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Credit Conditions and the Real Economy: The Elephant in the Room

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Abstract

We explore crucial but unobserved influences on the real economy due to structural shifts in non-price credit supply conditions. The global financial crisis (GFC) of 2007–09 demonstrated that shifts in credit conditions are the 'elephant in the room' for economies with liberalized financial markets: large, and ignored at one’s peril. We chose Australia as an interesting case study because over the three decades to 2008 it experienced one of the most rapid increases in household balance sheets and house prices in the world. The literatures on consumption, house prices and credit suggest that credit conditions may operate on the real economy through several channels. First, financial liberalization and innovation (FLIB) enhances the ability of all households to smooth housing and non-housing consumption across periods. Second, FLIB relaxes the mortgage down payment constraint on young, first-time home-buying households. Third, FLIB introduces a collateral channel from housing capital gains to real activity. Households with existing housing wealth can extract capital gains for other purposes through mortgage refinancing or home equity withdrawal products. However, rising house prices not only boost collateral for existing homeowners but also raise the mortgage deposit requirement. The balance of these two effects on the economy depends on the state of credit conditions and, to a lesser extent, the age distribution of the population. When credit conditions are easy, the positive collateral benefit of higher house prices to existing homeowners outweighs the negative effect on non- home-owning households who must now save for a larger deposit. Under these conditions, rising house prices raise consumption, mortgage debt and housing equity withdrawal (HEW). We have chosen the acronym 'latent interactive variable equation system' (LIVES) to describe our method. A common unobserved factor – a credit conditions index – determines intercept and parameter shifts in equations for consumption, house price, mortgage credit and HEW. This methodology provides a powerful technique for handling evolving and far- reaching structural change in an economy – a serious problem for econometric modellers. Our system extends the single equation house price and consumption modelling for Australia in Williams (2009, 2010), consumption equations for the United Kingdom, the United States and Japan in Aron et al (2011), and multi-equation work using UK credit data in Fernandez- Corugedo and Muellbauer (2006). Strong priors about the institutional environment and rich controls for other economic and demographic variables allow interpretation of the latent variable as credit conditions shifts due to FLIB. We represent this as a spline function consisting of smoothed step dummies. Credit conditions enter each equation as a common intercept term and through their interaction with interest rates, income growth expectations, housing collateral and so on. This paper summarizes the results for the consumption equation only. See the full version of the paper, Muellbauer and Williams (2011), for discussion of the equations for house prices, mortgage stock and HEW.

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