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Analysis of the Housing Market in the UK

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For most people in the UK, as in other countries, the purchase of a house is the single largest expenditure they ever make. In contrast with other purchases, a house is not only something that provides highly desirable services – convenient and independent housing – but it is also the single largest element of household wealth. For homeowners, this asset motive for buying a house is becoming increasingly important. As a store of value, houses are increasingly becoming both a critical component in households’ long term financial planning as well as a basis for raising consumption. Just like possessing a portfolio of valuable stocks and bonds, owning a house whose market price amounts to greater wealth. It follows, then, that a change in the market value of a house will change the owner’s wealth, and, consequently, the owner’s consumption expenditure.

While the housing market in the U.K. has experienced several dramatic phases in the past three decades[1], its behavior in the last decade or so is not only without precedence but it is also a reflection of a fundamental transformation in the economy’s financial system. Whether being labeled as the product of ‘irrational exuberance’[2] or being described as a ‘bubble’, housing market developments have spawned a wide body of thinking that is increasingly taking on a nervous tone – especially among economists.

A quick survey of the macroeconomic literature related to the housing market reveals that the period from the late 1990’s to around 2004 saw a confluence of several phenomena that seem to be related via a series of strong theoretical linkages. Key among these are historically high levels of home-ownership and housing wealth, an extreme housing-price boom, a generously liberal credit regime, unanticipated levels of borrowing, the lowest interest rates in generations, massive consumption expenditures/dangerously low savings rates, general economic prosperity, and, a rising trend in bankruptcies and house possessions.

The objective of this project is to highlight the linkage between housing wealth and consumption expenditures with special focus on the events of the last decade. Given the nature of macroeconomic linkages, it turns out that in order to study this relationship in the context of UK, it is necessary to tell an economic tale that incorporates all of the phenomena mentioned above. While there are rather straightforward theoretical reasons as to how and why the national housing wealth affects aggregate consumption, the historical and institutional realities of the financial industry, the changing consumer behavior with respect to credit, the evolving demography etc. have played an important role in shaping this relationship in the UK.

Over two-thirds of UK households owned their home and it is typcially their biggest investment they make. At the aggregate level, housing wealth is now greater than the size of their financial holdings[3]) and it is distributed in a considerably more equitable manner across socioeconomic and demographic segments as compared to the latter. Such investments bring reasonable returns over the long term, and in the last five years house price appreciation has more than doubled the value of the stock. It follows, then, that changes in housing wealth have the potential, in theory, to have sizeable effects on consumption, GDP, unemployment etc. The theoretical mechanism by which changes in housing wealth are transmitted into consumer demand, called the ‘wealth effect’ (discussed in detail later in the paper), is of critical importance to the economy because its impulses also affect an array of other macroeconomic variables and processes.

Clearly, the ability to draw on this major store of purchasing power has serious implications for the financial health and prosperity of homeowners and, hence, the economy. With respect to access to the ‘frozen’ housing equity, the UK experience has been uniquely successful as compared to those of almost all other OECD countries. A series of policy moves to deregulate and ‘liberalize’ lending practices resulted in democratizing the credit market such that loan products once provided to the privileged, became common-place. Households that had faced credit barriers could now affordably borrow large amounts thus unleashing the power of the wealth effect. Therefore, the ways in which UK households obtain and dispose off the equity is of particular interest to this study.[4]

This paper is organized as follows: the next section lays out the key issues involved in this study; the third section discusses the theoretical and analytical matters concerning the wealth effect in the context of the recent UK housing boom; the fourth section surveys the empirical research in this area; the fifth section presents the empirical work done for the study, including a description of the findings from regression analysis using Microfit; and the last section offers some conclusions from the work. (There are graphs and figures associated with the text and they are appended at the end.)

A Review of the Peculiar Issues and Macroeconomics of the UK Housing Market

Nature of the boom

With focus on the 1995-2004 period, this section lays out the key issues involved in understanding of the structure and strength of the relationship between housing wealth and consumption. At the outset it is necessary to have an overview of developments in UK’s housing market during the pertinent period to highlight the generation of housing wealth, the manner in which it is accessed in the form of equity, and channels of disbursement of the equity.

The UK housing market became truly energized in the mid-to-late 1990’s, beginning with a property boom in the London area and then gradually spreading to virtually every region. Homeownership levels reached historic levels and so did the share of ‘buy-to-let’ residential investments in the country’s portfolio. Using data published by Halifax-Bank of Scotland, Graph 1 provides the salient market metrics:

  • the price boom accelerated to push the price of the typical house from around £61,000 in 1995 to over £161,000 by 2004 – an increase of over 160%;
  • not only was the speed and tenacity of housing prices unprecedented, the annualized percentage growth rate seem to rise with the level of prices.

Far from being a localized phenomenon, this housing boom covered the entire UK, as Graph 2 demonstrates. While, the origin of the boom was in Greater London and the Southeast in the mid 1990’s, it quickly enveloped East Anglia and the Southwest. However, by 2001 the boom entered its most vigorous phase as it spread to the peripheral regions with prices almost doubling in a five-year period.

