Housing Prices Sheltered Consumers
from Reverse Wealth Effect

In prior issues we've noted that much of the consumption boom (and low savings rate) of the late 1990s was driven by rising household wealth resulting from soaring stock markets. The positive wealth effect from rising stock prices all but eliminated the aggregate desire of the household sector to save out of current income. Households were wealthier, and felt it. That ended abruptly in early 2000 and U.S. households subsequently lost over $4 trillion in net worth because of falling equity prices. Many economists have been forecasting an inevitable adjustment in the household sector as consumers ratchet up their savings rate out of income to compensate for the market-induced reduction in their wealth. But, two years after the market's sharp decline, it still hasn't happened.

Now, a recent study for the National Bureau of Economic Research suggests why. Economists Karl Case, John Quigley and Robert Shiller found that the macroeconomic wealth effect associated with rising residential real estate values has been seriously underestimated. An analysis of data from 14 countries plus the U.S. suggests that the housing market appears to be "far more important than the stock market in influencing consumption," both in the U.S. and other countries.

The authors speculate that one reason may be that while three-quarters of all stocks are owned by just 10% of U.S. households, more than two-thirds of U.S. households own their homes. For many households, their home is their most valuable asset. Moreover, credit markets have made it relatively easy to tap the value of that asset through refinancing and home equity loans, the proceeds of which can finance additional spending.

There are two direct implications of a strong wealth effect associated with residential real estate values. First, the worries of some forecasters that consumers will hold back in the early stages of this recovery because of the hangover from decline in equity markets may be overblown. Second, so long as housing prices continue to rise, or even plateau, there is reason for optimism for continued strength in consumer spending.