NEW YORK (MainStreet) — Sometimes economists go to great lengths to explain things that seem pretty obvious to the rest of us, including the “wealth effect.” Put simply, it means people spend more when they feel richer. If the stock market soars, people buy more houses, luxury cars and nights on the town. Gee, you think?
The same thing presumably happens when home values go up, but until now the power of this effect has been unclear. Now academic research shows this is indeed a key factor in consumer spending, and has a powerful effect on the economy as a whole.
The findings also indicate how unwise this behavior can be.
“Our finding has been very controversial,” said Karl E. Case, senior fellow at the Joint Center for Housing Studies at Harvard, in an interview for the Squared Away Blog on the site of the Center for Retirement Research at Boston College.
“Some people say housing’s wealth effect doesn’t exist. Our own earlier work suggested that it works when the housing market is on the way up but not on the way down. We now have evidence that it works in both directions.”
In his paper, Wealth Effects Revisited: 1975-2012, Case and his co-authors say a 10 percent increase in home prices causes a 1 percent increase in consumer spending, and a 10 percent drop in home prices causes a 1 percent drop in consumer spending. The approximately 35 percent decline in home prices during the Great Recession therefore caused a $350 billion drop in consumer spending.
One of Case’s co-authors is Yale economist Robert J. Shiller. The two men are creators of the Standard & Poor’s Case-Shiller Home Price Indices, a widely followed measure of home prices.
Part of the wealth effect from housing is psychological, as homeowners feel freer to spend when they feel richer. But rising home prices can also supply spending money as people convert equity to cash with home equity loans or cash-out refinancing. This is one reason so many homeowners got into trouble during the recession: They borrowed against their growing equity, and, after home prices collapsed, could not sell their homes for enough to cover the debt.
That’s why the large home-related wealth effect measured by Case, Shiller and their co-author, the late John M. Quigley, an economist at the University of California at Berkeley, is somewhat worrisome. Spending the extra wealth caused by rising home prices can lead to trouble later.
And in some respects, that wealth is an illusion. As the value of one’s home rises, the price of the homeowner’s next home is probably rising as well. The homeowner could have trouble maintaining his standard of living if tapping into the current home’s equity will leave too little to buy a similar or better home later.
Of course, the Great Recession underscored the very real danger of a decline in home prices. Although that had not happened before on a nationwide basis, regional declines are not uncommon. Even if the homeowner intoxicated by the wealth effect does not tap home equity, spending other assets could leave her short if the home’s value does not continue to climb — especially if the homeowner expects to trade up someday.