Where's the wealth effect?

April 21, 2011: 11:38 AM ET

Rising assets are supposed to create a feeling of confidence, which in turn leads to more spending. But neither higher stocks nor a rebound in home prices will likely have that effect this time.

FORTUNE -- Do people really spend more when they feel richer? Economists, including Federal Reserve Chairman Ben Bernanke, have often referred to the concept of the "wealth effect," saying that higher stock and home prices could eventually spur more consumption.

This has generally played out in recent history. But as the U.S. economy recovers from a deep recession, it remains to be seen whether a rise in asset prices will bump consumer spending as much as it once did.

consumption

This scene is not playing out in malls across the country.

In 2010, as companies reported better-than-expected earnings and the Federal Reserve pledged to buy up to an extra $600 billion in Treasuries to help stimulate the economy, the S&P 500 advanced 23% from its July low. The momentum continued in 2011, and the Dow Jones Industrial Average is now at its highest level in three years.

In defending the Fed's bond-purchasing plan late last year, Bernanke said that "higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion." The Fed is expected to announce next week that its quantitative easing program will end in June.

Stock prices certainly are higher. So where's the wealth effect?

The unfortunate reality is that most people haven't benefited from a rising stock market. As Barry Ritholtz has pointed out, 80% of American families have less than a 10% stake in the stock market -- only the wealthiest Americans invest heavily in 401k plans and retirement accounts.

To be sure, consumer spending has been inching back, with purchases increasing 0.7% in February following a 0.3% rise the prior month, according to the Commerce Department's latest report released in March. But the latest increases mostly reflect higher food and gas prices. And many analysts say high unemployment, although it's slowly improving, could continue to constrain consumer confidence.

It could be that home prices have a bigger wealth effect than stocks, as some economists argue. When prices surged in the late 1990s and early 2000s, consumption outpaced income growth, according to a report by the U.S. Congressional Budget Office. But since people spent more, they saved less. And during that period, the personal savings rate steadily dropped from 2.5% to negative 0.9%.

The overall wealth effect is relatively modest. The general rule of thumb is that a $1 rise in the price of a home generates two to five cents of additional spending annually, says David Backus, economics professor at New York University's Stern School of Business. Many expect home prices still have further to drop this year. But when they rebound, could this eventually lead to more consumption?

Before the collapse of the housing market in 2008, homeowners, particularly younger ones, commonly borrowed against their houses and spent the extra cash. But the idea of home ownership as an investment vehicle has been eroding, as millions find themselves stuck with mortgages worth more than the value of their homes.

"There's a question going forward if people are going to treat houses like piggy banks again," says William Miles, economics professor at Wichita State University, who studied the wealth effect. "It is perhaps questionable we will see as large a housing effect than in the past."

And maybe that's a good thing.

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Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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