The Wealth Effect

This is one of those cool academic ideas that resonate with non-academics. If you’re an armchair economist you’ll nod and say, “oh yeah” when you read about it. I’m talking about the wealth effect. The wealth effect is the change in consumers’ attitude and spending behavior caused by the perception of increased wealth.

When a 10% tax hike to pay for the Vietnam War failed to slow consumer spending in 1968, economists attributed the behavior to the wealth effect. Disposable income actually fell, but paper wealth was rising sharply with the stock market, and consumers continued to spend.

We’re living through a good example right now. Most economists expected the January 1, 2013 2% tax hike from elimination of the temporary Social Security tax cut to reduce consumer spending because of reduced disposable income. It hasn’t, and the most likely cause is the current rebound in the housing market and the rise of stock prices; this may be leading consumers to feel more secure with their personal finances and ultimately spend more.

It’s important to note that the concept is that perception of increasing wealth trumps the reality of declining income. Don’t confuse the wealth effect with Alan Greenspan’s “irrational exuberance” which was fueled by a real increase in disposable income based largely on the housing bubble.

Of course, a rising stock market that goes on long enough should eventually lead to increased business confidence, hiring, falling unemployment, and a rise in disposable income. That would be great, because then we won’t be depending on perception, but on real prosperity.



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