There is widespread disagreement about the role of housing wealth in explaining consumption. Much of the empirical literature is marred by poor controls for the common drivers both of house prices and consumption, including income, income growth expectations, interest rates, credit supply conditions, other assets and indicators of income uncertainty (such as changes in the unemployment rate). For instance, while the easing of credit supply conditions is usually followed by a house price boom, failure to control for the direct effect of credit liberalization on consumption can over-estimate the effect of housing wealth or collateral on consumption.

In their new paper Housing Wealth, Credit Conditions and Consumption, Janine Aron and John Muellbauer put forward an empirical model grounded in theory with more complete controls than hitherto used. They study consumption in the UK and South Africa. Both countries experienced substantial credit market liberalization and rising consumption to income ratios. However, South Africa's circumstances in the 1980s prevented an asset price boom, thus allowing the illumination of the direct role of credit liberalization. The paper incorporates methodological improvements in the measurement of credit conditions, and also clarifies the multi-faceted effects of credit liberalization on consumption.

The Bank of England still appears to be uncertain about the effect of house prices on consumption and its new macro-econometric model has already seriously broken down in modelling this effect. Our new paper explains why the correlation between consumption and house price growth in the UK shifted since 2000 and what the many factors are which influence this correlation. The paper finds that over a two year horizon, a £100 increase in housing wealth now raises spending by around £3, much the same as an increase in stock market wealth. Before credit conditions were liberalised, the housing wealth effect was far less and this suggests that the use of housing collateral for increasing debt is the main way housing wealth affects consumption.

Their paper uses the Credit Conditions Index (CCI) constructed by Emilio Fernandez-Corugedo and John Muellbauer in Consumer Credit Conditions in the United Kingdom. Credit supply conditions faced by UK consumers, particularly in the mortgage market, have been liberalised since the late 1970s, with implications for the housing market and consumer spending. This paper examines quarterly micro data from the Survey of Mortgage Lenders to learn about changes in credit conditions from loan to value ratios (LVRs) and loan to income ratios (LIRs) of first-time buyers (classified by region and age). It combines data on the proportions of high LVR and high LIR loans with aggregate information on UK consumer credit and mortgage debt to give ten quarterly series for 1975-2001. These are modelled in a ten-equation system. A comprehensive set of economic and demographic influences on the demand and supply of credit, applying relevant sign restrictions, are controlled for. A single time-varying index of credit conditions captures the common variation in the ten credit indicators which cannot be explained by the economic and demographic controls. The broad coverage of credit market indicators and thorough investigation of economic forces driving the credit market should make the resulting credit conditions index more robust than previous estimates. The index increases in the 1980s, peaking towards the end of the decade. It retraces part of this rise in the early 1990s, before increasing again to levels, for the preferred measure, exceeding the previous peak. The index is useful for understanding the growth in household debt, for modelling consumption (see discussion above) and the housing market (see the UK housing bubbles paper by Gavin Cameron, John Muellbauer and Anthony Murphy), and for interpreting current monetary conditions.

A precursor of this paper is John Muellbauer's Measuring Financial Liberalization in the UK Mortgage Market, presented at the European Meeting of the Econometric Society in 1997. This paper analysed data on loan to values from building societies for first time buyers in 11 regions from 1971 to 1995 with exactly the same object in mind as the recent paper with Emilio Fernandez-Corugedo. The recent paper solves the problems uncovered in the 1997 paper, specifically the fact that building societies became less representative of the mortgage market when this market was being transformed by new entrants in the 1980s.

The first attempt to estimate a consumer credit conditions index was in John Muellbauer and Anthony Murphy's Income Expectations, Wealth and Demography in The Aggregate UK Consumption Function presented at HM Treasury's Academic Panel in 1993. Their 'flib' index, based on the analysis of average loan to value ratios (LVRs) in the United Kingdom for first-time buyers from the 5% Sample of Building Society Mortgages. Effectively the method involved regressing the log average LVR on the log of the mortgage interest rate, the log house price to income ratio and the real mortgage interest rate, for 1969-80 data, and using post-1980 dummies as a measure of the easing of credit conditions due to financial liberalisation. Among the innovations in this paper were the interaction effects between 'flib' and the illiquid wealth to income ratio, and the use of forecast income growth rates to proxy permanent income. The paper suggested that the marginal propensity to spend out of illiquid financial wealth and housing wealth were similar, at around 0.04. It seems likely that the slightly lower figure of 0.03 found in Aron and Muellbauer's 2006 paper above reflects the role that asset prices play in their income forecasting equation, missing in this 1993 paper.