RDP 2021-10: The Rise in Household Liquidity 1. The Rise in Household Liquidity

Households need liquid assets, such as cash, to get through periods of financial stress (Ganong and Noel 2018). Liquid assets provide a buffer for households to avoid cutting back on spending during periods of income loss (Andersen et al 2021). For example, during the COVID-19 pandemic, households accumulated significant holdings of liquid assets at a time of great uncertainty about the future.

As has been well documented, household wealth has increased relative to income over recent decades and both sides of the household balance sheet (assets and liabilities) have expanded (Ellis 2006; Piketty and Zucman 2014) (Figure 1). It is also well known that interest rates have been on a trend decline over recent decades (Mian, Straub and Sufi 2021), and that this decline in interest rates has contributed to higher housing prices and debt (Debelle 2004; Ellis 2005; Schularick and Taylor 2012; Jordà, Schularick and Taylor 2014). It is common in the mainstream media, and even among academic research, to read that higher housing prices and debt over recent decades has made the economy more financially fragile (Bartscher et al 2020).

But it is less well known that, as part of this process of balance sheet expansion, the value of household liquid assets (which includes cash, deposits, equities and bonds) has also risen rapidly relative to incomes. In other words, households have larger liquidity buffers today than in the past, which has helped to service the higher debt. When measured net of liquid assets, the trend rise in the household debt-to-income ratio in Australia has been much less significant over recent decades and, in fact, has been falling since the global financial crisis (Figure 1). Moreover, the value of household liquid assets now basically matches the value of gross household debt, at least at an aggregate level.

We argue that the rise in household liquidity is a ‘side effect’ of the growth in housing prices and debt and the trend decline in interest rates over recent decades. In a world of uncertainty, many home owners with mortgage debt value liquidity for precautionary reasons, given the potential for future income or consumption falls. Rising levels of mortgage debt (relative to incomes) make mortgage payments larger and the risk associated with any income shock also increases. Households have responded to this increased risk by saving more for precautionary reasons (Boar, Gorea and Midrigan forthcoming). The higher rate of saving has occurred through both amortising mortgage debt (including paying ahead of schedule) and saving in other liquid assets, such as bank deposits and equities.

Some of the same underlying forces that have contributed to the rise in housing wealth, such as the trend decline in interest rates, have also allowed households to build liquidity buffers by increasing the capacity to pay down existing levels of debt. The capacity to save through debt amortisation has been further supported by mortgage market innovations, such as offset and redraw accounts, which are common in Australia but unusual by international standards. These products make it easier and more cost-effective for home owners to save by paying down mortgage debt ahead of schedule. By rebalancing their wealth portfolios through debt amortisation, home owners can liquidate some of their housing wealth and therefore better smooth consumption. Overall, these developments in the mortgage market have contributed to reducing financial fragility.

To support this story, we undertake a detailed exploration of the determinants of household liquidity in Australia, in terms of both the distribution across households as well as over time. This exploration exploits a wide range of data sources, including national accounts, household surveys and loan-level data.

First, we document some facts about the cross-section and dynamics of household liquidity. For example, the average household holds a relatively large share of their asset portfolio in liquid assets. Household liquidity is unevenly distributed across the population, and this cross-sectional distribution is strongly correlated with the housing life cycle – specifically, age and housing tenure. Liquidity buffers have risen significantly relative to both income and spending since the start of the 21st century. The increase in liquidity in Australia has been broad based across the population, such that the share of liquidity-constrained households (with particularly low buffers) has gradually fallen over time. The decline in liquidity constraints has been strong among households with mortgage debt, even taking into consideration that households hold debt for longer now. The rise in household liquidity has not been specific to Australia but has been observed in basically all OECD economies since the start of the century (Figure 2).

Second, we provide evidence that the rise in household liquidity is closely linked to higher housing prices. The average household has not shifted the composition of their asset portfolios more towards liquid assets – instead, both liquid and illiquid wealth have risen relative to income. More specifically, households have responded to higher capital gains on housing, as well as increased mortgage debt, by increasing their holdings of liquid assets. Consistent with this, there is a strong positive correlation between the growth in housing prices and the growth in liquid assets across local housing markets in Australia, as well as across other advanced economies.

Third, we explore the mechanisms through which higher liquidity is linked to higher housing prices and debt. Consistent with the strong increase in liquidity buffers among home owners with mortgage debt (or ‘mortgagors’), most of the increase in aggregate household saving over the past decade is accounted for by mortgage debt amortisation. This is consistent with the idea that households often choose to accumulate wealth by saving in a ‘mortgage piggy bank’ (Bernstein and Koudijs 2021), possibly because housing provides a commitment device to reduce temptation and self-control problems (Attanasio, Kovacs and Moran 2021).

