Housing & the Consumer

Two closely connected forces sit at the heart of the economy: the consumer, whose spending is the single largest driver of economic activity, and housing, a huge sector whose health ripples through everything from construction to confidence. This lesson examines the consumer and housing, why they matter so much, and the cautionary lesson of how housing excess helped trigger the most severe financial crisis in generations.

The central role of the consumer

Consumer spending is the largest component of the economy, accounting for roughly two-thirds of GDP in the United States through the consumption component introduced in the first lesson of this unit. Because the consumer is so dominant, the health of household spending is critical to the overall economy, and when consumers spend freely the economy tends to grow, while when they retrench the economy weakens. Consumer spending is driven by income and employment, examined in the labor market lesson, along with confidence about the future, household wealth, and access to credit, all of which combine to determine how willing and able households are to spend.

Measuring consumer health

• Retail sales data tracks consumer spending on goods, providing a timely read on the strength of the consumer.
• Consumer confidence and sentiment surveys gauge how optimistic or pessimistic households feel about their finances and the economy, which influences their willingness to spend.
• Personal income and spending figures, along with the savings rate, reveal how much households are earning, spending, and setting aside.
• Household debt levels indicate how much consumers have borrowed, which affects both their capacity to spend and their vulnerability to economic shocks.

The importance of housing

Housing is an enormous sector and a key driver of the economy, both directly through construction and related industries and indirectly through its effects on household wealth and confidence. Housing activity is tracked through indicators including home sales, both of existing and newly built homes, housing starts and building permits, which measure new construction and are watched as a leading indicator because permits signal future building activity, home prices, and mortgage rates. Housing is also notably sensitive to interest rates, since mortgage rates, which are tied to the broader interest rate environment examined earlier in this unit, strongly affect the affordability of homes and therefore the level of housing activity, with rising rates tending to cool the housing market and falling rates tending to stimulate it.

The wealth effect

An important channel linking housing and the consumer is the wealth effect, the tendency of people to spend more when they feel wealthier and less when they feel poorer. When home values and stock prices rise, households feel richer and tend to increase their spending, even if their actual income has not changed, which supports economic growth. Conversely, when home or stock values fall, households feel poorer and tend to cut back their spending, which can weaken the economy. Because housing is the largest asset for many households, changes in home values have a particularly strong wealth effect, making housing's influence on consumer spending, and therefore on the broader economy, especially powerful, and connecting housing directly to the consumer-driven economy.

The consumer is two-thirds of the economy, and housing is the consumer's largest asset. When housing turns, the whole economy feels it, as 2008 made unforgettable.

The 2008 cautionary tale and the honest caveat

Housing's central economic role carries a sobering cautionary lesson from the financial crisis. In the years leading up to 2008, a combination of rapidly rising home prices, excessive and poorly underwritten mortgage lending, and enormous leverage built up dangerous excesses in the housing market, and when home prices fell and mortgages defaulted, the damage spread through the financial system with devastating force, triggering a severe global financial crisis and recession. This episode demonstrated how excess and leverage in housing can drive systemic risk, threatening not just the housing sector but the entire economy, and it connects to the lessons on bubbles and on the dangers of leverage from across this curriculum. The honest caveat that accompanies the study of housing and the consumer is that, while their data is essential for understanding the economy, it is noisy and revised like all economic data, and confidence surveys in particular are imperfect predictors of actual behavior. More importantly, the 2008 experience is a permanent reminder that the housing sector, for all its importance to growth, can become a source of grave danger when fueled by excessive leverage and speculation, underscoring the recurring themes of this curriculum about the perils of leverage, the reality of bubbles, and the importance of vigilance even toward sectors that appear to be engines of prosperity.