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The wealth effect is a psychological bias resulting in a change in our spending behaviour, as a result of a perceived change in wealth. The wealth effect theory states that when house prices or equity markets go up, households feel more wealthy and spend more. Awareness of this bias can help individuals curb increasing discretionary spending faster than income rises.
Consumer Consumption and the Economy
Consumer consumption is a measure of household spending on goods and services.
Even a small decrease in consumer spending can lead to economic damage. Governments are therefore motivated to stimulate consumer consumption during economic downturns. During the COVID-19 economic downturn, this translated to rock bottom interest rates, Job Keeper, Jobseeker and a range of home buyer/builder grants.
The effect of consumer consumption on the national economy also means it has been studied, producing interesting data individuals can use to improve their own financial behaviour.
High rates of consumer consumption on top of record low-interest rates are a recipe for a booming economy. But it never lasts forever. When the economy turns again, and asset values fall, households can end up in excessive debt or even negative equity.
An increase in your home value is not realised unless you sell it. Similarly with gains in your superannuation or stock portfolio. Yet increases in these values, even if the money is not accessible, seems to affect household consumption.
Evidence for the Wealth Effect
Case, Quigley and Shiller studied the effect of changing property values on household spending. Between 1975 and 2012 they observed an increase in home values resulted in increased consumer consumption. A reduction in home values led to a decrease in spending.
Increases in the stock market value have also been linked to increased household spending in the US.
Most recently, an RBA analysis of Australian data suggested that a 1% increase in property value in Australia will cause a 0.16% increase in household consumption. Changes in house values result in larger and faster increases in consumption than financial wealth.
When housing values increase, we spend more and the savings ratio decreases. During economic downturns, with falling house values (and fear) such as during the GFC or COVID 19, national savings ratios increase.
Increased spending due to increased household paper wealth, despite stagnant income occur because:
- Of a psychological bias. Households feel wealthier and so tend to spend more.
- The ability to borrow based on increasing asset values. Households can borrow to upgrade their home or purchase a car.
- Housing transactions tend to increase (related to increased borrowing power), which leads to further consumption through employment of property transaction professionals, home renovations and purchase of furnishings.
Change and Make up of Household Wealth
Thanks to Fidelity‘s recent paper on household wealth we can see that home values have disproportionately grown Australian’s wealth over the past 20 years.
Many Australian’s are “House rich, cash poor”. Unless retirees move to a significantly cheaper property, this equity often remains trapped inside their homes.
Consequences of the Wealth Effect
“When household wealth grows strongly, consumption typically grows faster than household income and the saving ratio tends to decline. “RBA Bulletin 2019
It seems as soon as there is an increase in house values, we are pretty quick to start spending. The majority of spending occurs on household furnishings and vehicles.
The change in supply-demand inevitably leads to inflation in the products or services in demand. The effects are obvious to anyone in current times.
Friends are trying to purchase new cars but are on 6-month waiting lists. Production shortages of semiconductors compound the demand-supply balance. The effect trickles down. Used car prices have increased by over 30% in four months.
The massive demand to improve our homes after experiencing lockdown will inevitably be increasing costs to renovate or build in 2021.
If you weren’t convinced already, the ABS has given us yet another reason not to smoke!
Looking further down the list, the increases in the price of meat, household appliances, furniture and motor vehicles are all over 5% in just 12 months. Indulging in the wealth effect by spending on these items with the rest of the herd is super expensive!
House value increases are not steady each year. Some years (likely 2021) will provide incredible growth. There may be years where there is no growth or even a decrease in value. Spending $30,000 on a new car because your house increased $60,000 this year doesn’t really make a lot of sense.
How Individuals Can Use Understanding of the Wealth effect
As with most financial decisions, running with the herd is rarely the best choice. Making counter-cyclical decisions often works well in personal finance, as well as investing.
There are three main ways individuals use their understanding of the wealth effect to get ahead.
1. Stick to your Financial Plan
Recognise what is happening when you get over-excited about your home value increasing. Or all your friends are buying new cars, and you start to consider doing the same.
Refer back to your financial plan, and stick to it.
Avoiding emotional financial decisions is important in good times and bad.
Timing for that new car, house upgrade or renovation should be according to your financial plan.
Remember, your big increase in home value this year may be followed by years of no (or even negative) growth. Try not to waste your home equity on depreciating assets, it has far better potential uses.
2. Delay Consumer Consumption Until There is an Increase in Supply
Whenever there is too much demand for available supply, prices increase.
This provides motivation for existing suppliers to increase production and for new suppliers to pop up.
Often this will eventually lead to an oversupply, or demand will reduce (or both).
Once supply exceeds demand, prices will reduce and it becomes a “Buyers market”. Whatever you are buying, this is ideally the sort of conditions you want to be buying in.
If you have plans to purchase a car, upgrade your house, buy furnishings or household goods if possible delay until the demand drops and supply increases. This will also help the impulse to purchase contrary to your financial plan pass.
3. Avoid Over Leveraging
Interest rates can’t stay this low forever.
Our economy is doing far better than predicted. Border lockdowns will, fingers crossed, eventually become a thing of the past.
The RBA aims to keep inflation at 2-3% long-term, and uses interest rates as a tool to manipulate inflation.
If you are buying a new property, or borrowing to renovate, make sure you have done the maths. Don’t rely on the banks (they don’t have your best interests as their number one priority!)
Check you will cope with mortgage repayments when interest rates rise. Fixed rates offer short-term security but you need to be able to confident you will cope with the repayments when the fixed rate ends.
What rates you calculate up to depends on your risk profile. For me, a 6% rate seems reasonably conservative. Note the variation in home loan interest rates over time.
Your wealth accumulation journey starts as soon as you make the first step. Subscribe to Aussie doc for a weekly email to keep you up to date on track to your goals.
Aussie Doc Freedom is not a financial adviser and does not offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.