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What house problem?

Created:
14 April 2008
Written by:
Chris Dillow

One disadvantage economists have traditionally had over many natural scientists is that it's usually harder for us to run controlled experiments. In this context, this year's fall in house prices is a welcome development.

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We know there's a huge correlation (0.72, R-squared = 52.2 per cent since 1970) between annual changes in house prices and consumer spending. But correlation is not causality. Much of this relationship exists not because house prices affect spending, but because the same things - such as incomes, unemployment and interest rates - affect both.

But the problem is that one of these things can't be observed directly. Both house prices and spending should be strongly influenced by households' long-term income expectations. But we can't measure these accurately. And if we don't fully control for them, we'll over-estimate the impact of housing upon consumer spending - that's the omitted variables bias.

Which is why the current fall in house prices is so welcome. It seems not the result of lower income expectations - the strength of consumer borrowing and retail sales tell us this - but of a restriction in the supply of credit. We should, therefore, see a purer house price effect upon spending than we've had before.

And I suspect this effect could be small, because housing is not net wealth for the economy as a whole. Yes, lower prices are a problem for someone planning on trading down. But these are offset by prospective first time buyers and people hoping to trade up, for whom lower prices are a good thing.

Nor even is it obvious that a fall in housing turnover would be disastrous for spending. Sure, some people can only tolerate the hassle of buying new carpets and furniture when they move house. So demand falls on this account. But others might figure: "If we've got to stay in this place, we might as well make it nice. And the money we save on estate agents and lawyers will get us a new car." Net, there's little impact on spending.

So, this might sound terribly unEnglish, but I suspect we exaggerate the importance of the housing market.

Certainly, we do for share prices. Since 1970, the raw correlation between annual changes in house prices and in the All-share has been 0.01. Which means the odds are good (roughly 50-50) that shares won't be hurt by a fall in house prices. Equity investors should find something else to worry about.

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