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'More financially secure': The 'wealth effect' explained

·Finance reporter
·6-min read
Boats and residential waterfront apartments.
There's a theory that as asset prices rise, consumers start spending more money. (Source: Getty)

Stock markets around the world have enjoyed steady rises into the green throughout 2021 - and it's leading to increased spending from consumers.

The ASX 200 has risen 9 per cent over the course of this year, London's FTSE 100 is up about 11 per cent and the Dow Jones Industrial Average - which tracks 30 of the US's top businesses, has gained 18 per cent.

And these stock market gains, coupled with global increases in house prices, are leading to increased consumer spending.

Unsurprisingly, consumer spending in Australia has been on a steady increase for decades and, after a significant fall in July last year due to the pandemic, spending is now almost back at pre-pandemic levels.

A graph showing how consumer spending fell sharply in July, 2020.
Consumer spending fell off sharply in 2020, but has since increased to pre-pandemic levels. (Source: Trading Economics)

Renewed consumer confidence has also led to an uptick in the consumer price index (CPI), which measures household inflation and includes statistics about price changes for categories of household expenditure.

In the three months to September, CPI rose by 0.8 per cent, which also led to an increase in bond yields and talk that the Reserve Bank of Australia (RBA) may increase interest rates for the first time in 11 years.

The increase in consumer spending in the context of rising asset prices has been studied as a psychological phenomenon known as the 'wealth effect'.

What is the 'wealth effect'?

The wealth effect is an economic concept and psychological phenomenon that refers to a change in consumer spending patterns following a rise in the value of unrealised assets such as a stock portfolio, business or home. 

The idea behind it is that consumers feel more confident about their financial wealth when the value of their assets has risen - even if there has been no increase in their earnings, reduction in debt or change to regular costs.

And it makes sense. [A quick personal anecdote from your author: I have been investing some of my savings using the Raiz platform and have seen a 9 per cent increase in my portfolio this year. I feel richer, as the value of my stock portfolio has increased, even though technically that money is not sitting in my own bank account.]

An unrealised asset is an asset you own that has yet to result in you receiving actual money. Your house, for example, can increase in value, but the asset is not realised until you sell it and the money hits your bank account.

How does the wealth effect work?

Researchers have studied the wealth effect for years, seeking to understand if it is a real phenomenon or simply an esoteric economic phrase.

One study published in the National Bureau of Economic Research (NBER), for example, found that for every dollar of increased stock market wealth, consumer spending rose by 2.8 cents per year.

Men wearing protective mask walk near an electronic stock board showing Japan's Nikkei.
Rising stock market prices may make you more likely to splash that cash. (Source: AP)

"The researchers find that in addition to greater consumer spending, a rise in a country's stock market wealth is associated with increases in local employment and payrolls," the paper says. 

"Consistent with economic theory, they find that both employment and payrolls go up in non-tradable industries, but that there is no response of employment in tradable industries. They also find that the residential construction sector is highly responsive to rising stock market wealth."

For its part, the RBA conducted a study in 2019, which found a "positive and stable relationship between household wealth and consumption, largely reflecting changes in spending on motor vehicles, durable goods and other discretionary spending ... increases in household wealth also supported household spending". 

"Many categories of consumption expenditure appear to grow more quickly when wealth increases," the study says. 

"The positive relationship between consumption and wealth is particularly robust for housing wealth and has been stable over time."

Does everyone believe in it?

No. The wealth effect has its fair share of critics.

Three leading US economists, Charles Calomiris, Stanley Longhofer and William Miles, have argued that the wealth effect is overstated, particularly when it comes to the housing market, and that any increase in spending is relatively minor; which backs up the 2.8-cent increase found by the NBER.

The RBA itself has been sceptical about the existence of the wealth effect, and many critics argue the inverse - higher consumer spending leading to an increase in asset values - is more likely. 

Most commentators agree that increased consumer spending is a likely impact of rising house prices, but cast doubt on whether stock market gains lead to more money being spent.

An aerial view of a residential block under construction in China's Nanning city.
A booming housing market has been shown to lead to increased consumer confidence. (Source: Getty)

Which makes sense. Though stock markets generally rise - albeit slowly - over time, they are more fickle than house prices, which, as any millennial could tell you, seem to be on an inexorable increase.

What's predicted to happen in the near future?

Unsurprisingly, consumer spending is expected to increase.

A report produced this year by Deloitte forecast that consumer spending would grow strongly into 2022, assisting Australia's economic recovery post-COVID.

“Spending options have been limited and, with many households having cash to burn, consumers flocked to retail," Deloitte partner David Rumbens said.

"This has supported what is likely to be the strongest gain in retail spending in a decade.

“Australian consumers have more options for spending with the easing of restrictions and a need for social contact is supporting eating out and other activities at the expense of other retail spending.

"The war chest of savings built up for many over the past six months is starting to be drawn down, providing some buffer for household spending. These savings will certainly play a pivotal role in supporting spending going forward.

“The signs so far are that consumers are willing and able to play their part in Australia’s economic recovery, but the hit to disposable income, limited population growth and the ongoing vaccine rollout place some risks on that growth for 2021-22.”

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