Debunking the "Wealth Effect."

The conventional wisdom debunked.
June 10 2008 1:06 PM

Debunking the "Wealth Effect"

Declining house prices don't necessarily slow down consumer spending.

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Extrapolate that to the economy as a whole. Since its peak of just over $20 trillion in the fall of 2007, the value of Americans' household real estate has fallen by $525 billion, or about 2 percent, according to the Fed. Following the estimates from the CBO's report, a 2 percent decline in housing prices reduces GDP growth by between one-tenth and one-half of a percentage point—which is not nothing but also not enough to push the economy into recession in the first quarter, even combined with record-breaking energy prices and rising unemployment.

Backus questions even the CBO's modest estimates, calling the economic impact of the decline in housing values "too small to identify with much precision, given how many other things are going on."

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The wealth effect fallacy helps explain how, on the same day the Fed reported a second quarter of falling wealth, chain store retailers last Thursday reported stronger-than-expected sales in May. Some credited federal rebate checks for keeping spending growing, but the fact is that except for cars and gas, month-on-month same-store chain retail sales have grown throughout 2008 as home equity has fallen. Levkovich says that rising energy costs and poor job growth play a much bigger role in determining spending than personal housing wealth.

Falling home prices will continue to be a political issue this year, especially as Americans judge the respective proposals of John McCain and Barack Obama to help homeowners stranded by mortgages they can no longer afford. But those falling prices don't automatically mean we're in for economic payback—however ominous the headlines. As Backus says, "It's a better story if there's a disaster on the horizon."

Christopher Flavelle reports for ProPublica, the nonprofit investigative newsroom in New York City. He is Canadian.