Feedback loops are an important concept in finance and economics. In a nutshell, positive feedback loops are pro-cyclical in that they act to make an economy more volatile by accentuating booms and then busts. By contrast, negative feedback loops are counter-cyclical in that they act to reduce volatility and make an economy more stable by mitigating boom/bust cycles.
Positive feedback loops come in various forms. With respect to the Australian housing market, there are two positive feedback loops that can dramatically impact the Australian economy via their effect on the level of credit growth, aggregate demand, and employment:
- mortgage hypothecation – the process whereby increases (decreases) in home values result in decreases (increases) in bank capital adequacy requirements, leading to increases (decreases) in mortgage lending; and
- wealth effect – the process of rising (falling) asset prices leading to rising (falling) consumer confidence, borrowing, household expenditure and employment.
Rather, I want to focus on the second point – the link between Australian home values and consumer confidence, borrowing, household expenditure and employment.
This is a topic that I have discussed several times before. For example, in Why Australian’s aren’t spending, I argued the following:
…throughout the 2000s, when global credit conditions were benign, household debt levels and asset prices rose continually. These conditions made Australians feel richer (the ‘wealth effect’), spurring consumer confidence, spending and employment growth…
With house prices rising inexorably, Australians began using their homes as ATMs, withdrawing large amounts of their new found home equity…Much of this money was spent on consumption, thus further boosting incomes and employment.
However, the process of debt feeding asset prices feeding confidence, consumer spending and employment growth appears to have stalled now that house prices have flat-lined. Australians have, instead, begun reducing consumption and repaying debt…
The golden era for retailing that was 2000 to 2008 is now over and the age of frugality has begun.
Recently, a number of reports have explained the ‘wealth effect’ positive feedback loop in greater detail.
First, today’s Australian Financial Review contains an interesting article entitled Falling house prices stifle shopping, which draws on research by Citigroup showing that changes in home values are a leading determinant of household consumption expenditure:
Retailers can blame the poor housing market for lacklustre consumer spending and should expect the weakness to continue…
Citigroup…found that changes in personal wealth, together with income and interest rates, play a big role in spending…
The largest determinant of household consumption is income… But changes in the value of household assets are a leading determinant too. Houses comprise about 60% of household assets…
A 10% increase in wealth translates to 1.7% growth in final consumption expenditure in the following quarter.
This means that when house prices go up, people spend more.
The problem for retailers has been that most peoples largest asset is their home, and property values have been falling, or have been at best flat in recent months.
Citigroup’s findings are supported by recent experience in Australia, New Zealand and the United Kingdom, where the rapid rise in household net worth up until 2007, most of which was on the back of rising home values, led to households withdrawing large amounts of home equity between 2001 and 2008. Much of this borrowing was spent on consumption, which further boosted incomes and employment.
To illustrate, consider the following charts showing home equity withdrawal in those countries.
In all three countries, rising home values between 2002 and 2008 created a positive feedback loop whereby households borrowed against their homes to fund consumption expenditure.
However, as soon as the Global Financial Crisis hit, and housing prices corrected, households began reducing consumption and repaying debt, as evident by the increasing home equity injection.
Another recent report by Deutsche Bank also lends weight to the positive feedback loop created by rising (falling) asset values. The report argues that wealth and the terms of trade have been key determinants of household savings over the past 40 years, and sees these factors as being behind the recent rise in the household saving rate.
In regards to the ‘wealth effect’ discussed above, Deutsche provides the below chart plotting the household savings rate against private sector wealth. As you can see, much of the decline in the household saving rate (the flip-side of which is increased borrowing) since the early 1980s can be attributed to a rapid increase in wealth over that period, much of which was due to rising home values. Figure 1 also shows the negative wealth shock seen during the GFC, and the associated increase in saving.
Once the positive feedback loop caused by rising (falling) home values is understood, it’s easy to dismiss the common misconception that unemployment would need to rise before home values would fall. Rather, rising (falling) home prices tends to lead decreases (increases) in unemployment simply because of the wealth effects described above.
Put simply, as long as Australian housing values remain stagnant or falling, consumption expenditure, credit growth and job creation will remain subdued, even with Australia’s terms of trade near century highs.