Real Estate Chronicle

When house values increase - especially as dramatically as in recent years - people feel freer to spend from the wealth they have, or the wealth they perceive they have. They may decide to buy a bigger car, to eat out more often, to indulge in electronics or fashionable items, all of which is in most cases financed by their equity. And, strangely enough, people spend their hypothetical riches faster when their houses go up in value than when their stocks do, because they believe that housing gains are more stable.

In response to this greater affluence, the general trend of people is to increase their spending. Conversely, when housing values diminish people cut back spending in a similar way. The general consensus is that a $100 drop in wealth, over time, reduces spending by about $5.00 per year. This suggests, therefore, that weakening housing prices have a mild effect on consumer spending, to the tune of an approximate annualized rate of spending reduction of five percent.

This makes sense, in that economic theory tends to support the fact that rational consumers ought to adjust their long-term spending in response to changes in their wealth, not the ease in which they can tap it. But there is another element equally important to be factored into the determination of the level of prosperity: how well debtors manage their debt. For instance, the Mortgage Bankers Association (MBA) reports that seasonally adjusted index of mortgage application activity, which includes both refinance and purchase loans, increased 3.6 percent to 575.6 for the week ended December 29, 2006. The index stood at 555.8 the previous week, which was its lowest level since early August. Demand for home refinancing loans also strengthened as the MBA's seasonally adjusted index of refinancing applications increased 2.2 percent to 1,640.4. In 2005 the index stood at 1,363.2.

This evidence would suggest that consumers are using more of their home equity to pay off other borrowings such as credit card debts, in light also of the fact that mortgage debt in both the United States and Canada carries considerable tax advantages. This is another indication that, contrary to the forecast of some analysts, consumers manage their debts prudently, not recklessly.

The equilibrium in the issue as to whether consumers ought to treat their housing wealth as a nest egg or as a credit card - that is whether they should save rather than spend - is to be found in the ratio of spending to personal income. Surveys have shown that this ratio has peaked at more than fifty percent in 2005, meaning that people spent more than fifty percent of their disposable income using mortgage-equity withdrawal. This in turn would indicate that a slowing of mortgage-equity withdrawal could drag down spending faster than anticipated. The stakes here are high, because the behaviour of consumers will largely determine whether North-American economies will tumble into a recession or will merely slow down. This is so because in North America housing wealth has a bigger influence on consumption than other financial assets such as stocks and bonds.

Which in turn means, once again, that the level of prosperity is affected by the degree of spending proximately derived from the real capital wealth of consumers.