Debt, Inequality and House Prices: Explaining the Dynamics of Household Borrowing Prior to the Great Recession

Growth rates of income inequality and household debt levels are strongly correlated within OECD economies. I explain this evidence through the role of collateral capacity and mortgage lending. My analysis of disaggregated US data in the decade preceding the 2007/2008 financial crisis shows how the rise in income inequality across US regions was associated with a higher than average increase in house prices. Exploiting geographical variation across US regions, I apply a methodology which can be considered similar to a diff-in-diff approach. I show that between 1997 and 2007 a 1% increase in inequality, measured as the ratio of top incomes to median incomes, determined an increase in the the self-reported value of homes of about 0.6% across US states and 0.7% across metro areas. Inequality therefore induced a wealth effect in homeowners. I also show that the increase in housing wealth was associated with higher consumption, despite constant real income. A 1% increase in top incomes induced a 0.46% increase in 'non-rich' homeowners' consumption, and a 0.18% increase in mortgage debt. The wealth effect experienced by homeowners living in high-inequality regions can therefore explain the link between inequality and house-hold debt without recourse to behavioral explanations such as the 'conspicuous consumption' hypothesis.