MA Thesis Research Proposal: Calculating the ...

MA Thesis Research Proposal: Calculating the Housing Wealth Effect from Israeli micro data v. 1.0.2 Brandon Payne December 27, 2016

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introduction

The proposed study uses data from the Israeli Household Expenditure Survey (HES) for 2003-2015 to assess the effects of recent rapid increases in home prices on household private consumption expenditure. The independent variable in the study is changes in home prices. The dependent variable is the change in household consumption less housing expenditure. The literature suggests that households with identifiable characteristics will have their consumption effected in different ways by a change in housing prices. After a rise in housing prices, those who are long housing, i.e. they own a larger, more expensive house than they intend to in the future, will tend to increase consumption, even before they have booked a profit from a sale of their expensive home and moved to a less-expensive one. Those who are short housing, including renters who will buy in the future, and those who want to trade-up to more house, will decrease their consumption and increase their savings for the future home purchase. It is important for economists and policy makers to have an acccurate estimate of the housing wealth effect in order to predict the effect on the Israeli GDP of policies which will effect prices in the Israeli housing market. In the wake of massive cost-of-living protests in the summer of 2011, there remains considerable public pressure to reduce the price of housing. This project seeks to provide evidence of the existence of the housing wealth effect, quantify its magnitude and provide an estimate for the effect on GDP of a reduction in home prices back to their long-term average. This will be valuable data for those considering policies aimed at deflating the housing market.

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literature review:

This section provides relevant information about the Israeli economy as a whole, particularly situating it within global financial markets and examining constraints on government policies. It then discusses factors influencing the structure of the housing market in particular. It closes with a look at economic literature on the Housing Wealth Effect.

2.1

the Israeli economy

The Israeli economy has undergone a transition from one of centralized-planning to one with a greater utilizition of market-based approaches. The start of the tranformation can be dated to mid-1985, when a National Unity Government ended hyperinflation with a reform program including shrinking of the government budget and budget deficit, and a move toward a floating currency.1 Important policy tools during the period of cental-planning were multiple exchange rates and subsidized interest rates. The move from a fixed to a floating exchange rate regime has reduced the efficacy of these policy tools. Instead, domestic interest rates are largely set by the foreign-exchange market. Growth in the budget deficit is restrained by the 2010 New Fiscal Rule.2 This means that increases in government spending on social programs, must be matched by cuts elsewhere, or new tax revenue. A lack of alternative sources of tax revenue make it difficult for the government to reduce the price it seeks on the sale of state lands in order to boost the supply in the housing market. Long-term solutions to this problem, which include increasing the workforce participation rate, have proven difficult to implement.

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houses, apartments and condos

The structural characteristics of the Israeli housing market can be described briefly as follows: all but a small minority of dwelling units are in multi-family structures3 and most households (70%) own the apartments in which they live. Of non-owners, 87% are renters, and the rest live in apartments owned by others but don’t pay rent.4 Additionally, public construction of low-cost housing was a feature of the central1. Yair Aharoni, “The Changing Political Economy of Israel,” The Annals of the American Academy of Political and Social Science 555 (1998): 127–146. 2. Ministry of Finance, “New Fiscal Rule,” March 2010, Elva Bova;Tidiane Kinda; Priscilla Muthoora;Frederik Toscani, Fiscal Rules at a Glance, Background Document 12/273b (IMF, April 2015). 3. Eli Borukhov, Yona Ginsberg, and Elia Werczberger, “Housing Prices and Housing Preferences in Israel,” Urban Studies 15, no. 2 (1978): 187–200. 4. Gilat Benchetrit and Daniel Czamanski, “Immigration and Home Ownership: Government Subsidies and Wealth Distribution Effects in Israel,” Housing, Theory and Society 26, no. 3 (September 2009): 210–230.

