The “wealth effect” is the most dangerous euphemism in economics
Economists look for correlations to infer causations for macro-economic events. Unfortunately, most macro economists fail to look at the individual incentives, the micro reasons, some events occur. What’s even more amazing, or amusing, is how much effort and study they put in to trying to understand these correlations without having the foggiest notion what they’re talking about.
The biggest misunderstanding in macro economics today centers around the idea of a “wealth effect.” Economists noted that people spend more money when asset values rise and less money when they don’t. Of course, times of rising asset values also correspond to times of general prosperity, so it’s difficult to identify what’s really causing people to spend more, the fact that their assets increased in value or that they just made more money.
Carl Case and Robert Shiller are pioneers in the study of the wealth effect. They noted that stock prices had little effect on people’s propensity to spend; however, house prices have a strong correlation to people’s spending habits. The conventional interpretation is that rising house prices make people feel more confident than rising stock prices, so rising house prices has a greater impact on people’s desire to spend. That interpretation is partially true because prior to the housing bubble, house prices had never gone down while stock prices had crashed repeatedly. A rising house price appeared more stable. However, that isn’t what’s really going on.
If stock prices go up, people don’t have ready access to that money. They would have to sell some of that stock and pay taxes on the gains in order to obtain the money. That’s work. That’s a hassle. That’s why the correlation between stock price gains and consumer spending is so weak.
If house prices go up, it’s a different story. When credit is loose, lenders will loan 100% of the value or more of a house with a HELOC or second mortgage. This gives homeowners immediate access to cash, and it doesn’t have any tax implications. That’s easy. That’s convenient. That’s why there is a strong correlation between house price gains and consumer spending.
There’s only one problem. It’s a Ponzi scheme! It’s theft! Remember, Neighbors stealing from neighbors: HELOCs make a comeback. Don’t let the euphemism, wealth effect, distract you from the more accurate dysphemism, Ponzi effect. The boost to the economy is real and quite visible. The economic instability and outright theft is hidden.
Perhaps we will get lucky this time around. If lenders keep prudent lending standards in place and don’t allow unlimited HELOCs at 100% LTV, we won’t be asked to bail the banks and their borrowers out again. If that happens, the “wealth effect” will be weaker than it was during the housing bubble.
Rising House Prices, Not Stocks, Make People Feel Wealthy
As a key influence on households’ spending decisions, the health of the housing sector trumps stock-market moves, a paper released this week by the National Bureau for Economic Research claims.
The study, written by prominent economists Karl Case, John Quigley and Robert Shiller, refines their existing study of what is called the wealth effect. Case and Shiller are well known names, especially on housing issues. Quigley, another luminary, died in May, before the research’s publication.
Most economists and policymakers agree asset price gains can be big drivers of consumer spending power. Rising home or stock prices are generally agreed to increase consumer spending, while falling asset prices cut the other way.
If most economists agree, then it’s probably wrong. Rising asset prices only contribute to consumer spending if they sell the asset and covert it to cash or if they borrow against it. Nobody takes a look at their stock portfolio and decides to deplete their cash savings to buy a car because their stocks went up.
That said, economists and policymakers have had a hard time quantifying the wealth effect.
That’s because it’s an illusion created in their own minds.
That’s problematic for many reasons, but it’s even more so due to the fact that the housing market’s crash and apparent recovery are considered central to the overall fate of the economy.
To that end, the Federal Reserve is pursing a policy course deliberately aimed at driving up all manner of asset prices in hopes its actions will boost household spending to power better overall growth.
OMG! The wealth effect is now being used as justification for the federal reserve inflating asset bubbles in all asset classes. Amazing!
In the paper, the economists update their decade-old work, drawing on a wider and more up-to-date set of data ranging from 1975 to the second quarter of 2012. The broader information changes and clarifies what was once thought about the wealth effect’s influence.
There is “at best weak evidence of a link between stock market wealth and consumption,” the economists wrote.
In other words, when their is no direct way to spend the increase in value, there is no increase in consumption. The wealth effect is not real.
“In contrast, we do find strong evidence that variations in housing market wealth have important effects upon consumption,” they said.
“An increase in real housing wealth comparable to the rise between 2001 and 2005 would, over the four years, push up household spending by a total of about 4.3%,” the paper stated. Meanwhile, “a decrease in real housing wealth comparable to the crash which took place between 2005 and 2009 would lead to a drop of about 3.5%.”
As with any Ponzi scheme, it works great while its inflating, but when it’s deflating, not so much. This is the best evidence available that housing finance is a Ponzi scheme, assuming anyone is willing to consider the truth revealed in the data.
This finding upends the old understanding that housing gains tended to push spending higher by a wider margin that home price declines depressed spending, the economists wrote.
The Ponzi effect was more pronounced during the housing bubble because the behavior was much more widespread. Lenders actually encouraged Ponzi borrowing and made it very easy for anyone with a house to obtain all the free money they wanted.
The paper’s conclusion provides some additional hope that a nascent housing sector recovery could in fact be a meaningful contributor to a broader acceleration in growth over coming years.
WTF? This is where people really don’t get it. Should we hope for another massive Ponzi scheme requiring bailouts for bankers and loanowners alike? People are looking for the short-term visible effect without considering the long-term hidden impact of mortgage equity withdrawal.
It may also explain why even as the stock market has scored strong gains in recent years on the back of extremely aggressive monetary policy, growth to date has been so middling and disconnected from the story told by equities.
A note from Deutsche Bank sees housing contributing strongly to a better economy. “The wealth effect on consumer spending could be substantial” this year, the bank told clients.
Remember to short Deutsche Bank stocks after the underwrite a bunch of HELOCs this year… Oh wait, I forgot, they are too-big-to-fail.
“We are projecting home price appreciation of 5-10% in 2013, which translates into a further increase in household assets, i.e. wealth creation, ranging between $860 billion and $1.720 trillion.”
“Through its direct and indirect effects, the housing sector alone could potentially contribute as much as 2% to real GDP growth this year,” Deutsche said.
I would like to see homebuilding recover for professional reasons, but if that means we will see more Ponzi borrowing on HELOCs, I’d prefer a continued recession. The “wealth effect” is the most dangerous euphemism in economics.