Are Economic Theory and Housing Equity Withdrawal Behaviour at Odds? An Application of Mental Accounting

Kenneth Gibb and Alex Marsh Housing Studies Association York, April 2012

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Overview

Received view of income, wealth and consumption implies households optimise across the portfolio and smooth over life cycle Financial innovation has resulted in housing wealth becoming more liquid More liquid housing wealth offers opportunity to smooth via overpayment, equity withdrawal and equity release products By allowing smoothing such innovation is welfare-enhancing Does the evidence support the received view?

An alternative framework – Richard Thaler’s mental accounting, a core element of behavioural economics – may be helpful What are the implications for housing economics, research and policy?

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HEW £b cash

HEW £b cash -10 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Source: Pawson & Wilcox 2011 UK Housing Review.

Structure of the Argument

• • • • • The standard view on consumption, wealth and income, smoothing and its applications to housing economics The evidence on equity withdrawal Behavioural economics and mental accounting Re-interpreting the facts and their implications for policy, innovation and market behaviour Conclusions and further research

‘A simple formulation of the life cycle savings hypothesis suggests that consumers will distribute increases in anticipated wealth over time and that the marginal propensity to consume out of all wealth, whether for stocks, real estate, or any other source, should be the same small number’ Case, Quigley & Shiller, 2005, p.332

Consumption, income and housing

Case, Quigley & Shiller (2005) in Advances in Macroeconomics 5(1) Carroll, Otsuka & Slacalek (2006) German Institute for Economic Research, October Bostik, Gabriel & Painter (2006) Lusk Center for Real Estate USC, July Englehardt (1994 JUE vol. 36) and RSUE vol 26 1996) Thaler (1990) Journal of Economic Perspectives Thaler (1999) Journal of Behavioural Decision Making Wilkinson and Klaes (2012) 2 nd edition of Introduction to Behavioural Economics Anager (2012) A course in behavioural economics • • Consumption as a function of current income, modified to consider: - relative income - permanent income - life-cycle income - recent developments Do economic agents smooth their consumption over their lives? How do they do this? Do they use liquid housing assets?

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Economics literature

US evidence since the 1980s suggests positive but varied effects on consumption from rising housing wealth; also that rising housing wealth may increase renter savings towards a down-payment (i.e. reducing consumption) This has helped to explain the ‘savings puzzle’ Evidence from Germany, Japan, Canada and UK broadly in support Case et al, recognising the mental accounting thesis, argue that long term international and US state evidence suggests that mpc out of housing wealth is 0.4 but only 0.1 for stocks. – Other studies (Carroll et al found figures of 0.9 and 0.04 respectively, Bostik et al found housing assets had three times a bigger effect on Consumption than financial assets) Mixed evidence of symmetry i.e. housing wealth falls may lead to equivalent falls in consumption while increases have smaller effects in the other direction (e.g. Engelhardt, 1996) Question remains to housing wealth holders behave like economic agents in life cycle and permanent income model worlds?

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HEW in the UK

HEW required financial deregulation of mortgage market Recognition in the late 1980s that HEW was big enough in booms to affect aggregate consumption Early debates about the impacts of HEW on lifetime spending and savings, as well as inheritance Strongly pro-cyclical, capable of going negative (net debt repayment) and closely follows house price change Counter-arguments that debt is someone else’s asset and therefore the effect is much less important that it appears Currently HEW is historically at record negative levels (and therefore reducing agg consumption) of more than £34 billion in 2010 Doesn’t look like lifetime smoothing!

25 20 15 year HEW as % of total Consumption 10 % house price change (annual) 5 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 0 18 Source: Pawson & Wilcox, 2011, UK Housing Review -5

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Mental accounting and behavioural economics

Growth of BE: – heuristics that ‘explain’ choices that deviate systematically from optimal expected utility outcomes – – – – time inconsistent preferences bounded rationality group behaviour e.g. herds or shoals impact on many sectors of economics e.g. finance, policy making (the ‘nudging’ industry) • An alternative to Expected Utility – prospect theory with its focus on: – relative not absolute gains or losses (the importance of reference points) – – – – Losses valued roughly twice as highly as similar sized gains both gains and losses display diminishing sensitivity loss aversion [where most housing interest has been focused] Thaler’s mental accounting is an explicit application of prospect theory

Source: Wiki Commons

Key Features of Mental Accounting

• • • Thaler: ‘The set of cognitive operations used by individuals and households to code, categorise and evaluate financial activities’ (1999, p.183) MA, rooted in prospect theory, designed to understand and overcome anomalies in behaviour: – non-fungibility (“Money is money”; substitution between different income sources or spending decisions), – self-control issues, – – loss aversion, wealth budgeting – is consumption overly sensitive to current income? Too difficult to ‘solve’ for future income? Cf: financial market investments and narrow framing Choice bracketing – opening and closing accounts, sunk costs and payment decoupling

Mental Accounting Matters

• • • • Policy implications (also relates to bounded rationality): – – DellaVigna (2009) – firms know better than consumers biases reduced where aggregation might cancel them out, where experience and expertise matter, as does competition A re-interpretation of equity withdrawal: MA and the HEW evidence suggests that LCH and PIH may not be good representations of how we spend, save and plan our finances. This raises wider questions e.g. our confidence in income elasticity measures, let alone macroeconomic forecasting Re-thinking financial innovation – MA may explain low take-up on equity release Methodological and research design questions – how can we best ‘do’ research on MA?

Conclusions – going forward

• • • Recap of argument This is just an indirect analysis re-interpreting the evidence and the literature We are pursuing empirical strands to this programme: • micro panel household data • qualitative analysis of newly purchasing/selling households in Glasgow and Bristol project underway • long term ambition to fund a major household survey