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planning period. This aided the absorbtion of large waves of immigrants through the early 1960s. This housing was later sold to its residents at subsidized prices. Public construction of housing was greatly curtailed with the shrinking of the government sector after 1985. New homes are constructed based upon the profit motive in a highly regulated market. A privitized construction boom began in the early 1990s, in preparation for an anticipated large immigration from Ethiopia and the former Soviet Union. The government offered economic incentives to builders and streamlined planning and approval procedures. This increased the number of new housing starts fourfold between 1989 and 1991 and reduced the time necessary to build a unit from 31 to 12 months. However the increased supply did not keep pace with the rate of immigration. The immigrants received loans at a subsidized interest rate and created increased demand in the market which pushed up housing prices throughout the 1990s. Prices and construction starts began to fall in the early 2000s, during an economic downturn. Both of these metrics bottomed in 2008, followed by a rapid rise through 2011, at which time their paths diverged. Uncertainty connected with the housing protests led to a fall in housing starts, reducing supply while prices continued upward.5 The main factor in the price increase since 2008 has been excess demand fueled by low interest rates, which in turn are a product of large capital inflows.6 The market is currently characterized by pent-up demand due to years of low-housing starts. Equity market volatility, a new capital gains tax and an income tax exemption for the first 5,080 shekels of rental income create incentives to invest in rental property. Property investors compete with young families for the limited supply of new apartments and price them out of the market.7

2.3

the housing wealth effect

There is a strong correlation in the movements of home prices and consumption. It is not altogether clear if the relationship between them is causal, or in fact the work of a third factor which drives movements in both.8 Causal explanations are split between those focusing on a pure wealth effect, and the relaxation of liquidity constraints. Under a pure wealth effect, households spend more and save less out of current income as a response to increases in wealth. The relaxation of a liquidity constraint can be understood as a 5. Benchetrit and Czamanski, “Immigration and Home Ownership: Government Subsidies and Wealth Distribution Effects in Israel.” 6. Jesse Colombo, “Why Israel’s Boom Is Actually A Bubble Destined To Pop,” Forbes, April 2014, accessed December 11, 2016. 7. Noam Gruber, “The Israeli Housing Market,” State of the Nation Report: Society, Economy and Policy, 2014, 91–168. 8. Martin Browning, Mette Gørtz, and Søren Leth-Petersen, “Housing Wealth and Consumption: A Micro Panel Study,” The Economic Journal 123, no. 568 (April 2013): 401–428.

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reverse mortgage, in which the home’s equity is drawn-down to fund current consumption.9 An alternative explanation for the co-movement seen in home prices and consumption is known as the Common-Factor Hypothesis. This posits that a common third factor, often theorized as expected future income, rather than the housing wealth effect, drives both changes in consumption and home prices.10 The pure housing wealth effect is described as follows. Under the life-cycle hypothesis current consumption C is some portion11 of current wealth W plus some portion12 of current income Y.13

𝐶 = 𝛼𝑊 + 𝛽𝑌

(1)

