Is the Wealth Effect a Myth?

The wealth effect is the tendency of consumers to increase their spending during times of financial boom and cut back on spending during times of financial bust. Christopher Flavelle, writing for Slate, says the wealth effect is a myth.

The premise behind the wealth effect seems sensible enough: When the value of your assets—like stocks or a house—rises, you feel wealthier and are more likely to splurge. When it falls, you're likely to curb your spending, either because you can't take as much equity out of your home or because you simply feel poorer and so change your behavior. Aggregated across the economy as a whole, the wealth effect suggests that current falling home prices should lead to a recession.

That premise underpins much economic writing.... Yet the idea of a wealth effect doesn't stand up to economic data. The stock market boom in the late 1990s helped increase the wealth of Americans, but it didn't produce a significant change in consumption, according to David Backus, a professor of economics and finance at New York University. Before the stock market reversed itself, "you didn't see a big increase in consumption," says Backus. "And when it did reverse itself, you didn't see a big decrease."

However, more Americans own houses than own stocks—shouldn't a change in home equity have a bigger impact on spending than a change in the stock market? Not so, says Backus. "There wasn't much of a wealth effect on the way up [for housing prices]," says Backus, "and probably there won't be much of a wealth effect on the way down, either."

Tobias Levkovich, the chief U.S. equity strategist for Citibank, says focusing solely on housing as the driver for consumer spending is misleading. Levkovich found that if Americans had spent all the equity they took out of their homes, consumption since 2002 would have been two to three times higher than it actually was. "The story about housing-driven consumer spending persists in the absence of hard data," he wrote in a report to investors in February, adding that household deposits like savings accounts and short-term certificates of deposit grew by more than $1.5 trillion over the same period—indicating that some of the home equity was saved, not spent.

"None of this diminishes from the pain that some people are suffering because of home price declines," says Levkovich. "But if you're talking economics, GDP is far bigger than that; consumer spending is far bigger than that."

That's not to say that a change in home equity doesn't affect the economy. But the impact is much smaller than the headlines suggest. Last January, a report by the Congressional Budget Office estimated that when the value of a family's house changes by $1,000, their consumption would change by somewhere between $20 and $70....

Falling home prices will continue to be a political issue this year.... But those falling prices don't automatically mean we're in for economic payback—however ominous the headlines.

Could this be why the data suggests we have been avoiding a recession so far?