The Price of Homes and the Wealth Effect

As defined by Wikipedia the wealth effect is:  The wealth effect is an economic term, referring to an increase (decrease) in spending that accompanies an increase (decrease) in perceived wealth.  

What drives the wealth effect?  Here is where things breakdown.  For a long period of time people thought it was home prices, equity prices, etc., but largely equity prices (asset prices in general).  Recent research by Karl Case and Robert Shiller, the guys that the developed the Case-Shiller index, indicates that it is largely driven the perceived value of the consumer's home.

As a key influence on households' spending decisions, the health of the housing sector trumps stock market moves, a paper released this week by the National Bureau for Economic Research claims.

The study, written by prominent economists Karl Case, John Quigley and Robert Shiller, refines their existing study of what is called the wealth effect. Case and Shiller are well known names, especially on housing issues. Quigley, another luminary, died in May, before the research's publication.

Most economists and policymakers agree asset price gains can be big drivers of consumer spending power. Rising home or stock prices are generally agreed to increase consumer spending, while falling asset prices cut the other way.

That said, economists and policymakers have had a hard time quantifying the wealth effect. That's problematic for many reasons, but it's even more so due to the fact that the housing market's crash and apparent recovery are considered central to the overall fate of the economy. To that end, the Federal Reserve is pursing a policy course deliberately aimed at driving up all manner of asset prices in hopes its actions will boost household spending to power better overall growth.

In the paper, the economists update their decade-old work, drawing on a wider and more up-to-date set of data ranging from 1975 to the second quarter of 2012. The broader information changes and clarifies what was once thought about the wealth effect's influence.

There is "at best weak evidence of a link between stock market wealth and consumption," the economists wrote. "In contrast, we do find strong evidence that variations in housing market wealth have important effects upon consumption," they said.

"An increase in real housing wealth comparable to the rise between 2001 and 2005 would, over the four years, push up household spending by a total of about 4.3%," the paper stated. Meanwhile, "a decrease in real housing wealth comparable to the crash which took place between 2005 and 2009 would lead to a drop of about 3.5%."

This finding upends the old understanding that housing gains tended to push spending higher by a wider margin that home price declines depressed spending, the economists wrote.

The paper's conclusion provides some additional hope that a nascent housing sector recovery could in fact be a meaningful contributor to a broader acceleration in growth over coming years. It may also explain why even as the stock market has scored strong gains in recent years on the back of extremely aggressive monetary policy, growth to date has been so middling and disconnected from the story told by equities.

A note from Deutsche Bank sees housing contributing strongly to a better economy. "The wealth effect on consumer spending could be substantial" this year, the bank told clients. "We are projecting home price appreciation of 5-10% in 2013, which translates into a further increase in household assets, i.e. wealth creation, ranging between $860 billion and $1.720 trillion."

"Through its direct and indirect effects, the housing sector alone could potentially contribute as much as 2% to real GDP growth this year," Deutsche said.