Housing is the dominant store of wealth for households,14 so that a change in home prices can be a significant change in household wealth. For owners of housing, as the value of their home rises or falls with prices in the housing market, their wealth is rising or falling, and their consumption is predicted to follow. Under this model, a change in housing prices is predicted to have the opposite effect on renters as on owners. Some portion of renters are understood to be currently saving for the future purchase of a home. As they see home prices increase they will reduce the portion12 of current income that they consume, in order to increase savings for the now more expensive planned purchase.15 Several studies16 have found evidence of this different effect on renters and owners and seen it as support for the existence of a housing wealth effect. However, some studies17 have failed to find evidence of this effect, which instead lends support to the alternate hypothesis that a common factor is driving changes in both home prices and consumption. The dichotomy between owners and renters can be further refined. Some households first purchase 9. Jonathan S Skinner, “Is housing wealth a sideshow?,” chap. 8 in Advances in the Economics of Aging, ed. David A. Wise, vol. Advances in the Economics of Aging (University of Chicago Press, 1996), 241–272. 10. Eva Sierminska and Yelena F. Takhtamanova, Wealth Effects Out of Financial and Housing Wealth: Cross Country and Age Group Comparisons, technical report 2007-01 (Federal Reserve Bank of San Francisco: Working Paper Series, 2007). 11. A fraction between 0 and 1, represented by α. 12. A fraction between 0 and 1, represented by β. 13. Pierre-Olivier Gourinchas and Jonathan Parker, “Consumption Over the Life Cycle,” Econometrica 70, no. 1 (2002): 47–89. 14. Jie Gan, “Housing Wealth and Consumption Growth: Evidence from a Large Panel of Households,” Review of Financial Studies 23, no. 6 (February 2010): 2229–2267. 15. Jonathan Skinner, Housing Wealth and Aggregate Saving, NBER Working Papers 2842 (National Bureau of Economic Research, Inc, 1989). 16. John Y. Campbell and Joao F. Cocco, “How do house prices affect consumption? Evidence from micro data,” Journal of Monetary Economics 54, no. 3 (April 2007): 591–621; Christopher D. Carroll, Housing Wealth and Consumption Expenditure, technical report (Johns Hopkins University, 2004); Charles Calomiris, Stanley D. Longhofer, and William Miles, The (Mythical?) Housing Wealth Effect, Working Paper, Working Paper Series 15075 (National Bureau of Economic Research, June 2009). 17. Orazio Attanasio, Andrew Leicester, and Matthew Wakefield, “Do House Prices Drive Consumption Growth? The Coincident Cycles Of House Prices And Consumption In The Uk,” Journal of the European Economic Association 9, no. 3 (2011): 399– 435; Laurence Levin, “Are assets fungible?: Testing the behavioral theory of life-cycle savings,” Journal of Economic Behavior & Organization 36, no. 1 (1998): 59–83.

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a starter-home, then trade-up to a larger and more expensive home during their peak-earning years, and finally trade-down to something more-modest during retirement. In line with this narrative, Browning18 divides home owners into three age cohorts, but doesn’t find good evidence for separating his oldest cohort, those over 55 years of age, from his middle group. In his simpler model, younger households, where the oldest spouse is under 41, are considered short the housing market, and are found to have a behavior similar to renters, decreasing consumption in response to home price rises and increasing consumption in response to falls in the housing market. Older households are long the housing market, their consumption moves in the same direction as the change in housing price.19 This behavior by older and younger households has been observed in several studies.20

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methodology of the study

Taking as inputs data on home prices, income and consumption, we solve equation 1 for α, the fraction by which consumption will rise or fall in response to a change in wealth. This gives us a range of values for the households in our survey data. We test our hypotheses by comparing the means, μ of this range of α values for different populations. First, to test the claim of a housing wealth effect as opposed to the common factor hypothesis, we split our households into owners and renters. We look at a period with rising home prices and compare the means of these two groups, in a one-tailed test.21

𝐻0 ∶ 𝜇𝑜𝑤𝑛 ≤ 𝜇𝑟𝑒𝑛𝑡

𝐻1 ∶ 𝜇𝑜𝑤𝑛 > 𝜇𝑟𝑒𝑛𝑡

If we find that owners increase their consumption by an amount less than or equal to renters after a rise in home prices, then we fail to reject H0 , and have not found support for existence of a housing wealth effect among Israeli households. Next we divide homeowning households into older and younger cohorts. An older household is defined as being one in which the oldest spouse is 41 years of age or older during the survey year. This age was 18. Martin Browning, Mette Gortz, and Søren Leth-Petersen, “House prices and consumption: a micro study,” University of Copenhagen, mimeo, 2008, Browning, Gørtz, and Leth-Petersen, “Housing Wealth and Consumption: A Micro Panel Study.” 19. Browning, Gortz, and Leth-Petersen, “House prices and consumption: a micro study.” 20. Richard Disney; John Gathergood; Andrew Henley, “House Price Shocks, Negative Equity, And Household Consumption In The United Kingdom,” Journal of the European Economic Association 8, no. 6 (2010): 1179–1207; Orazio P Attanasio and Guglielmo Weber, “The UK consumption boom of the late 1980s: aggregate implications of microeconomic evidence,” The Economic Journal, 1994, 1269–1302; Orazio P. Attanasio et al., “Booms and Busts: Consumption, House Prices and Expectations,” Economica 76, no. 301 (2009): 20–50. 21. Since we have only found support for the housing wealth effect if owners react more strongly to price changes than renter.