Since most of the home purchases are financed through mortgages, the two variables that shape housing demand decisions are the interest rate and property prices. As it turned out, with historically low nominal lending rates (see discussion later), the home prices was the chief determinant behind purchases. The feeding frenzy that was the housing market pumped prices to such a level that placed typical accommodations out of reach of most would-be buyers. The Affordability Index, calculated as the ratio of housing prices to household disposable income, rose from 3.09 in 1995 to 5.45 in 2004.

It is useful to note that higher aggregate housing wealth can be a product of a rise in housing prices and/or a growth in the stock of housing. As is displayed in Graph 3, the early 1980’s saw housing wealth grow due to a steady rise in prices while in the late 1980’s and early 1990’s we see stability in it despite declining prices. There was rising home ownership during all three intervals; in the early 1980’s it was engendered by the privatization of some public housing [5, p. 12] while the late 1980’s and early 1990’s it was due to stimulated demand spurred by declining prices and interest rates.

With housing prices rising at around 20% per annum, vast slices of society saw the value of their homes reach unseen levels as the market injected equity. This store of equity was virtually a battery filled with purchasing power that was steadily getting charged by the market and that could be tapped into, if needed, to finance purchases. Halifax (2005) reports on it website that at the end of 2005, UK’s housing wealth reached a historic peak at £3,408 billion which amounts to triple the figure in 1995 with the last five years seeing a 60% increase. As Graph 3 illustrates, since the mid-1990’s the unprecedented spurt in housing wealth can be attributed mainly to rising prices. Clearly, an index of housing prices is an excellent proxy for housing wealth. [5]

What generated the price boom?

As compared to the preceding 15 years, the last decade saw the housing market subjected to a variety of macroeconomic and financial forces. Following Her Majesty’s Treasury (2003) and Farlow (2004), one can identify demand- and supply-side factors responsible for shaping the current housing market.

On the demand side, the key market forces were:

  • According to Her Majesty’s Treasury (2003) the early 1980’s saw a sustained campaign of liberalization of the credit market that led to increased competition among banks and non-traditional lenders, rampant development of new credit products, and enhanced capacity of banks to create liquidity; all of which made obtaining housing loans easier and a more egalitarian process by lowering transaction costs. [6]
  • Low and declining interest rates pushed down the cost of mortgage credit thereby stimulating housing demand;
  • Macroeconomic prosperity with higher disposable income and lowered unemployment rates allowed for more purchasing power;
  • Expectations of continuous expansion and future employment created an optimism among households
  • Despite an ageing population, members of typical home-buying age-cohort (especially baby-boomers) saw their households grow, thus creating a greater demand for family housing;
  • And lastly, the explosion in ‘buy-to-let’ purchases led to a massive speculative demand fueled by expectations of sustained housing price increases.

On the supply side, the major market forces according to Farlow (2004) and Her Majesty’s Treasury (2003)were:

  • a low price-elasticity of supply due to a combination of policy regulations, regional scarcity of land, and lags in obtaining licence/local approval;
  • Scarcity of existing housing available for purchase i.e. low vacancy rate;
  • Rising costs of construction, especially due to labour shortage and rising prices of materials.

When a strong level of demand and a limited and inelastic housing supply are combined, one can see why prices have risen so quickly.

Housing wealth vs. Financial Wealth

To understand the rising significance of the recently acquired housing wealth, it is interesting to compare it with the ownership of financial assets in UK. Housing remains UK’s greatest asset with the total of shares, bonds, and cash amounting to £1.6 trillion. In the past, financial assets - pensions and holdings of shares, bonds, and bank accounts - accounted for bulk of the nation’s wealth. However, recent history has created housing as the asset that is held more widely and equitably – across geographic regions, age cohorts, and income groups – than financial wealth. Pensions were clearly concentrated among the older age groups and the bulk of other financial assets were held largely by a small opulent minority.

Data provided by National Statistics (www.statistics.gov.uk) and Her Majesty’s Treasury (2004) describe UK’s home ownership as widespread across all income and age categories with older segments having a larger rate. Whereas shares and bonds are owned largely by people in higher income groups – for obvious reasons – the housing boom has proved to be a moderating or equalizing force as all homeowners have benefited from rising property values.[7]

The English Longitudinal Study of Ageing (2002) provides some supporting evidence in this respect. The study finds that because of the relatively even distribution of recent gains, housing wealth has become more important than non-pension financial wealth, especially in the 50+ age group. The following table shows that not only is the typical size of housing wealth ownership greater than net financial wealth (non-pension), but that it is far less concentrated across society as reflected by the lower inter-quartile ratio and lower Gini coefficient.

Table 1.


Net Housing Wealth

- approx.

Net Financial Wealth – approx.







Inter-quartile ratio



Gini Coefficient



Source: English Longitudinal Study of Ageing (2002), IFS.

The data shown in Graph 4 reveals though financial wealth had dominated all through the 1990’s, the rapid growth of housing wealth since the mid 1990’s coupled with the stock market bust has again placed the two neck and neck. Even with parity in value, the prominence that housing wealth commands in the national balance sheet is the consequence of its relatively equitable distribution and the fact that in spite of recent volatility in housing prices, it is historically far more reliable as an investment than the market value of corporate shares – the dominant component of financial assets.

