Thursday, June 26, 2008

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?

9 comments:

  1. Nah, we are deep in a recession and feeling the effects of our account deficit (aka oil is skyrocketing).

    Inflation is masking the several percentage drop in GDP.

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  2. I dont know but if this is true, this is something we really should pay attention to. We just sort of took it for granted that there was a cause and effect relationship - after all it made sense!

    If its not true, it could really affect how much longer this housing downturn lasts. Job losses could lead to another wave of falling housing prices. If those losses are minimal, maybe that second wave will not come. If it doesnt come we are alot closer to the "bottom" than we may think.

    Oh so many questions!!!

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  3. I think there was an affect. Things have NOT been good these last 6-7 years. We've lost a lot of jobs, and most of our economy was actually floating on the artificial wealth that showed up from turing our homes into businesses, flipping, pulling out equity, etc.

    With out that economic "growth" would have been much flatter.

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  4. The professors comments are correct only for those that bought conventional and late.

    in areas where you saw from 2002-4 to 2006-7 a 250% increase in home prices or valuation then the homeowners who stayed in their homes took out lots of equity in houses that they probably already had a little equity in.

    So its not the late in the game home buyers who saw little equity increase that the econmy revoilves around its the 80 % that didnt buy at all but took out HEL's...on the 250% increases in values...

    Lance

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  5. No. (And I think we are in a recession now; I think the data will make that clearer soon.) It's not about how consumers FEEL. It's about how much collateral you have to borrow against. It's not just about consumers, it's also about businesses. When your collateral declines in value, you have less credit available to you. When it rises, you have more. The story should not be about consumption. It should be about NOT SAVING, or NOT PAYING DOWN DEBT, which amounts to the same thing. You can save or you can invest or you can consume. It will now be necessary for Americans to save more (or pay down debt more) and so they will invest and consume less. It is not about how rich you feel. It is about how much money the bank lets you borrow against your house.

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  6. "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...."

    Is that a change of $20-$70 monthly? annually?

    Let's assume it's annually. My condo unit in Orange County has dropped from $390k in January 2006 to about $190k this month...a $200k drop...which means that I would decrease my consumption by $4000 to $14000 this year! If one household reduces consumption by $14000, multiply that by about 1 million households just in OC (whose house price decline is bigger than my $200k decline on average)....we're looking at potentially $14 billion less spending just in OC.

    No wealth effect?????

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  7. Having "wealth" in your residence and having "wealth" in stocks are not the same thing. If you judge that the market has hit a peak and sell your stocks (or rental property you own), you have the money to spend or put elsewhere. But most people don't own rental property; they own only their own residence. And everyone needs someplace to live - they don't need replacement stocks.

    If you keep your current house and it is now worth 20% more than last year, you can sell it, but it will cost you the same amount to buy another house just like it, to say nothing of the transaction costs (which are far more than for stocks).

    If you don't sell, but borrow against it - news flash (a fact that is constantly glossed over on programs on HGTV etc.) - you have to pay the money back, just as with any other loan. You are simply borrowing more money.

    With few exceptions, the only people who might actually have more wealth are those who sell the house and move to a cheaper community at the same level of income and all other factors (which is hard to imagine - if they give up some desirable factors to live in the new community, then they are less "wealthy" - even moving back home with the folks, rent free, does have its costs).

    So most people don't have any more real wealth than they had the year before. This isn't a true wealth effect.

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  8. anonymous asked...
    "Is that a change of $20-$70 monthly? annually?"

    I think it's total, not annually. We're talking about a change in wealth, not a change in income.

    However, as Dean Baker said a few posts down, there's about an average of $110,000 in housing bubble wealth for each house spread across the U.S. (Obviously, for California it's much more than $110,000 per house and in Montana it's much less than $110,000 per house.)

    At $45 per thousand (the midpoint between $20 and $70) that gives us an average decline in spending of about $4950 per owner-occupied household. With approximately 75,000,000 owner-occupied households in the USA, that's a total spending decline of $371.25 billion (assuming no mathematical mistake on my part).

    Compare that to U.S. annual GDP of $13,790 billion.

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  9. Nope, I was wrong. After reading the original source, it's $20-$70 per thousand (2-7¢ per dollar) per year. So, we're talking roughly a 2.7% decline in annual GDP.

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