A Study on the Wealth Effect and the Economy

The “wealth effect” is the premise that consumers tend to spend more when broadly held assets like real estate and stocks are rising in value. The notion that the wealth effect spurs personal consumption makes sense intuitively. Anyone who owns a home or contributes to a 401(k) plan might be inclined to splurge while sitting on huge profits, even if those profits are only on paper.

Some experts say that housing gains produce a wealth effect but stock market gains do not; others say the inverse is true. Regardless of whether it is caused by real estate or the stock market, the lesson from history is that investors should treat the wealth effect with caution, since spending unrealized gains that are susceptible to reversals is seldom a good idea.

Wealth Effect of Housing vs. Stock Market

One of the most widely cited papers on the comparative wealth effect of the stock market versus the housing market was written by economic luminaries Karl Case and Robert Shiller (developers of the Case-Shiller home price indices) and John Quigley. Their paper, “Comparing Wealth Effects: The Stock Market versus the Housing Market,” was first presented in July 2001. It was later updated in 2005, when it attracted widespread attention due to the housing boom then underway, and again in 2013.

Case, Shiller, and Quigley said their research for the period from 1982 to 1999 found “at best weak evidence” of a stock market wealth effect, but strong evidence that variations in housing market wealth have important effects on consumption.

They concluded that changes in housing prices should be considered to have a larger and more important impact than changes in equity prices in influencing consumption in the U.S. and other developed nations.

The Effect When Home Prices Decline

The authors updated their research in a new paper released in January 2013, in which they extended their study of wealth and consumer spending to a 37-year period, from 1975 to the second quarter of 2012.

Case, Shiller, and Quigley said that their extended data analysis showed that house price declines stimulate large and significant decreases in household spending.

Specifically, an increase in housing wealth similar to the rise between 2001 and 2005 boosted household spending by a total of about 4.3% over four years. However, a drop in housing wealth comparable to the decline between 2005 and 2009 would cause a spending drop of about 3.5%.

Wealth Effect Skeptics

In a June 2009 working paper, three American economists, Charles W. Calomiris of Columbia University, Stanley D. Longhofer, and William Miles of Wichita State University, argued that the wealth effect of housing has been overstated and that the reaction of consumption to housing wealth changes is probably very small.

Disputing the conclusions by Case, Shiller, and Quigley, the article said that the authors failed to take into account a “simultaneity problem,” which refers to the possibility that both consumption and housing prices are driven by changes in expected future income.

When the economists used statistical techniques on the data to correct the simultaneity problem, they found no housing wealth effect.

Wealth Effect and Home Equity

A housing wealth effect may be verified by the spending spree that millions of U.S. homeowners indulged in during the first decade of this millennium. These consumers weren't sitting on paper profits. They cashed them in by taking out home equity loans.

The consumption binge of the 1990s and early 2000s was fueled largely by equity extraction from residences. Homeowners essentially used their homes as automated teller machines (ATMs).

According to a 2007 study by the Board of Governors of the Federal Reserve, equity extracted from homes was used to finance an average of about $66 billion in spending from 1991 to 2005, or about 1% of total personal income expenditures (PCE). While equity extraction financed an average of 0.6% of total PCE from 1991 to 2000, that share rose to 1.68% from 2001 to 2005 as the prices of homes soared.

Mark Zandi, chief economist at Moody’s Analytics, estimates that before the 2008-09 financial crisis, every $1 increase in housing wealth produced $0.08 in extra spending, while every $1 in stock wealth gains boosted spending only by $0.03. Zandi estimates that in the 2013 slow-growth economy, the wealth effect of housing and stocks dropped to about $0.05 and $0.02, respectively.

Another report, this one by Visa, found that through the third quarter of 2022, the wealth effect nearly quadrupled: for every dollar in increased overall household wealth, spending increased $0.34. For security holdings, it was $0.24; for housing, it was $0.20.

How to Avoid the Wealth Effect

U.S. household wealth has reached a peak of almost $146 trillion in the second quarter of 2023, according to figures from the Federal Reserve Bank of St. Louis. With few exceptions (notably, the 2020 pandemic), it's more than doubled since the crisis of 2008-2009, when U.S. household wealth was about $56 trillion.

If you do not feel especially wealthy despite that stellar performance, you are not alone. Here are some pointers for coping with the temptations of the “wealth effect” on your personal financial health.

Focus on Wealth Creation

Your focus should be on building wealth during positive wealth effect periods and preserving wealth during negative wealth effect periods. But such wealth creation and preservation should be attempted in a measured manner, not by taking an inordinate degree of risk.

Avoid Aggressive Tactics When Markets Are Hot

Extracting equity from your home to spend on a vacation or to buy stocks is generally not a good idea.

As evidenced by the 2008-2009 financial crisis, paper profits have a disturbing tendency to disappear—in other words, prices go down as well as up.

Don't Be Swayed by Get-Rich-Quick Tales

Speculators who attempted to day trade stocks on a large scale in the late 1990s faced financial ruin when the market crashed in 2001-02. Real estate investors who snapped up multiple properties faced a similar fate when the U.S. real estate market endured its steepest correction since the Great Depression during 2008-2009. And some meme-stock traders of the early 2020s who were certain of a huge payout faced steep losses instead when retail investors' attention shifted and teetering companies went bankrupt.

Tune out the bragging by those who profess to have made it big by speculation, and refrain from using more leverage than your finances can comfortably handle.

Don’t Fight the Trend

The easiest way to create wealth is by staying with the trend. Being a contrarian can pay off sometimes, but if your timing is off you may have to bear sizeable losses.

As an example, short-sellers who were skeptical about the relentless advance in most U.S. stocks in 2013 and again in 2023 had little choice but to abandon their short positions after incurring huge losses.

Pay Attention to Wealth Preservation

Wealth creation is only half the equation; wealth preservation is the other half. If you are concerned about the possibility of an imminent steep correction in the markets, use trailing stops and options strategies to protect your gains.

Stay Attuned to Valuations and Signals

Asset valuations and other signals can provide an early warning of an impending turnaround in investor sentiment. While it is difficult or impossible to pinpoint market tops and bottoms, simple strategies like taking some money off the table when they hit record highs and adding quality companies at multi-year lows are sound tactics for wealth creation.

The Bottom Line

Although the wealth effect is at least partly a psychological perception, it has real-world impacts. Whether the effect is greater with a rise in home values or securities, the net result is an increase in consumption, which can boost the economy. Just take care not to spend more than you have—that is, not just what you have on paper.