With growth in house prices outstripping the growth in mortgage debt, mortgage equity has increased from £700 billion in 1995 to £2.4 trillion at the end of 2005 – a 250% increase. In real terms, the last five years have seen the value of housing stock rise by over 60%. Thanks to housing values rising faster than mortgage debt in each of the last ten years, UK homeowners now have a greater financial buffer for leaner times. Ten years ago, the typical home was worth 2.8 times as much as the typical mortgage; at the end of 2005, this ratio had increased to 3.5, underlining the fact that the country has more equity than a decade ago.

Tapping into housing wealth

A survey of related literature from Bridges et al (2004), Davey (2001), Farlow (2004), Nickell (2004), and Salt and Macdonald (2004) reveals a variety of ways in households can access the equity stored in the residences. The manner in which a particular household harvests equity depends on the circumstances under which the action is taken. Table 2 below has categorized the possible scenarios. The table explains that households that continue to occupy their home can draw equity by re-mortgaging, i.e. borrow by treating their property as collateral. Households who move could access equity either by over-mortgaging the new home, or by buying a cheaper house in the new location, or by selling their house move to a rental unit (thereby liquidating their asset and obtaining the entire stock of equity). The last possibility covers cases where the owner id deceased or leaves the country, leading to the final sale of the house and the release of 100% of the equity.

Table 2.

Category of Homeowners

Method of Extracting Equity

Houseowners retaining possession

Re-mortgaging: by taking out additional mortgage(s), borrowers could access equity up to a maximum percentage of value

Houseowners that move

Down-grading: these households move to a cheaper home, thereby harvesting the equity that equals the difference between the value of sale and the portion of mortgage that was owed

Over-mortgaging: these households move to a new residence but manage to obtain a mortgage loan that exceeds the value of the new purchase. This typically occurs in regional markets where there is strong expectations of continuous property-value appreciation

Final sale with return to rental: some households sell their houses in order to move to a rental property ostensibly due to either lack of affordability (those with diminished earnings) or convenience (mostly the elderly and the infirm)

Households in which the owner(s)

are deceased

Final sale: when the owners dies, the property is sold with the receipts being used for purposes other than purchase of a house

Having harvested the equity, how a given household’s chooses to allocate it across possible uses depends on a range of socio-economic and demographic factors like income level, family size, amount and composition of wealth, age(s) of the members, their geographical location, and even their ethnicity. The following section provides a detailed discussion of the conversion of equity into a specific one use – consumption.

Housing wealth and the consumption function: Theory, Analysis, and UK Evidence

In this section we begin with outlining the macroeconomic theory behind the consumption function with special reference to the wealth effect. The aim is to both explain the causal relationships behind the various ways in changes in the housing market can impact consumption as well as to identify the factors and circumstances under which the wealth effect might be weakened. The issues in this discussion are with explicit reference to the specific case of the UK.

The original Keynesian consumption function was presented as:

C = a + bYd(1)

Where C denotes real consumption, ‘a’ is the autonomous consumption expenditures, ‘b’ is the parameter symbolizing the marginal propensity to consume (hereafter, mpc) that was postulated as being a constant fraction, and Yd the real disposable income. Shifts in the consumption function are considered as being caused by ‘shocks’ or changes in variables other than Yd. Given the historical period when Keynes first conceived this relationship, it is not surprising that income was the chief driver of consumer spending. Presumably, because wealth was highly concentrated within the aristocracy and credit was a privilege for the few, Keynes decided to lump all non-income influences on consumption into the autonomous term. Over time, with growing sophistication of macroeconomic theory and of market-based economies in general, the consumption function came to be recognized as the following general formulation:

C = ƒ(Yd, Real Interest Rate, Price Level, Wealth, Expectations)(2)

This explicitly recognized the influence of, among other variables, wealth on consumption decisions, i.e. the wealth effect. However, the formulation stuck with the original assumption of the mpc being constant. That, after all, was acceptable because Keynes’s thinking was anchored in short run considerations and the assumption of unchanging consumers’ sensitivity to income changes was consistent with the model.

However, empirical testing of the formulation revealed that not only did the mpc vary with the length of time over which the estimation was conducted (it increased with time), but that its value tended to approach one. This certainly cast a cloud over the consumption function’s relevance and reliability in terms of explaining behaviour.[8]

With new thinking about consumption expenditures and about the time-horizon over which a household’s economic decisions were made, two new theories emerged. The Life Cycle Hypothesis (LCH)[9] and the Permanent Income Hypothesis (PIH)[10] both began from the fundamentally un-Keynesian assumption that households make decisions based on their assessment of not only the present but also the anticipated or likely future circumstances. In addition, both also held that rational spending and hence saving decisions necessarily involved long term planning – plausibly for rainy days, growth in family size, and old age.

According to Miller (1996) and Gordon (2003), the LCH assumes that permanent incomes are determined over the entire lifetime of the consumer, with allowance for a transitory element that depends on the consumer’s professional status. While the lifetime-oriented income could rise or fall in response to changes in productivity and unexpected events, consumption is smoothed and maintained at an even keel with dissaving (or borrowing) making up any shortfall in spending power. Similarly, in boom periods households save and accumulate purchasing power as wealth for future use. The long term level of income is assumed to follow a smooth path. Clearly, wealth plays a critical part in this model as the household accumulates savings in periods when smoothed consumption is below income. Similarly, as needed, wealth is accessed or made liquid for spending when planned consumption exceeds earnings.[11]