In Australia, paying down mortgage debt is a tax-effective method of saving for owner-occupiers. Principal payments on mortgage debt, including prepayments, explain almost all of the trend in the household saving rate over recent times (Figure 3). Home owners start with higher levels of debt today than in the past, but the rate at which debt is paid down has also risen. Saving in other assets has also been important during the COVID-19 pandemic.

We provide evidence that home owners facing greater income uncertainty, such as those worried about losing their jobs or that have more volatile incomes, hold relatively large liquidity buffers. Further, there is evidence that these households have increased their buffers by more than other indebted home owners. This suggests it is no coincidence that household liquid assets have grown alongside housing prices and debt. The rise in household liquidity is at least partly due to greater precautionary saving amongst owner-occupiers with mortgage debt.

But there are other causal mechanisms linking higher housing prices to higher liquidity. In an event study framework, we document that higher housing prices cause potential first home buyers to accumulate more liquid assets to finance housing deposits. This effect is stronger in recent years and in the more expensive capital cities of Sydney and Melbourne. This suggests that some of the growth in household liquid asset holdings is due to housing deposits increasing with housing prices. Higher housing prices can also support liquidity by increasing the capacity (and willingness) of home owners to withdraw equity and refinance their mortgages (Chen, Michaux and Roussanov 2020), and we find some empirical support for this too.

These mechanisms suggest that the rise in household liquidity is closely linked to the trend decline in interest rates that has been observed over recent decades in Australia and elsewhere. Specifically, disinflation and falling real interest rates have increased housing prices and housing deposits, and have also made it easier to amortise existing debt. This has boosted saving and allowed households with debt to accumulate wealth and build liquidity buffers. As further evidence, we use local projection methods to demonstrate that lower interest rates are associated with higher household liquidity buffers, including mortgage prepayment buffers, at the aggregate level.

Finally, we consider alternative explanations for the rise in household liquidity, including demand-side factors such as an ageing population and rising inequality, as well as supply-side factors such as changes in banking regulations. We find some evidence that the increase in liquidity is due to an ageing population and rising income inequality, although the effects are sensitive to the time period under consideration. We also find some evidence consistent with banks choosing to hold higher levels of deposits (as liquid liabilities) because of changes in bank liquidity regulations that were introduced following the global financial crisis.

There are two key motivations for our research. First, household liquidity buffers are important from a financial stability perspective. Past research has shown that the liquidity of household balance sheets is a key determinant of financial resilience. Households with limited buffers are typically more prone to financial stress. Low (or declining) liquidity buffers could pose a significant risk to financial stability, all other things being equal. Second, household liquidity buffers are important from a macroeconomic perspective. There is extensive research suggesting that household liquidity constraints are an important determinant of household spending (and its sensitivity to income and wealth shocks). But we know little about what determines household liquidity constraints.

There is a vast household finance literature that studies the determinants of household asset portfolios, and some of these studies look at the effect of housing on the household portfolio (e.g. Campbell and Viceira 2002; Curcuru et al 2010). However, these studies typically focus on housing price risk and the consumption commitment of housing as the underlying mechanisms (Chetty, Sándor and Szeidl 2017), and examine how housing investment and mortgage debt affects stock market participation (Flavin and Yamashita 2002; Cocco 2005). Overall, this literature typically focuses on the riskiness of the asset portfolio, such as low stock market participation, rather than the liquidity of that portfolio.^[1] This is surprising given that liquid assets, such as bank deposits, typically comprise a much larger share of households' portfolios than risky financial assets, such as equities.^[2]

To the best of our knowledge, we are the first to document the trend increase in household liquidity and its potential causes. Our empirical findings should therefore help in the development of new theoretical models to better understand why households hold such a high share of their wealth in liquid assets, and how household liquidity is linked to the housing market and the household's life cycle.

Our findings also have important policy implications from a financial stability perspective. First, the decline in liquidity constraints implies that the household sector may have become less sensitive to temporary income and wealth shocks, all other things being equal. Second, the decline in liquidity constraints, particularly among those with mortgage debt, has reduced the repayment risk associated with aggregate mortgage debt over the past couple of decades in Australia. Third, we show that housing equity is more of a liquid asset in Australia than in other countries due to financial innovations such as mortgage offset and redraw accounts. These financial products may mean that indebted households are less sensitive to income and wealth shocks in Australia than similar households in other countries. We leave this possibility to future research.

Footnotes

There is a closely connected, but older literature on household money demand that dates back to the models developed independently by Baumol (1952) and Tobin (1956). These models assume there is a trade-off between the liquidity provided by holding money (cash and deposits) to carry out transactions and the interest foregone by holding wealth in non-interest bearing assets. [1]

There is also a large literature that studies the effect of liquidity on asset prices, though much of the work focuses on the cross-section of company stock prices (and explains why some stocks are more liquid than others). [2]