All things being equal, lower interest rates spur both housing development and the price level of the existing housing stock.
Clearly new housing development adds directly to economic activity. But there’s also the economic theory that higher prices for existing houses (share prices and other assets) creates a ‘wealth effect’ – windfall recipients feel richer and spend some of that largesse, boosting the economy in the process. Call me sceptical.
My wife and I own no property, but we’d like to one day. As we’re natural born savers, it’s hard to say how much our savings rate is influenced by Sydney house prices. But with each uptick in property prices, I do get a bit more antsy about frivolous outgoings.
My older brother has been a supposed beneficiary of the housing boom and its wealth effect, he bought his apartment 15 years ago and it is worth multiples of his purchase price now. But a two-bedroom pad is becoming a squeeze with two kids, so he is an aspirational upgrader. Each uptick in house prices makes that harder, and means savings are prioritised over spending.
Like me, my two younger brothers are effectively short housing (renters). Unlike me, they’re not natural born savers. But they’d like to own one day, and have been saving hard to make it happen over recent years. Of course, that is as it ever was – joining the property ladder always required sacrifice. But the higher local house prices, the more they need to save.
There’s a reverse wealth effect going among our cohort. Rising house prices mean we need to save more, and that’s money not being recirculated into the economy.
Of course, there are also housing boom beneficiaries among my family and friends – including some friends that formed families and took on mortgages at a younger age, but particularly baby boomers like my parents, aunties and uncles.
The older generation in my family generally own suburban bungalows that are worth nearly a million bucks today, rather than say the $500,000-600,000 they might be worth if valuation metrics like house price to median family income were back at mid-1990s levels.
And the amount of incremental spending they’re making because of all this extra unrealised capital gain? Close enough to zero that we can round down.
If the market gapped up tomorrow and such houses sold for $2 million instead, it wouldn’t change my parents’ habits or plans one iota. They would continue doing their best to live off their superannuation and other liquid assets. But it would almost certainly cause my brothers and me to increase monthly savings.
Of course, this is purely anecdotal evidence and leaves me open to accusations of logical fallacy. It is not proof of anything. It could also be that the increased property development that occurs because of higher general house prices outweighs any such concerns.
But the wealth effect as economic gospel looks suspect to me, especially as it relates to an essential need like housing. The reduced spending of those of us who own no houses but aspire to, or own smaller houses than we want, dampens and perhaps even cancels out any positive from those that do own property.
Funnily enough, ABS data released today shows disappointing Australian retail sales for April, with year on year growth of 3.6% (and trending down fast). That compares with annual house price growth of around 10%. The whole wealth effect concept is perhaps due a rethink.
Good article and I’ve never thought of it from the perspective of aspiring house buyers.
I’ve always said that low interest rates encourage savers to spend even less because they aren’t earning as much on their term deposits and therefore have to save more. e.g. people like my mum who has been frugal all her life, gets the pension and has a modest term deposit that used to provide her a with little extra. Now she’s saving some of her pension !
I guess there is also a possibility that existing borrowers are taking advantage of the low rates to pay down their loans faster ? How many people reduce their repayments when interest rates drop ? Methinks few.
Gareth, as usual you are 115% right.
Also, as you point out but don’t explicitly state, – low interest rates don’t make the older generation feel all that much like spending as they have to save more to fund their own retirement.
In general wages are stagnant, whilst government services are increasing in cost and taxation levels are rising, (bracket creep, ciggies, beer, super, etc).
People are cautious and can’t or won’t spend as they save for this (house) or that (retirement).
It’s a hot and difficult topic and we sat down and had these type of discussions with our son who has just finished uni, moved into a share house and into a full-time job:
1 How to save money in a low inflation, low interest environment.
2 When to buy property.
To save; advice was to buy quality shares or LIC which offer a higher interest rate and a chance of capital appreciation compared to bank deposits.
Buy a unit/house; when you have a 25% deposit and have enough leftover money so that you don’t have to live on cornflakes only.
This is a 5 to 10 year get-ready plan.
This plan gives an active engaged stance and preparedness but realizes that the current property market looks over-priced and if interest rates change, or negative gearing changes, or foreign investors are locked out or punitively taxed, or something unpredicted disrupts the market, etc…….., well things could get interesting.
Hopefully you and your family and my son can buy at more reasonable price levels in the next 5 years.
I work in finance broking. Higher home values means our industry can lend out more (and we do)- that extra money goes somewhere
Apparently into ever increasing investment property ownership!
Since the 50% CGT discount was introduced, property investors went from net positive yield to net negative and investors share of new loans increased significantly.
What brokers seem to ignore is that debt eventually needs to be paid off and that is why the business/GDP cycle is so inextricably linked to the credit cycle.
