Will the negative wealth effect, from falling home values,
lead to less consumption growth?
Yes, and with a slow recovery in income growth, the result is a drawn out
overall recovery
Feb. 27, 2012
Kengo Tahara
Economist
Japan Center for Economic Research

The housing market collapse in the U.S. has not only stalled the real estate,
construction and related industries, but also further contributed to restrained
consumers’ expenditures. Four factors are holding down consumption growth. First,the population is increasing more slowly, and the average age is rising. Slowedpopulation growth in an aging population would alone mean less consumption growth
post-recession. But that is not the only factor. The second important driver is therenewed interest in building up savings and paying down debt. The result is that lessof the income dollar is spent, more is saved. And third, income is rising slowly, a trend
unlikely to change over the next few years. Job growth has improved but the new jobs
typically pay less than the job the current unemployed used to perform. In all, fewer
young people, with a slower earner path, or saving more money. Therefore,consumer demand is and likely will continue to rise slowly. But there is one more
important factor.
Across the United States, home values are approximately one-third lower in 2012 thanthey were before the housing market started to collapse in the second half of 2006.
Obviously, some families in certain metro areas (like Las Vegas or Phoenix or Fort
Myers Florida) have suffered even greater loss in home equity.
Household income is of course the most important determinant of household
consumption. But it is widely recognized that the value of assets also plays a role inaffecting household consumption. When the value of assets increases by price increaseof stocks or homes for instance, households tend to spend more even if their current
income flows are unchanged. This is called the wealth effect. The households increase
their expenditures by either liquidating some of the increased assets, or by reducing theamount of saving for the future (or borrowing more).
Two thirds of American households own their own residence, a higher proportion thanis typical among developed economies. For many if not most, the equity in their home
is their biggest and most important investment. The result is that real estate holdings by
the household sector is a bigger share of total household assets than one finds in other

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countries, roughly one third of all household assets. And therefore, losing a third of thevalue of these real estate holdings represents a very significant hit on total household
wealth.
Non-real estate holdings by the household sector generally consist of bonds and stocks,in that order. And most of these holdings are in the form of mutual funds, in various
retirement or trust funds. In fact, while two thirds own their own home, not more than
2 in ten households own stock directly, according to the Survey of Consumer Finances(2007) conducted by Federal Reserve Board.
The value of homes generally rose every year in the last half century. Indeed, the rateof increase picked up in the 1990’s. Many economists assumed that consumer
spending was positively influenced by the rise in value. Some went as far assuggesting refinancing families were treating home equity like an ATM. Researchshows that housing wealth elasticity tends to range between 0.03-to-0.18. And that is alarger reaction than a change in the value of other assets, generally speaking. But overthe past half decade, home values suffered very sizable declines, perhaps reversing thewealth effect on consumption. Indeed, in a recent speech, Federal Reserve Chairman
Bernanke suggested consumer spending could be as much a $200 billion–to-$375
billion lower per year, as consumers react to the loss of equity in their homes(depending of course on the actual loss in value for a specific family — implying somefamilies cut back even more).
This is a big number, perhaps 2 percent of total
consumption per year. Another 3-to-5 percent of income is being saved. Finally,
consumption represents two-thirds of total economic activity. Therefore, the observed
wealth effect is a very important determinant in the current economic environment.
Still, there are those who argue that the wealth effect is being overestimated. This
argument generally suggests that only discretionary spending is affected. For example,
what a family spends per week on groceries is not really impacted by a rise or drop inhousehold wealth. Buying a new car instead of a used car, and which model, could
be affected by a change in wealth. Whether one agrees that the observed wealtheffect in the current economic environment is large or overstated, no one would disputethat it is not just current purchasing that is impacted.
Saving is held in financial assets. Saving is also, according to economic theory,deferred consumption. The assets therefore are meant to be cashed in someday, to pay
for children’s college or marriage or for retirement and the like. A change in asset
values therefore has to change plans and expectations. A drop of as much as one third
in the most important class of assets has to have a big impact on future plans. And thatin turn impacts current expectations, which in turn impacts short term spending andhttp://www.jcer.or.jp/－ 2 －Japan Center for Economic ResearchFeb/27/2012

saving patterns. Perhaps the argument then is whether the wealth effect is very large(as much as 2 percent) or whether the secondary impart on plans and expectations
results in a change that large. This might all sound academic. It is anything but tomarketing analysts.
The last point to make is that many observe housing finally reaching a bottom in 2012,in terms of both home construction and therefore home values. If the value of homes
starts to recover, will the wealth effect, direct or indirect, drive up consumption rates?
To be sure, the price, production recovery of housing and related activity (such asfurniture and appliance production and sales) all play key roles in the economy. But
there is one more even important factor. Fundamental attitudes and expectation do notchange quickly under any set of circumstances. A big switch from significant andlong-term declines, to the beginning of some recovery is unlikely to rapidly drive up
wealth and therefore a positive and significant wealth effect. Rather, something more
gradual can be expected, and perhaps only after some delay. Put another way,consumers need to be reassured the losses are over and the recovery in value is real.
This does not happen overnight.

Kengo Tahara is an economist in Japan Center for Economic Research(JCER). He
joined JCER in 2008 after receiving a master's degree and completing the course
requirement for the doctoral program in agricultural economics from the University ofTokyo. For the last three years he specialized in business forecast for Japan's
economy. He has worked as an economic intern at the Conference Board in U.S. sinceJune 2011.
Figure 1:
The percentage of families holding stocks and houses andthe average value of holdings by income class
100%
90%
80%
70%
60%
50%
40%
30%
20%10%0%stocks (indirect holdings)
stocks (direct holdings)

900 $ thousandstocks (indirect holdings)
800
stocks (direct holdings)
700

residential property

residential property

600
500
400
300
200
100
00‐20

20‐40

40‐60

60‐80

80‐90 90‐100
percentile of income

0‐20

Source: FRB "Survey of Consumer Finances (2007)"

20‐40

40‐60

60‐80

80‐90 90‐100
percentile of income

Source: FRB "Survey of Consumer Finances(2007)"

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