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Debunking the “Wealth Effect”

Declining house prices don’t necessarily slow down consumer spending.

The U.S. housing bust has fed a decline in overall wealth

Last Thursday, the Federal Reserve reported that Americans’ net wealth fell for a second consecutive quarter, a nerve-rattling drop after five years of growth. The fall in wealth stems largely from declining house prices and comes as the economy overall continues to struggle. These coinciding events reinforce the idea of a reverse “wealth effect”: As the value of people’s assets declines, their spending will fall significantly, wreaking havoc on the economy. But no matter how popular that theory is in the business press, it’s unsupported by economic facts.

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. On Saturday, the New York Times’ Peter S. Goodman wrote that since last fall, “economic troubles that began with falling home prices have rippled out to other areas of the economy—to shopping malls, grocery stores and home improvement outlets.”

Likewise, the Wall Street Journal’s Mark Gongloff wrote last Wednesday that since 2000, net worth soared, and “[t]he resulting ‘wealth effect’ encouraged consumers to throw cash around more freely, keeping the economy humming.”

Now that wealth was falling, Gongloff suggested, it might be payback time for the economy.

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.

Extrapolate that to the economy as a whole. Since its peak of just over $20 trillion in the fall of 2007, the value of Americans’ household real estate has fallen by $525 billion, or about 2 percent, according to the Fed. Following the estimates from the CBO’s report, a 2 percent decline in housing prices reduces GDP growth by between one-tenth and one-half of a percentage point—which is not nothing but also not enough to push the economy into recession in the first quarter, even combined with record-breaking energy prices and rising unemployment.

Backus questions even the CBO’s modest estimates, calling the economic impact of the decline in housing values “too small to identify with much precision, given how many other things are going on.”

The wealth effect fallacy helps explain how, on the same day the Fed reported a second quarter of falling wealth, chain store retailers last Thursday reported stronger-than-expected sales in May. Some credited federal rebate checks for keeping spending growing, but the fact is that except for cars and gas, month-on-month same-store chain retail sales have grown throughout 2008 as home equity has fallen. Levkovich says that rising energy costs and poor job growth play a much bigger role in determining spending than personal housing wealth.

Falling home prices will continue to be a political issue this year, especially as Americans judge the respective proposals of John McCain and Barack Obama to help homeowners stranded by mortgages they can no longer afford. But those falling prices don’t automatically mean we’re in for economic payback—however ominous the headlines. As Backus says, “It’s a better story if there’s a disaster on the horizon.”