What is the Wealth Effect?
The wealth effect is a theory in behavioral economics which suggests that people are likely to spend more when the value of their assets, such as homes or investment portfolios, increases. This sense of increased financial security and confidence encourages consumers to spend more, despite their income and fixed costs remaining the same.
Key Takeaways
- The wealth effect posits that consumers feel more financially secure and confident about their wealth when their homes or investment portfolios increase in value.
- They tend to spend more, even if their income and fixed costs do not change.
- Critics argue that increased spending may lead to asset appreciation rather than the other way around, and only higher home values might be closely linked to increased consumer spending.
How The Wealth Effect Works
The wealth effect operates on the psychological impact that rising asset values, such as during a bull market, have on consumer behavior. As investment portfolios grow, feelings of financial security, often referred to as consumer confidence, strengthen. This heightened confidence leads to higher spending levels and reduced saving rates.
Businesses are also subject to the wealth effect. Companies may increase their hiring and capital expenditures (CapEx) in response to rising asset values, mirroring the consumer behavior. Consequently, economic growth generally strengthens during bull markets and diminishes in bear markets.
Special Considerations
At face value, the wealth effect seems like a logical driver of personal consumption. It’s reasonable to assume that individuals benefitting from large gains in housing or stock portfolios would indulge in expensive holidays, new cars, or other discretionary purchases.
However, critics argue that increasing asset wealth’s impact on consumer spending is minor compared to factors like taxes, household expenses, and employment trends. While asset value gains may enhance perceived wealth, they don’t equate to higher disposable income unless the assets are sold and the gains are realized.
An Example of The Wealth Effect
Supporters of the wealth effect highlight instances where significant interest rate hikes and tax increases during bull markets didn’t curb consumer spending. For instance, in 1968, taxes were raised by 10%, yet consumer spending continued to rise. Despite a decrease in disposable income due to higher taxes, people’s perceived wealth grew as the stock market continued to climb.
Criticism of The Wealth Effect
There is ongoing debate on whether the wealth effect actually exists, especially regarding the stock market. Some argue that the correlation is mistaken for causation: it’s the increased spending that drives asset appreciation. Others subscribe to the Pigou Effect theory, which proposes that falling prices enhance purchasing power and spur on consumption, thus increasing employment rates.
Housing vs. Stock Market Wealth Effect
More robust data links increased spending to higher home values than to stock market returns. Researchers, including Karl Case and Robert Shiller, found stronger evidence of a housing market wealth effect. Their comprehensive study covering 37 years (from 1975 to the second quarter of 2012) demonstrated that housing wealth increases correlate with about a 4.3% boost in household spending over four years. Conversely, a decline in housing wealth, akin to the 2005-2009 crash, indicated a roughly 3.5% reduction in spending.
Other economists concur that increased housing wealth promotes additional spending. Nonetheless, some disputes persist over whether previous research on the topic has been overestimated.
Related Terms: behavioral economics, consumer spending, bull market, capital expenditures, economic growth, discretionary items, stock market wealth effect, housing market impact.
References
- National Bureau of Economic Research. “Comparing Wealth Effects: The Stock Market Versus the Housing Market”.
- National Bureau of Economic Research. “Wealth Effects Revisited: 1975-2012”.
