Do consumers tend to spend more money when they have perceived notions of increased wealth? This developing theory has been defined by economists as “the wealth effect,” which is the simple notion that when consumers have more money, they spend more money. Economists, including Federal Reserve Chair Ben Bernanke, claim that higher stock and home prices will lead to an increase in consumer confidence, ultimately resulting in a rise in spending.
Increase in stocks
In 2010, the Federal Reserve launched a program called quantitative easing that promised to buy up to $600 billion in treasuries in order to boost the economy. In response to this program and businesses reporting better-than-expected earnings, the S&P 500 and the Dow Jones Industrial Average both experienced significant increases.
This surge continued well into 2011. According to the wealth effect, consumer spending should have also followed a similar trend, but it did not.
What was the problem?
According to reports, 80% of Americans invest less than 10% in the stock market. It is only the wealthiest of Americans that choose to heavily invest. Therefore, the program launched by the Federal Reserve resulting in an increase in stock prices had little to no effect on the average household.
Increase in housing?
So if higher stock prices can’t boost the economy, what about home investments? In the 1990s and early 2000s when the housing market was booming, many Americans took out mortgages in order to pocket extra spending cash. But since the housing market collapse in 2008 and the years subsequent to it, people have begun to realize their mortgages are often more than the value of their homes.
Rules created by the Dodd-Frank Act of 2010 enforced measures to prevent mortgage abuses. Lenders expect more regulations to be implemented in the near future.
In addition, most banks have tightened credit regulations that makes it virtually impossible for most homeowners to acquire new loans, making it even more difficult to people to enjoy the so-called wealth effect.
Implications
If housing isn’t going to stimulate the economy, it appears as though the wealth effect is entirely in the hands of the Federal Reserve. With plans to discontinue their quantitative easing program, the Federal Reserve may have no choice but to continue to pump money into stocks.
What are your thoughts?
Is the wealth effect fact or fiction?
Do you think the Federal Reserve should continue their stimulus program?
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