House Prices and the Wealth Effect - Essay Example

House Prices and the Wealth Effect Real estate as a business has links to so many other industries in the economy. A slight change in the real estate market results to a visible change in the economy since a change in housing prices affects consumer spending behavior. A rise in house prices increase wealth effect by affecting the amount one is willing to spend in their lifetimes (The Economist, “House prices and the” 2). This amount is inclusive of how much one will be willing to spend on hiring labor as well as provide labor. Such knowledge is the theory behind policy making in housing wealth. In a typical household, shares accounts for a relatively smaller proportion of average assets while housing takes the huge proportion. People will rather invest in housing that has moderate rises in price compared to the stock market that has sharp unpredictable prizes. Home values are thus more evenly distributed that financial related wealth that is spread among the rich whose spending has less effect to changing waves. Change in house prices thus present much higher effect to many people than change in share prices (Case, Quigley, & Shiller 3). However, this is not true across all economies. The influence of financial assets is much greater than that of housing wealth in Britain than in America because of Britain having refined instruments through which money is spent. In America, weakness in wealth effect on consumption was expected to reduce spending but the opposite happened. As more Americans became poor from the fallen share prices, spending grew considerably hence helping America avoids getting into recession. Housing prices instead went higher thus squaring out the effect of fallen stock prices. However, empty homes and increased unemployment have indicated that consumer spending is driven by real earnings that influence projections of earnings from stocks, property, and bonds. Thus fallen asset values that cause investors to spend less and the rest are put to savings (The Economist, “A housing slump helped” 1). For example in US in 2004, an increase in wealth by $1 caused an increase in spending between 1 and 7 cents. This translated to 0.0375 wealth effect for a model that assumed equal effect between housing and financial assets. The policy makers consider housing wealth as having similar effect as financial wealth in micro economics sense. However, some people have already established fault in such conclusion. They argue that increase in price of property increase cost on housing. This means that the aggregate gains through increased property prices is thus smaller compared to that of increased share prices. The effect on housing wealth to the economy is thus smaller compared to financial wealth (The Economist, “How much does housing” 2). On the contrary, another group of economists estimate that financial wealth has less effect on the economy in relation to housing wealth. For example, it is estimated that a $100 increase in house prices increase spending by $9 while a similar increase in shares increase spending by $4 (The Economist, “The “wealth effect”” 2. This imply that, wealth effect from housing is more significant compared to the effect from shares since it affects asset prices by increasing the price margins. The difference between wealth effect and shares is therefore a product of the value of shares comparative to housings. According to The Economist (“How much does housing” 1), fall in housing prices have sharp effects on consumer spending behavior. Like every other type of wealth such as shares, financial prosperity is aided by increase or decrease in prices. Increase in prices increase spending by a similar rate of increase and decrease will be an effect of slumped prices. Though the effect on consumer spending could be spread over time, the change could be smaller but gradual. However, some arguments have tried to demystify wealth effect caused by fluctuating prices in houses as assets. This is measured by how much people are willing to spend on housing than they will be willing to spend on other investments. Some economist argues that increased earnings projections from housing business could increase consumer spending behavior now without necessarily being influenced by housing wealth. This implies that, housing wealth has less influence on consumer behavior compared to equity wealth. Nonetheless, even the slightest effect has visible results in the general wealth index in the economy. The slightest change in house prices increase consumption through wealth effect. Whether consumer behavior is influenced by wealth effect or equity wealth, the behavior determine the possibility of a country going to recession. Changes in wealth either through shares or housing directs rational consumer in the long-term spending response (The Economist, “How much does housing” 2). Wealth distribution has caused many people to own homes than financial assts. The home owners attach house value to spending thus placing housing wealth as a better influence to consumer spending compared to financial assets. However, this effect is more during recession as asset prices decline with every increase in recession. During the Great recession, asset prices mostly house and stock prices fell considerably thus causing loss of wealth for a considerable number of American’s households. However, the magnitude of the loss varied as different households had different wealth composition. For example, households whose major investment was in stocks in Las Vegas, suffered great wealth loss compared to a household in Dallas whose assets were in the bank. It is estimated that during recession middle-aged and older households suffer more from fallen house prices than the younger households. Housing prices were favorable to renting families that could upgrade to buy houses at cheaper prices. This was different from old home owners who had to sell assets at lower prices. Younger households who rarely have savings could not afford buying houses either since during recession, getting loans become even more difficult (The Economist, “Most new borrowing” 5). Prices on financial assets also fell significantly. However, richer households invested more in stocks and homes with the hope to make more money after recession when prices will go up. For example among the 20% wealthy households, 97% of them are home owners and thy accumulate $183,000 worth of stock when the rest accumulate $1,000 with a remaining 3% home ownership. This wealth distribution when argued with generation presents a younger generations as more spenders than older generations during recessions. While younger households with savings own houses instead of stocks, the older households offset their stocks as a way of reducing risks on assets. The average drop in value of the stocks was consistent with the stock market index drop. For households who waited for the stocks and house values to recover however minimized the damage caused by the slump (Nakajima 26). References Case, Karl E., Quigley, John M., & Shiller, Robert J., “Comparing wealth effects: The stock market versus the housing market.” NBER working paper series. Web. January 2013. Nakajima, Makoto. “The diverse impacts of the great recession.” Philadelphiafed.org. Web. The Economist. “A housing slump helped cause the credit crisis. But its effect on spending may have been exaggerated.” The Economist. Web. 7Th August 2008. The Economist, “House prices and the wealth effect: Home discomforts” The economist. Web. July, 2009. The Economist, “How much does housing wealth boost consumer spending” The Economist. Web. 12th October 2006. The Economist. “Most new borrowing during America’s housing boom was for spending.” The Economist. Web. 3rd Sep 2009. The Economist. “The “wealth effect” may be stronger in housing markets than in stock markets.” The Economist. Web. 8th November 2001. Read More