The theoretical significance of the LCH – which forms the basis of much of the empirical research reviewed – is easy to see because the way it explicitly incorporates the wealth effect into the household’s lifetime decision horizon with respect consumption, it makes it convenient to model housing wealth. Like the stylized household in the model that begins income-earning phase of her life with modest income and some debt (incurred because of current consumption expenditures exceeding lifetime income), the typical new homeowner is relatively young with a mortgage debt that is several times her annual income and little in terms of savings. Over time, in the absence of tumultuous booms, population and income growth in the economy lead to a steady rise in property values and mortgage equity accumulates. With growing needs for durables, the homeowner then has the possibility of ‘cashing in’ some of the stored housing wealth when current income and savings prove inadequate, much in the same way as the theoretical consumer enters a life-phase during which dissaving takes place. The key idea here is that just like the accumulated housing equity is part of purchasing power for the lifetime, the consumption decision also cannot be inconsistent with a long term budgetary process.

This model also suggests that there are periods (or life phases) in the household’s lifetime when wealth is accumulated and when it is used up in the form of consumption. This clearly defines when and under what circumstances mortgage equity is spent. For a young family that continues to occupy a house, the prime motivation is to accumulate equity and harvest it for emergencies or for planned increases in spending that are in balance with expected lifetime earnings which presumably are adjusted for the debt service associated with the additional mortgage. This scenario is consistent with, say, a home improvement project that allows for a larger or growing family or with purchase of durables for a similar purpose. For older homeowners who are approaching retirement or are actually retired, withdrawing equity is consistent with their position in the ‘life-cycle’. Since the income stream is either expected to end or has ended, spending decisions warrant the use of savings and/or mortgage equity withdrawals (MEW).

Critical to this model is how it treats the rapidly accumulated wealth gains due to a market-driven housing price boom like UK just experienced. Analyzing the housing wealth effect in the context of the LCH, Bridges et al (2004) liken the rise in housing wealth to raising the household’s lifetime budget constraint. Assuming easy access to credit, they identify two pertinent theoretical relationships: one between housing price increases and the lifetime incomes of the wealthier households and the other between housing wealth and the newly acquired debt obligations of the re-mortgaging households. In theory, then, higher housing prices generate wealth effects depending on whether or not the price change is interpreted as permanent or temporary. If households perceive the gains to be permanent or unlikely to be reversed by a sudden housing bust (like what the UK witnessed in the 1980’s and early 1990’s), then it amounts a rise in lifetime income and higher consumption expenditures induced by it are ‘allowed.’ On the other hand if the price (and wealth) increases are due to random market activity and will most likely be followed by a decline, then the realized buildup of mortgage equity ought to be regarded as a temporary development and no serious consumption outlays need be planned to spend it. LCH holds that households that are pleasantly surprised by equity gains and choose to borrow against it for extravagance or pleasure spending are fully aware of the future debt-service implications and have made the necessary budgetary calculations that reveal that these actions related to the wealth-effect are compatible with their lifetime income. Curiously, O’Sullivan and Hogan (2003) report that Ireland also experienced a housing boom (though not as extreme as the one in UK), but that there were no signs of a wealth effect. This was presumably because Irish consumers did not put much faith in the housing market’s longevity and construing the recent price gains as transitory, let the accumulated equity stay ‘frozen.’ However, it is possible that there were indeed impulses related to a housing wealth effect but simultaneously counteracting forces offset it, resulting in generally unchanged aggregate consumption.[12]

The above discussion opens up three related and important issues: (i) the process by which accumulated housing wealth translates into consumption expenditure, i.e. the anatomy of the wealth effect in the housing context, (ii) the implications of multiple possible uses of MEW for the strength of the wealth effect, and (iii) other macroeconomic factors that can offset the wealth effect or perhaps prevent it from materializing.

Anatomy of the Housing Wealth Effect

There are two channels through which homeowners are able to raise their consumption via the wealth effect. As explained above, one way for homeowners to convert their housing wealth is by harvesting mortgage equity - MEW. Table 2 outlined the variety of ways in which households obtain equity. Benito and Power (2004), Bridges et al (2004), and Davey (2001) provide insight into how MEW has become a major source of consumer financing in the UK. Graph 5 clearly shows the close relationship between housing prices and MEW[13]. Throughout the last three decades, except for the 2003-2004 interval, UK’s homeowners have reacted to the housing market’s wealth rewards. As Davey (2001) explains, MEW was relatively unimportant in the 1970’s but rose sharply in the following decade. In the early 1980’s despite a recession, MEW climbed because the period coincided with the privatization of public housing. The first half of 1990’s, however, saw a steep decline in households use of withdrawn equity.In fact there was a brief period when there was a net injection of equity into the housing stock. It could be argued that this was a reflection of a rational economic behaviour on the part of homeowners’ as they assessed a downward trend in housing prices as being detrimental to their long term finances. With a declining value of their housing wealth, UK’s homeowners cut back on withdrawals. Since the mid-1990’s price boom, that downward trend in MEW was quickly reversed. This period saw MEW grow faster than housing prices hinting at the possibility of a overly optimistic body of borrowers who expected housing prices and equity accumulation to continue rising at an ever increasing rate. Since at least part of the MEW is withdrawn by homeowners re-mortgaging their houses (see Table 2), this translates into loans secured by their properties. Halifax – BOS (2005) offer compelling evidence in this respect. They report that in 2004, total gross lending secured by dwellings was an astronomical £291 billion – 4% more than the previous year. The figure that was a mere £57 billion in 1995, doubled by 1999 and with growth rates sometimes exceeding 35% had risen to five times that level in 2004. This monumental withdrawal can be interpreted as a major windfall for the homeowners who suddenly found themselves swimming in an ocean of purchasing power made available by the housing market.