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chosen to make the data compatible with Browning22 for comparison purposes. Again, the group with a higher mean is spending a greater amount in response to an upward movement in home prices, and reducing spending by a greater amount in response to reduced home prices.

𝐻0 ∶ 𝜇𝑜𝑙𝑑𝑒𝑟 ≤ 𝜇𝑦𝑜𝑢𝑛𝑔𝑒𝑟

𝐻1 ∶ 𝜇𝑜𝑙𝑑𝑒𝑟 > 𝜇𝑦𝑜𝑢𝑛𝑔𝑒𝑟

Here if we fail to reject H0 , then we have found evidence for the housing wealth effect’s different influence on younger homeowners who are still short housing, and older homeowners who are long housing.

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data used in proposed study

The household expenditure survey is an annual survey of 9000 households which has been conducted by the Central Bureau of Statistics since 1997. It provides information on demography, family income and consumption. This includes amounts spent on rent or imputed rent and non-housing expenditures. It contains information on the number of rooms in the dwelling. Home value data for use in my calculations are provided in CPI Table 6.2 - “Average Prices of Owner Occupied Dwellings (NIS Thousand), by Residential Area and Size Groups (Rooms in Dwelling).” This gives the average prices for homes of differing numbers of rooms, 1.5-2, 2.5-3, 3.5-4 and 4.5-5, in nine Residential Areas: Jerusalem, Tel Aviv, Haifa, Gush Dan, Center, South, Sharon, North and Qrayot Haifa. Pseudo-panels are constructed according to the locations and home sizes. Regression analysis is used to find the amount by which consumption varies after a change in housing prices.

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expected findings

I expect to find an overall average α of around 0.18, inline with earlier calculations from Israeli data.23 I also expect to find evidence of continued crowding out of young households by older owners of rental property. I expect to find evidence that some younger households are staying in the rental market longer and that this is shifting the overall balance between owners and renters down from it’s previous 70%. This will have an effect on my final predictions for the magnitude of the housing wealth effect on GDP. During 22. Browning, Gortz, and Leth-Petersen, “House prices and consumption: a micro study.” 23. Sigal Kahn Michael; Ribon, The Effect of House and Rent Prices on Private Consumption in Israel - A Micro Data Analysis, technical report (Bank of Israel, May 2013).

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the most recent rise in home prices, from 2008 to 2015, there were more home owners, who increased their consumption, so that rising home prices had a large positive effect on GDP. Now, I predict that rising US interest rates will cause capital to leave Israel, local interest rates to rise and rapid drops in the home prices, over the short-term, 2017-2020. However, due to a slightly greater proportion of renters in the market, the slow down in GDP due to the housing wealth effect will not be quite as great as it would have been, had the home ownership rate stayed at it’s previous level.

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conclusion

It is absolutely critical that the sensitivity of consumer spending to changes in housing prices be calculated for the State of Israel. This will allow a more clear understanding of the growth of GDP and consumer spending in the past ten years. It will allow better calibration of macro-economic models useful in predicting the effects of policy decisions and fluctuations caused by externalities. The proposed study aids in the construction of such models by a calculation of the housing wealth effect. Finally, it calculates the amount of household spending during each year 2003-2015 which can be attributed to the wealth effect.

