Experts: Wealth Effect Hasn't Arrived

Friday, 15 Mar 2013 11:22 AM

By Michael Kling

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According to the wealth effect theory, people will feel wealthier and spend more when stock prices and home values rise, even if they’re not selling their homes or stock portfolios.

While both home and stock values have increased, some experts say the wealth effect has yet to arrive during this recovery, according to CNNMoney. The Dow Jones Industrial Average has reached new highs, and the housing market is recovering and rebounding, but spending isn’t increasing the way it has in the past.

Economists estimated a few years ago that consumers spent an extra 3 cents for every $1 in stock market gains and an additional 8 cents for $1 in home price increases.

Forbes Columnist: ‘Who the Hell Cleared This?’

However, having lived through recent stock market volatility and housing market bubbles, consumers might be less likely to view their stock or housing wealth as permanent. That financial insecurity, economists predict, will continue to restrain spending.

“Given that stock prices have been up, down and all around over the past decade, households don’t fully believe they are worth as much as their 401(k) statement says,” Mark Zandi, chief economist at Moody’s Analytics, told CNNMoney. “At least not yet.”

“Wealth effects appear to have shrunk since the 2007-2008 financial crisis, and more so for housing wealth than for stock market wealth,” Credit Suisse economists Neal Soss and Henry Mo wrote in a paper titled “Honey, I Shrunk the Wealth Effect.”

Although the spending stimulus may be larger in the future, rising home values will probably not increase consumer spending enough to offset the restored payroll tax, they warned. After seeing their home values drop in the real estate collapse, families are less likely to believe their housing wealth is permanent, which will restrain their spending, the researchers said.

Increases in housing wealth that simply restore previous values will impact spending less than rising home values in the years before the bubble popped.

“Mortgage equity withdrawals, once the main channel through which consumers generated the cash flow to spend beyond their current take-home pay, show no sign of recovery,” the Credit Suisse economists wrote.

The diminished wealth effect means the Federal Reserve will have to “engineer” even larger bull markets in stocks and real estate, they said.

“The great financial crisis is proving to have a long tail.”

Forbes Columnist: ‘Who the Hell Cleared This?’

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