The other channel through which housing wealth engenders greater purchasing power in the hands of homeowners is comparatively subtle mechanism. Bridges et al (2004) discuss in great detail, how even without using their property s collateral, homeowners have gained access to ever rising amounts of unsecured credit. The rising value of housing wealth was interpreted by banks and other lenders as indicative of greater borrowing ability, i.e. greater creditworthiness. Naturally, this perception of the lenders was shaped, in part, by expectations of continuous a housing boom. A side implication of this phenomenon is that homeownership in the UK had become a screening device or filter for lenders’ decisions about whom to consider for loans. It follows that this would place renters at a disadvantage with respect to access to credit. Several studies, including Bridges at al (2004) have cited evidence of homeowners being supplied credit on terms far more favorable than those offered to non-owners. It can be reasonably expected that a large portion of the unsecured borrowing was directed toward consumption.

Critical to both these channels is the issue of the ease with homeowners are able to obtain credit in lieu of their housing wealth. The mere existence of mortgage equity must be complemented with an efficient system to gain access to it for the wealth effect to take place. Benito (2004), Bridges et al (2004), and Her Majesty’s Treasury (2003) all stress that the liberalization of UK’s financial system that began in 1979 (see footnote 6 in Sec. 2) has been instrumental in creating a credit market that has facilitated the historic levels of MEW.

With rising competition among banks and building societies and tremendous product innovation, the lending industry has created a series of affordable and accessible ways in which homeowners can obtain credit. All three studies portray the boom in housing prices and MEW in the UK as unique as compared to all other OECD economies. The coincidence of rising housing prices created huge reserves of withdrawable mortgage equity and supply-side changes in the form of lower restrictions on lending practices and other financial reform is responsible for the explosion in MEW since the mid 1990’s. The declining interest rates, as shown in Graph 6, can partially be attributed to the freer credit market with more lenders competing for homeowners’ business. Although nominal rates had been on declining trend since the late 1980’s, the real interest rate shifted into a distinctly decline in the early 1990’s as a result of low inflation. Adding to the combined impact of liberalization policies of the 1980’s, will be the effect of the Consumer Credit Act. “Crucially, once the Consumer Credit Act (CCA) drives the removal of the GBP25,000 ceiling on regulated loans occurs (most likely to come into effect in the Autumn of 2006 when primary legislation is passed), it is expected that existing and any future mainstream entrants will be willing to offer larger loans, thus increasing their competitive threat. In addition, as mainstream lenders tend to offer the lowest prices on the market, specialist lenders are going to have difficulty competing against this escalating encroachment.” [3]

This underscores that for the wealth effect to take place, the economy must be equipped with the appropriate financial infrastructure to provide the means of converting housing wealth into disposable funds.

Does MEW lead to higher consumption? Maybe.

It turns out that the transmission mechanism that translates MEW into consumption is subject to leaks and obstacles. This has the broad implication that only a part of MEW is directed toward consumer spending. Research reveals that how MEW is channeled is somewhat related to how housing activity is withdrawn and who is doing the withdrawal. Not only are there different ways of equity extraction (see Table 2), but the motives for extraction vary.[14]

Figure 1 provides a graphic that summarizes the different ways in which MEW are accessed and used. As it shows, there are only two channels through which the wealth effect works – spending on non-housing consumption and home-improvement projects. Clearly, a chunk of MEW is never spent thereby creating source of weakness in the linkage between housing wealth and consumption.

Farlow (2004) and Benito and Power (2004) are among a few studies that have examined the structure of MEW in the UK. Apparently, demographic and socio-economic factors are major determinants of how MEW is used. Bank of England The general conclusion is that only about half of the MEW is accessed by re-mortgagers, who are the biggest spenders. Some salient conclusions from their research are as follows:

Henley and Morley (2001) find that homeowners below the age of 40 have spent a larger percentage of the MEW as compared to those above 55.

Farlow (2004) separates households that withdraw mortgage equity into two categories: one being re-mortgagers and the other a combination of down-graders, over-mortgagers, and deceased. He finds that for re-mortgagers, 47% of the borrowers admit to spending borrowed funds on home improvements, 17% of them purchased items for the house, and 18% bought cars. Note that borrowers could allocate funds across multiple areas of spending. In general, just under two-thirds of the re-mortgagers expressed home improvement or major purchases for the housed as the prime reason for borrowing. This is in sharp contras with the other group - down-graders, over-mortgagers, and those representing the deceased homeowners. While there are motivations for home improvements and indulgent purchases, like the re-mortgagers, the allocations are as follows:

  • In the case of households making a final sale – those moving to a rental apartment or instances where the property was sold due to death, only 8% of the funds were spent and 67% were saved;
  • Those trading down, spent 31% of the MEW and saved 36%
  • Over-mortgagers spent 41% and saved 27%.

It is useful to note that a large fraction of this group are elderly with distinctly different attitudes toward spending.

