The wealth effect is the economic phenomenon in which individuals spend more when stock prices increase and, as a result, equity portfolios are increasing in value. They do so because their sense of the reliability of their wealth is increasing. Thus, increases in consumer spending are directly correlated to increases in the value of stock portfolios.
The period (typically running a few months or years at most) during which asset prices are consistently rising and, as a result, portfolio values increase is known as a bull market.
To visually encapsulate this fairly simple idea:
|Perceived wealth||Level of consumption|
Why Does the Wealth Effect Occur?
The Wealth Effect happens for psychological reasons. Consumers view themselves as more wealthy when their portfolios increase in value.
In other words, increases in the value of their assets causes consumers to feel more comfortable spending their money. Mentally, they conflate their increased net worth with an increase in their overall income, which predisposes them to spend more money, perhaps on unnecessary items like luxury goods.
Effects of a change in wealth
When the wealth of an individual or household increases, the following results are likely to occur:
- Higher incomes from interest, rent, or dividends may result from greater wealth.
- It becomes easier to withdraw equity from one’s home via mortgage equity withdrawal, as well as to remortgage one’s home.
- The savings ratio (that is, the ratio of savings to disposable income) decreases. This is because, as their perception of their own wealth grows, people become more comfortable taking financial risks, spending their income, and borrowing money.
- Rising house prices are likely to make banks more inclined to lend mortgages.
- Governments that tax wealth will experience greater tax revenue.
Why the Wealth Effect Matters
Historically, during bull markets (defined in the first section of this piece), raising taxes and interest rates have not impacted the volume of consumer spending. The phenomenon is sometimes theorized as the cause of this surprising reality.
The Validity of the Wealth Effect Theory
The wealth effect is not a universally accepted concept. As some experts point out, the idea is not always backed up by data. For instance, to paraphrase David Backus (New York University professor of economics and finance): while the late 1990s stock market boom caused an increase in wealth, consumption was unaffected by this economic environment.
Although the wealth effect would predict such effects, consumption did not increase before the stock market reversed itself; likewise, it did not decrease once the stock market reversed.
Effect On the Housing and Stock Market
Additionally, some economists note that housing gains can create a wealth effect, while stock market gains will not. According to economists Karl Case, Robert Shiller, and John Quigley, there is little evidence of a wealth effect created by the stock market, but “a statistically significant and rather large effect of housing wealth upon household consumption.”