Connection betwen leverage, house prices and consumption

FRBSF Economists Reuven Glick and Kevin J. Lansing explain the relationship very clearly in this short note:

Household leverage in the United States and many industrial countries increased dramatically in the decade prior to 2007. Countries with the largest increases in household leverage tended to experience the fastest rises in house prices over the same period. These same countries tended to experience the biggest declines in household consumption once house prices started falling.

Lessons??

Going forward, the efforts of households in many countries to reduce their elevated debt loads via increased saving could result in sluggish recoveries of consumer spending. Higher saving rates and correspondingly lower rates of domestic consumption growth would mean that a larger share of GDP growth would need to come from business investment, net exports, or government spending. Debt reduction might also be accomplished via various forms of default, such as real estate short sales, foreclosures, and bankruptcies. But such deleveraging involves significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores.

As countries begin to emerge from the recession, it is important to consider what lessons might be learned for the conduct of policy. History suggests that asset price bubbles can be extraordinarily costly when accompanied by significant increases in borrowing. During the recent housing bubble, underwriting standards were weakened and credit extension rose at abnormally high rates, creating a self-reinforcing feedback loop that drove house prices upward. In the aftermath of a global boom-and-bust cycle in credit and housing, financial regulators should take the necessary steps to prevent a replay of this damaging episode.

Read the paper for details. Very nicely and simply written.

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