Benito & Power (2004), using data from 2003 Survey of English Housing find that while liquidation and down-trading based extractions are spread evenly across all income percentiles, re-mortgaging to obtain secured loans is concentrated among higher income groups and it amounts to only 40% of value extracted.

Bridges et al (2004) find that households who are own the bulk of the MEW are not big spenders. This group consists mainly of down-sizing households, older households with no dependent children, widowed individuals, retired people, and families with a high ratio of rooms per residing member. These characteristics seem remarkably consistent with the cohort identifies by the LCH as owners of wealth.

Finally, as noted by Bridges (2004), Farlow (2004), Her Majesty’s Treasury (2003), and Salt and Macdonald (2004), the UK is especially positioned to experience a strong wealth effect due to higher housing wealth because of the high ownership rate – close to 65%. Because of this there is a large fraction of the population that can potentially respond to higher housing wealth by increasing consumption expenditure.

The analysis above suggests that there are ample reasons for the wealth effect to be weak in the UK. Judging by the evidence provided, only a part of the mortgage equity is withdrawn by households who are inclined to spend – re-mortgagers - and they too do not spend all of what they reap. Therefore, at best about a half of the MEW would be channeled into consumption expenditures. A broad inference from this analysis is that a disaggregated perspective yields insights that are not possible through viewing macroeconomic data.

Other forces that weaken the wealth effect

Graph 7 displays the pattern of consumption (deviations from trend) and MEW in the UK over the 1995-2005 period. Beginning in 1997, there appears to be a strong positive correlation between the two series. However, there is a sudden break in the relationship in 2002. The following discussion attempts to analyze these observations.

Speculative Activity

Even though Benito and Power (2004) finds that the median income of re-mortgaging households in around GBP 33,600 and only a quarter of borrowers earned GBP 40,00 or more, a large share of MEW was done by those in upper-income groups.

Additionally, a major component of the housing demand in the last five years was investors involved in ‘buy-to-let’ purchases. The alarmingly high price-to-earnings ratio reported by Halifax – BOS suggest housing getting increasingly unaffordable for the majority of the buyers, yet the Halifax Affordability Index grew by 60% to 5.45 in the last five years. It is plausible that rising demand was due in part to buyers who demand housing not for residential purposes, but rather as investment properties.

Additionally, as shown in Graph 3, housing prices that were rising at the rate of 20% or more, suddenly stabilized and began decline toward the end of Q2 2004. Surely this cannot be due to an exhaustion of what might be termed as organic residential housing demand. A plausible explanation is an abrupt end to a speculative fever. Another piece of evidence that supports the presence of a strong speculative demand for housing is that rising interest rates failed to retard the rise of prices. (Of course, interest rates are procyclical and rising GDP could offset their negative effects on demand.) Furthermore, the Council of Mortgage Lenders reported that buy-to-let lending dropped 18% between Q1 and Q3 of 2004 – as compared to only a 3% drop for owner-occupied buyers. Given that speculative activity of all kinds is conducted mainly by people with high incomes and wealth, it is unlikely that whatever gains were made through buy-to-let transactions ended up as higher consumption expenditures. To add to this, it is accepted that higher income groups have a lower mpc. Therefore, speculation weakens the wealth effect and it is likely that it happened in the UK.

The use of unsecured credit

Structural Changes in the economy

Farlow (2004) asserts that whereas from 1970 to the mid 1990s, there was a strong correlation between growth of housing prices and growth of consumer durables spending - something also supported by Bank of England (2004) - that link seems broken during the last decade or so. Housing prices have accelerated but the rate of growth of spending has stabilized. See Graph 7.This is partly due to an ageing population that has reduced the importance of durables in consumption.[15] Also, as Bridges et al (2004) stress that widespread access to unsecured credit by homeowners has also contributed a possible diminished reliance on MEW.

Benito & Power (2004) are also skeptical about the state of the linkage between housing wealth and consumption. They suggest that even if there is a positive correlation between the two, it might not imply a causal relationship. Rather, it is possible that the two are independently related one or more macroeconomic variables. They cite the increasing role of unsecured credit in the economy and the financial iberalization as key structural changes responsible for changing this relationship.

Salt and Macdonald (2004) and Aoki et al (2001) confirm the weakening link between housing equity and consumption – especially during the last 5 years. They analyze that if consumption had risen at a rate that is even a fraction of the housing price inflation, UK would have seena declijne in the savings rate. But savings as a ratio of disposable income has remained steady. They say that absence of evidence regarding housing wealth’s influence on consumption does not evidence of its absence because the relationship does not stay constant over time. Once the housing market reruns to normalcy and changes in prices reflect demand and supply considerations with respect to residential housing and the buy-to-let boom fades, one can expect the linkage to reappear.

Finally, population data obtained from National Statistics shows that not only the annual rate of growth of households fallen to a very low level – 1.1%, but that the typical size of a household living under a roof is rising (mainly due to the increasing share of non-white families). Both these have serious implications for the structure of long run consumption, especially with respect to durables, cars, etc.

