but the people who did do it spent more than they would otherwise.


July 7, 2009 10:19 AM

I read the summary post, and although Calomiris et al do address refis, I believe the analysis haa a fatal flaw.

They compare "housing wealth" to equities. The problem is, most people are not economists.

Most people at least think they understand a home loan, but far fewer would know how to acquire a stock portfolio, much less how to borrow against it. I'm willing to bet that fewer than 1 in 50 subprime borrowers could explain what shorting stocks means. Most people only own stocks through a 401k, and borrowing from that would lead to explicit penalties.

Part of this equation is that human aspect of comfort. People have seen more than one bubble in the stock market over the last two decades, but nobody ever saw a housing bubble before and thought it was safe to do those refis.

A bubble is a bubble and that makes no sense, but people were comfortable gambling with their homes.

One family in my neighborhood bought a house they could not afford at $150k, got a refi a few months later for $188k, then took their 5 kids on a vacation to Hawaii and bought lots of fancy furniture. Within 2.5 years they were in foreclosure. They had done things to the house that reduced the value, and were trying to sell it for nearly $250K hoping to get out with cash. Now the bank has it priced at $165k and that is still too much because the family did stupid things (like removing the heating system) to the house.

Another part of the problem was virtually unregulated free agent mortgage brokers. Before I moved here I waa in SoCal and I had brokers telling me all the lies they used to sell loans (I still would not buy more than I could afford, which is why I'm here instead of there).

The standard lies were:

1) It's only hard for the first year, then you get all your interest back on your taxes (truth: you only get back as much as your tax liability, but if you paid more interest than that it's gone).

2) You can pay the lower rate on an ARM for a year then refi into a fixed-rate loan.

3) The house will continue to increase in value and will take care of everything you're doing now, including buying the house on a loan of 125% of the house value.

4) Interest rates are so low you can buy a lot more house for the same money now. An ARM is a good deal because rates are low so you won't reset much higher than the teaser rate.

5) Piggyback loans will save you. One for the down payment and another for the balance. You can own a home with nothing down!

Just imagine anyone buying stocks based on those arguments.

I watched people fall for this left and right, and saw bidding wars breaking out all over SoCal. I put the first bid on a condo I could afford, and 18 hours later it had bid up by $36,000. Anyone with an ounce of sense could tell you that nothing made a condo worth $36,000 more on Tuesday than it was on Monday.

Meanwhile the purchase price increases were driving up rents in the region. That made the tradeoff look more attractive. When you are paying $2k a month in rent for a crappy apartment, that house payment for a McMansion looks pretty good.

What the borrowers never understood is that by financing the down payment (vs. traditional 20% cash down) they were driving up their own price, too. By the time they signed there was PMI, HO insurance, in some cases condo fees. The fees stacked up but they signed anyway.


July 7, 2009 01:41 PM

Yes, the problem with the paper as posted is this paragraph, which ends in gobbledy gook:

"Up to this point, we have neglected the question of whether housing wealth change affects consumption through another, indirect channel – a financing channel – by affecting consumers’ access to credit. For example, if houses serve as better collateral than other assets, then it is possible that “constrained consumers” (those who wish to borrow today and repay loans from anticipated increases in income in the future) may face better lending terms as the result of an increase in the value of their homes, which in turn may increase their non-housing consumption. Some observers point to the latest housing boom and the increased use of home equity lines of credit and other mortgages during the boom as evidence that housing prices spurred consumption through this financing channel. While this indirect financing channel is a theoretical possibility, it is an empirical question whether it is significant in its effect, and even if the indirect financial effect is present it should not produce a “first-order” effect of housing wealth on consumption – housing wealth should still matter much less for consumption than other forms of wealth."

As an empirical question, this is remarkably easy to answer - did equity loans go up? Did they go up when incomes were stagnant or going down, as for instance at the trough of the tech bust? Did they keep going up afterwards? You can shuffle and jive about first order effects all you want - the key question is there, and they evaded it. Because, of course, it would have blown their theory out of the water.


July 7, 2009 02:56 PM

All of this presupposes homebuyers are informed rational agents. For about 30% of them, the only question is what are the payments and am I approved. Prudence, future calculation, long range planning is not within their capacity or inclination.


July 17, 2009 10:11 AM

Rycoka and odograph make great points -

1) consumer credit artificially boosted demand for housing

2) there was "greater fool" speculation that fed on itself and back into 1)

These are classic patterns that have been seen time and time again -- "The Ascent of Money" by N. Ferguson is a good read about financial history that I would recommend (esp to central bankers!).

Thank you for your interest. This blog is no longer active.



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