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References Aharoni, Yair. “The Changing Political Economy of Israel.” The Annals of the American Academy of Political and Social Science 555 (1998): 127–146. Attanasio, Orazio P., Laura Blow, Robert Hamilton, and Andrew Leicester. “Booms and Busts: Consumption, House Prices and Expectations.” Economica 76, no. 301 (2009): 20–50. Attanasio, Orazio P, and Guglielmo Weber. “The UK consumption boom of the late 1980s: aggregate implications of microeconomic evidence.” The Economic Journal, 1994, 1269–1302. Attanasio, Orazio, Andrew Leicester, and Matthew Wakefield. “Do House Prices Drive Consumption Growth? The Coincident Cycles Of House Prices And Consumption In The Uk.” Journal of the European Economic Association 9, no. 3 (2011): 399–435. Benchetrit, Gilat, and Daniel Czamanski. “Immigration and Home Ownership: Government Subsidies and Wealth Distribution Effects in Israel.” Housing, Theory and Society 26, no. 3 (September 2009): 210–230. Borukhov, Eli, Yona Ginsberg, and Elia Werczberger. “Housing Prices and Housing Preferences in Israel.” Urban Studies 15, no. 2 (1978): 187–200. Browning, Martin, Mette Gortz, and Søren Leth-Petersen. “House prices and consumption: a micro study.” University of Copenhagen, mimeo, 2008. Browning, Martin, Mette Gørtz, and Søren Leth-Petersen. “Housing Wealth and Consumption: A Micro Panel Study.” The Economic Journal 123, no. 568 (April 2013): 401–428. Calomiris, Charles, Stanley D. Longhofer, and William Miles. The (Mythical?) Housing Wealth Effect. Working Paper, Working Paper Series 15075. National Bureau of Economic Research, June 2009. Campbell, John Y., and Joao F. Cocco. “How do house prices affect consumption? Evidence from micro data.” Journal of Monetary Economics 54, no. 3 (April 2007): 591–621. Carroll, Christopher D. Housing Wealth and Consumption Expenditure. Technical report. Johns Hopkins University, 2004. Colombo, Jesse. “Why Israel’s Boom Is Actually A Bubble Destined To Pop.” Forbes, April 2014. Accessed December 11, 2016. 8

Finance, Ministry of. “New Fiscal Rule,” March 2010. Gan, Jie. “Housing Wealth and Consumption Growth: Evidence from a Large Panel of Households.” Review of Financial Studies 23, no. 6 (February 2010): 2229–2267. Gourinchas, Pierre-Olivier, and Jonathan Parker. “Consumption Over the Life Cycle.” Econometrica 70, no. 1 (2002): 47–89. Gruber, Noam. “The Israeli Housing Market.” State of the Nation Report: Society, Economy and Policy, 2014, 91–168. Henley, Richard Disney; John Gathergood; Andrew. “House Price Shocks, Negative Equity, And Household Consumption In The United Kingdom.” Journal of the European Economic Association 8, no. 6 (2010): 1179–1207. Kahn, Sigal, Michael; Ribon. The Effect of House and Rent Prices on Private Consumption in Israel - A Micro Data Analysis. Technical report. Bank of Israel, May 2013. Levin, Laurence. “Are assets fungible?: Testing the behavioral theory of life-cycle savings.” Journal of Economic Behavior & Organization 36, no. 1 (1998): 59–83. Sierminska, Eva, and Yelena F. Takhtamanova. Wealth Effects Out of Financial and Housing Wealth: Cross Country and Age Group Comparisons. Technical report 2007-01. Federal Reserve Bank of San Francisco: Working Paper Series, 2007. Skinner, Jonathan. Housing Wealth and Aggregate Saving. NBER Working Papers 2842. National Bureau of Economic Research, Inc, 1989. Skinner, Jonathan S. “Is housing wealth a sideshow?” Chap. 8 in Advances in the Economics of Aging, edited by David A. Wise, vol. Advances in the Economics of Aging, 241–272. University of Chicago Press, 1996. Toscani, Elva Bova;Tidiane Kinda; Priscilla Muthoora;Frederik. Fiscal Rules at a Glance. Background Document 12/273b. IMF, April 2015.

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