I actually think that the recent inflation in asset valuations whether from QE or low interest rates seems to have had the effect of promoting further investment in these assets rather than spending in the real economy but only time can prove this right or wrong.
Yes, this seems to be the only kind of wealth effect I see going on. Borrow to buy property, get it revalued, use any additional equity based on the valuation to gear up again and buy more. Rinse and repeat.
Hi Gareth,
For once, I wholeheartedly and emphatically disagree with you. It’s true that you have identified some instances where the wealth effect is neutral or even marginally negative, but everyone in the examples you’ve listed are either 1. net buyers of property, 2. aspirational net buyers of property or 3. non-participants in property (I would classify renters with no intention of buying as non-participants in the property market rather than shorters).
However, for every dollar of property purchased there is a dollar sold, and it is these net sellers who are the engine room of the wealth effect. Net sellers include:
1. Old landlords like my parents who are cashing out of property.
2. People like myself who used to owner-occupy property but sold out on valuation grounds.
3. Local governments, who effectively manufacture new residential land, by rezoning.
Much to my chagrin, I know that my parents have been spending much of their property (and share) gains on at least three or four holidays per annum, god knows how many restaurant meals, plus all sorts of frivolous renovations and landscaping on the property where they live, and ‘hobby’ businesses that have abysmal returns on capital. I have no doubt that if the property boom hadn’t happened they would be more circumspect.
If I wasn’t a miser, I’d probably be doing something similar.
Local governments in this country are hardly cash-strapped (yet) either.
Add to all of this the multiplier effect of all the extra wealth that tradesmen, hardware and furniture retailers and all of the other indirect beneficiaries of this have collectively earned and largely spent, and it should be clear that at a conceptual level there ought to be a wealth effect.
Statistically this has been supported by historical data in other jurisdictions that have experienced large asset bubbles/booms.
That this hasn’t been clearly borne out in the Australian statistics for the current boom, is, in my opinion a result of other demographic factors. Harry Dent has written a number of interesting books about the effects of demography on asset prices, and The SocGen analyst Albert Edwards has plenty of similar things to say in his research notes, if you can get them.
Thanks SG, with all your fine comments to this blog over the years I know to pay attention, especially if you disagree. I understand there are positives for some – your parents being a clear example—but I just wonder how much my brothers, me and our ilk offset the gain. I don’t think the offset is insignificant. I’m not spending money on my garden, because I don’t have one. And I’m saving more than otherwise because that garden is going to cost a lot more than I thought 5-10 years ago.
Off on a slight tangent, stewing on your comment in recent days I’ve been wondering about whether the wealth effect is simply a non-linear thing. As assets move from, say, underpriced to fairly priced, it creates positives for the asset owner without too much negative/change of behaviour for the aspirational owner. As assets move from, say, rather overpriced to horribly overpriced, the positives continue but the negatives start to deduct more fully from the total? The law of diminishing returns so to speak. It’s just a thesis, I’ll leave it to some uni grad to test it.
Thanks Gareth, I’m very flattered.
Re the tangent: An even more tangential thought: My thinking is that from a purely economic standpoint, discrepancies between price and value are a form of economic inefficiency whether they are the bargains that value investors love, or the bubbles that we hate, the fact of the matter is that either way, resources are being inefficiently allocated. Wealth distribution becomes lumpy, and this change in wealth distribution changes consumption patterns.
The greatest case of over-valuation I can think of is the Japan bubble of the late 80s, whilst the most insane under-valuation I can think of is Russia in 1998. In the former case, the effects of the asset mispricing have been muddied by twenty years of continuous central bank/government intervention, but nevertheless, Japan was the world’s biggest luxury goods market for many many years and even today it is still the world’s second biggest luxury goods market.
However, in the case of Russia 1998, the effects are crystal clear – the 1998 crisis created a crop of billionaires and millionaires that in just a few years transformed Russia from one of the least unequal (in GINI terms) to one of the most unequal countries on earth. The wealth effect in that instance certainly happened, the only problem was that it happened in London, New York and Corcheval (i.e., places you can splash money around without getting shot) rather than in Russia itself. The effect is also certainly non-linear – as anyone who has seen New Russians in show-off mode can attest.
Opposite extremes produced surprisingly similar outcomes.
A laymen would be forgiven for assuming that the world’s central bankers have their long-term economic interests at the forefront of their minds, but the perverse reality seems to be that they are as short sighted as many others in the market. Even if there was irrefutable proof of a wealth effect, how is it a good idea to drag that future consumption forward to today in the hope that the the inevitable come down won’t happen this time? And what do they plan when conditions normalise? I’m not sure the S&P 500 will continue to hover around it’s highest valuations in history just to suit the Fed and won’t a crash create a “poverty effect”?
Thanks for the article Gareth