Evidence debunking the "wealth effect."

Economists have often noted that housing prices and household consumption are closely synchronized. When the housing market does well, and home values appreciate, people tend around the same to increase their consumption of other things as well. Of course, this pattern prompts a key question (as our readers swift to parse the distinction between correlation and causation are probably already wondering): Do people buy more stuff because rising home values make them feel wealthier, or do they buy more stuff because consumption and home values are similar but unrelated signs of deeper changes in the economy?

Economists in fact have long theorized that the first scenario may be true, that people experience something called the "wealth effect" when assets that we already own (our homes, or stocks) increase in value. In theory, this makes us wealthier – or at least makes us feel wealthier – and as a result, we feel more comfortable going out and spending money (although the extent of the effect may vary). Based on this theory, economists often look to the housing market for signs about the outlook for other kinds of consumption, too.

A new study suggests, however, that we may have this relationship wrong. Researchers looking at 90,000 Danish households between 1985 and 2001 (a period that spans both ups and downs in the local housing market) found little statistical support for the theory when it was applied to actual people. Homeowners, particularly aged 45 and older, didn't appear to increase their consumption significantly as housing values went up (although some younger households did take out consumption loans based on their housing equity after a 1992 reform enabled them to). As the researchers write in The Economic Journal:

Controlling for factors related to competing explanations, we find little evidence of a housing wealth effect on consumption: unexpected innovations to house prices are uncorrelated with changes in total expenditure at the household level.

Admittedly, this study was conducted in Denmark prior to the most recent worldwide recession. It's also possible that whatever patterns homeowners exhibited pre-2007 may have changed during an economic collapse tied directly to the housing market. If homeowners ever had great confidence in the implied wealth of rising home values, more of them may now realize how quickly such value can disappear.

Top image: Andresr/Shutterstock

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