An alternative to LCH

The discussion of the variety of ways in which MEW is accessed and the diversity in its usage strongly hints that perhaps a single theoretical model – i.e. the LCH – is incapable of explaining the observed patterns in consumption. While some households choose to spend their MEW in a hurry, others use it for debt reductions, and yet others use it as a channel to raise funds for their businesses. It is possible that the model put forth by behaviouralists – the behavioural life cycle theory (BLCT)- can provide a different perspective and insight into understanding the recent trends in UK. [see 30]

The BLCT criticizes the neoclassical thinking embodied in the LCH on the grounds that “even the simplified theoretical characterization of the consumer’s dynamic programming problem is too hard for most consumers to solve, and in any case, inherently impatient consumers lack the self-control needed to follow the saving pattern that would be required if they could solve the optimization problem.” (14, p.392]

Thaler and Shefrin (1981) claim that people evaluate possible economic actions/outcomes based on a process of rule-of-thumb metal accounting by which they categorize their purchasing power into three elements: current income, current assets, and future income. Furthermore, each household then assigns a different mpc to each of these components based on their subjective determination. Consequently, households can then be placed in a behavioral spectrum that has the ‘myopic doer’ on one extreme and the ‘farsighted planner’ on the other. The former is characterized as the impulsive buyer who has a weak will associated with unexpected gains (MEW?) high time preference and enjoys consuming with apparent disregard for the future, anticipated debt servicing etc., while the other is exactly the type that LCH has in mind and is one who conducts systematic financial and budgetary planning and makes spending decisions with caution and mindfulness regarding saving for the future. This explains why some households over-consume during their earnings years and why small windfall gains are consumed at a higher rate but a greater proportion of larger gains is saved.

Graham and Isaac (2002) provide survey evidence that even educated consumers (college professors) prefer the idea of income smoothing over consumption smoothing because the former is better for planning consumption/saving decisions. They find that it is common place to see households react to unexpected or surprise earnings by earmarking it for preferred uses like debt reduction or luxurious purchases. This unpredictability could be yet another explanation for why the wealth effect has not been clearly observed for the UK and it is consistent with what Dickey (2001) and Benito and Power (2005) have analyzed. Phang’s (2002) findings about how Singaporeans reacted to gains in housing wealth lends some support to the BLCT. She suggests that because of a traditional emphasis on bequest, risk aversion, and lack of alternative housing there is no support to LCH. Using micro-level survey data, Aoki et al (2001) accept that while some households behave consistently with the LCH as they show consumption smoothing, others are impatient or subject to credit inaccessibility and tend to act as “rule of thumb” consumers who spend their current income in each period.

Survey of Modeling the wealth effect

According to Her majesty’s Treasury (2003) and based on the reviewed research, most empirical work in assessing the relationship between housing wealth and consumption is rooted in the LCH. The modeling is such that consumption is allowed to deviate from its long run / smooth path in the short run, but attempts to return to it. Also, consumption, in the long run, is correlated with the long run path disposable income and wealth.

Typically, the model specification incorporates lags and takes the following general form:

C = f(Y, W, ….Yt-1, Yt-2 …. Yt-k , Wt-1, Wt-2 …. Wt-k, expectations)(3)

There are several issues that emerge after reviewing a sample of research in this area. First, almost all of them have estimated relationships for periods other than the one that is of interest in this paper – 1995-2005. Second, only a few have paid specific attention to MEW and have instead relied on housing prices as a proxy for housing wealth. Finally, given the discussion about structural changes in the UK economy and the institutional reforms in the financial industry, there is some doubt that the models will have adequate predictive power with respect to the UK.

In assessing the wealth effect due to housing market changes, Case et al (2005) say that not only is housing wealth’s influence on household behaviour analogous to that found for stock market wealth, but that in recent times (in the U.S.) the former has dominated the latter.

They use the following formulation:

Ct = Ct-1 + Yt + Stockt + Houset + Ct-1 Yt-1) + Stockt-1 + Fixed Effects + t (4)

where all variables are in real per capita terms and expressed in logs. They comment that households have only imperfect knowledge of their own financial wealth, and so it would be expected that they should not all react instantaneously to changes in components of wealth.

They estimate an error-correction model which is used in the presence of unit roots. With co-integrated relationship between consumption and income, they find that the coefficient on lagged ration of consumption to income (Ct-1 Yt-1) is significantly negative implying that temporary shocks arising from other variables will have an immediate impact on consumption but will eventually be suppressed unless the shocks also impact income. They not only find a highly significant short run effect of housing market wealth, but that it is significantly larger than the influence of financial wealth

They do not include lags on household housing wealth, given the strong serial correlation of home price changes, which would introduce substantial multicollinearity into the regression.

Kennedy and Andersen (1994) also estimate a model in error-correction form that focuses on the savings ratio for the period 1970-92. Their model allows for both short and long term influence of each of the variables

S/Yd)t = 1(S/Y) t-1 + 2PH t-1 + 3(D/Y) t-1 + other levels terms

+ PH) + D/Y) + other dynamic terms(5)

where S/Y = household saving divided by disposable income; PH = real house price index; D/Y = ratio of household debt to disposable income

They find that for the UK 2 = 0.07, i.e. a unit change in the real house price index in the previous period lowers the saving ratio in the current period by about 0.07 percentage points. Also 2/1 (the impact of housing prices in the short run) = -0.049, and 1 (the effect of a change in housing prices changes) = 0.025, suggesting that higher housing wealth has a depressing influence on savings and that a greater change in housing prices leads to a stronger reaction from savings.

