Market Analysis

What Wealth Effect?

Folks fearing the weak housing market will dampen consumer spending shouldn't worry—consumer spending tracks disposable income, not home equity.

Story Highlights:

  • Folks fear the weak housing market will dampen consumer spending, which, as the largest component of GDP, would impact the economy.
  • But consumer spending tracks disposable income, not housing equity.
  • Consumer spending so far this year is in positive territory, signaling the economy's in better shape than most believe.

What makes us feel wealthy? For some, wealth is an intangible entity, derived from family, friends or good health. For just as many, perhaps the majority, wealth is measured by material assets. And of this second group, when imagining solid, substantial, owned assets, most folks think of their homes.

Housing is important to humans on many levels. It serves in capacities ranging from shelter, sanctuary, status symbol to, in times of modern real estate, an investment. With all these come potent emotions, not the least our sense of personal wealth. Given the current US housing downturn, it's natural for many to assume we are poorer (or at least feel poorer), and when we feel poorer, we spend less. It's little wonder many fear the weak housing market will translate directly into consumer spending troubles. And since consumer spending comprises two-thirds of GDP, they may reason a recession can't be far off.

U.S. Household Net Worth Fell the Most in 5 Years Last Quarter
By Carlos Torres,

Many people believe housing and consumer spending are linked due to the "wealth effect." This traditional thinking surmises people feel wealthier when house prices (or any other asset) increase in value—even when there are no realized gains. Just feeling wealthier causes people to spend more. Sounds reasonable, right? But facts show housing prices are a poor gauge of consumer spending health.

House Prices Fall: Should We Care?
Chris Dillow, The Times

As noted in the preceding article, house prices in the US fell by 16.6% since peaking in July 2006, while retail sales over the same period rose 5.0%. Even with higher gas prices and continued housing market weakness, consumers continue to spend—completely contradicting the wealth effect theory.

Some Chains Post Strong Sales Despite Gas Prices, Low Confidence
By Kevin Kingsbury, The Wall Street Journal

Truth is, an increase in housing wealth only marginally affects consumption habits, but an increase in disposable income sends consumption running for the roses. A range of studies* show a $1 increase in housing wealth typically increases consumption by $0.02 - $0.07. In comparison, a $1 increase in disposable income typically increases consumption by $0.60 - $0.95. The marginal propensity to consume hinges on disposable income, not home equity, and disposable incomes have steadily increased. In line, consumer spending so far this year is in positive territory, signaling the economy's in better shape than most expect.

Still, some point out a number of liquidity-constrained home owners use their houses as collateral, and falling house values can impact the size of the loan and the subsequent consumption. But this number has a very low effect on overall consumer spending.

Measurements of wealth, no matter how you define it, are based in psychology. If house prices have you worried about your wealth, relax: Rises or falls in home prices—unless you sell your home—are not the same as realized gains or losses. So even if home prices fall, consumers may not necessarily be less wealthy. And if you are still worried about your wealth, remember your family, friends and good health.

Source: "Marginal propensity to consume" ranges selected as representative of a wide range of studies. Congressional Budget Office, Nat. Bureau of Economic Research, IMF, Federal Reserve, National Association of Realtors.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.