Girouard and Blondal (2001) examine the impact of housing wealth on household consumption for the UK, France and Italy. The sample period used for estimation was 1970 to 1999. The specification of the model is conventional, with consumption determined by real disposable income and wealth in the long-run:

(c/y) = fw/y)hw/y)ow/y)(6)

where all variables are real and c = private consumption, y = disposable income, fw = net financial wealth, hw = housing wealth, and ow = other household wealth (total net worth minus fw + hw)

All variables are entered in logs so the parameter estimates can be interpreted as long run elasticities of household consumption with respect to the various components of household wealth: a one per cent increase in housing wealth, for example, is estimated to lead to a long-run percentage increase in private consumption equal to . The authors also allow for a long-run influence from interest rates and inflation on the level of private consumption, though in the cases of France and Italy the estimated impacts are either insignificant or perversely signed.

This study also uses a two-step error correction estimation approach in which the residuals from the long-run levels relationship above are included in a second dynamic specification modeling growth in private consumption. The coefficient on this error correction term can be interpreted as a measure of the speed at which private consumption adjusts to any deviation in its level relative to the equilibrium implied by the estimated levels relationship. The second stage regression also allows for dynamic or short-run influences on private consumption from changes in the various components of wealth.

They find that all-important key elasticity of consumption with respect to housing wealth significantly positive.

Henley and Morley (2001) model consumption such that it responds slowly to changes in the permanent income.

ct = hpt hpt-1t7.a)


t = t-1 + t-2 + t(7.b)

where c = change in log consumption, hp = change in log real home price, 1 and 2 the decay parameters capturing the partial adjustment rate to permanent income shocks.

Using UK data for 1972-1996 they find that consumption is extremely responsive in the short run with respect to both housing prices and permanent income. While income from two periods ago continues to drive consumption – lending support to LCH, there is a perverse lagged effect of housing prices. The constant term picks up the trend in consumption. They find that for UK, = 0.268 and = -0.062 – implying that the housing market is very responsive to changes in prices in the short run. With 1 and 2 estimated as 0.359 and 0.122 respectively, there is evidence that cyclical changes do have a lasting effect on consumption.

Her Majesty’s Treasury (2003) used data for a period that was closer to the latest housing boom - 1992-01 – and estimated a specification that incorporated effects on consumption due to real income, wealth, and interest fates. They also use an error correction model with the following form:

logC = a1 + a2logC-1 + a3logY-1 + a4logFW-1 + a5logHW-1 + a6R-1 + a7logYt-i +

a8logFWt-i + a9logHWt-i + a10Rt-I(8)

where C is real consumption, Y is the real disposable income, FW is the stock of financial wealth, HW is the stock of housing wealth, and R is the real interest rate.

They find that for the UK, the long run elasticity of consumption with respect to real disposable income to be in the 0.8-0.9 range and those with respect to real housing wealth and net financial assets to be 0.1 and 0.05 respectively. This result is consistent with what Case et al (2005) found, i.e. that the long run impact of housing wealth is stringer than that due to financial wealth. Furthermore, it was found that the long run impact of real housing wealth were weaker than the short run effects signaling a very responsive consumer body in UK.

This paper also estimates an error-correction model to to assess the impact of housing wealth on consumption. However, a major departures from the mainstream econometric analysis on this topic, housing wealth is proxied by MEW. This is something that has been suggested by Farlow (2004) and others and, given the discussion in the preceding sections, seems a more appropriate specification than the ones that use housing prices.

Empirical Analysis

We use quarterly data for the period 1995-2005 collected from the following sources:

Real Housing Prices: Halifax-BOS (2005)

Real Consumption, Real Household Disposable Income, Inflation: Datastream

Interest Rate : End month weighted average interest rate, 2 year fixed mortgage (75% LTV), Banks & Building Societies (IUMBV34): Bank of England

Mortgage Equity Withdrawals: Bank of England

To examine the presence of the wealth effect in the UK, a correlation analysis was conducted to obtain a cursory understanding of the data. The 1976-2005 period was broken into three separate phases. The first phase represents the financial liberalization period in UK when the lending system was reformed to make it more competitive. The second period, 1985-1994 is one that was marred by periods of declining housing prices. And, the final phase is the one of interest to us as it covers the period of the housing boom.

Table 3 contains some very interesting results. With respect to consumption, the association with disposable income declined steadily over the time period. At the same time the association with financial assets and MEW grew. Housing prices and the real intrerest rate also saw a strengthening influence on consumption. Clearly, the role of financial variables gradually took over as the drivers of consumptions opposed to income.

The second tier in the table shows the correlations with respect MEW. Clearly, there is growing evidence of housing prices shaping housing wealth, and, hence MEW. Also, the association with interest rate is as expected.

The final tier shows correlation coefficient with Housing prices. Again, there is strengthening relationship between prices and interest rates. Analysis of the correlation coefficient with lagged value of MEW suggests the presence of speculative activity. The argument can be made that with speculative gains being made, the investors ploughed back some of their gains into the housing market thereby pushing prices even higher.

While this is a rather simple analysis, it does –provide some context for the estimation process that follows.

Table 3


Correlation between Real Consumption



Real after-tax Income

Net Financial Assets

Mortgage Equity Withdrawal

Real House Prices

Real Interest Rate


























Correlation between Mortgage Equity Withdrawal



Real after-tax Income


Real House Prices

Real Interest Rate























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