When house prices or share markets rise strongly, people feel richer. Some of them change how they behave. They might cut back on regular saving, take a holiday they had postponed, renovate the kitchen, buy a new car, or borrow against their home to fund spending. Economists call these responses wealth effects.
Wealth effects matter far beyond the households involved. They shape demand for countless businesses, from builders and car dealers to restaurants and travel agents. They influence how fast the economy grows and how central banks set interest rates. And because they depend on asset prices, they can reverse sharply when a boom ends, taking demand away from businesses that had come to rely on it.
This article explains how wealth effects work, why their impact on spending is often temporary, how borrowing against assets amplifies them, why they create a trap for policymakers, and what businesses can learn from them. It is part of GoCore’s series on bubbles.
How people respond to rising wealth
Small movements in asset prices usually make little difference to behaviour. But if the rise in wealth is large enough, then after a while some people change what they do.
The responses vary:
- Spending more from income. A household that feels wealthier may reduce its regular saving and spend more of its income, perhaps dining out more often or upgrading purchases.
- Selling assets to spend. Investors may take some profits and use the proceeds for a car, a boat, travel or home improvements.
- Borrowing against assets. Homeowners may increase their mortgage to fund a renovation, an extension or other spending.
- Buying more assets. Some respond by buying a second property or more shares, often using borrowed money.
- Reducing debt. More cautious people may sell some assets to pay off loans, reducing their risk.
Is spending gains foolish?
It is tempting to see spending gains as short-sighted. But it can be perfectly rational. Many people have a target level of wealth in mind, for retirement or security. If rising asset prices bring them to that target sooner than expected, spending more is a reasonable response. After all, for most people the purpose of accumulating assets is to spend them at some point.
The problem arises when the price rise turns out to be temporary. People who adjusted their spending to a level of wealth that later disappears face a painful correction. There is also a danger that, after a period of gains, people come to expect continuing gains at the same pace and raise their spending further on that assumption.
People respond gradually
The evidence suggests that most people do not spend their gains immediately. They respond slowly. Studies of wealth effects commonly estimate that each extra dollar of wealth adds only a few cents a year to spending, with estimates varying considerably by country, by type of asset and by period. Housing wealth and share wealth may also have different effects, partly because housing wealth is more widely held.
Why so gradual? Perhaps people are slow to recognise that they are better off. Perhaps they are cautious, waiting to see whether the gains are permanent before spending them.
The trap in waiting
That caution contains a trap. The judgement about whether higher prices are permanent tends to depend on how long prices have held up, not on whether valuations make sense. During a bubble, prices often stay above sensible valuations for years. People come to see those high levels as normal, conclude that their wealth is permanent, and spend accordingly, often just as the bubble approaches its end.
Borrowing against assets
A common response to rising asset prices is to borrow more to finance spending.
For most households, this takes the form of mortgage equity withdrawal: releasing some of the increased value of a home by increasing the mortgage, refinancing to a larger loan, or drawing on a redraw facility or home-equity line of credit. In many countries it has become much easier over recent decades to borrow against home equity, as lending rules have been relaxed and products have multiplied.
Investors can also borrow against shares through margin loans, or take leveraged positions through products such as contracts for difference or leveraged exchange-traded funds. These options are more widely used by people with substantial portfolios.
Borrowing against assets has two important effects. It allows spending to rise faster than income, and it increases the household’s exposure to a fall in asset prices, because the debt remains even if the asset’s value falls. The article Borrowing against a boom looks at this risk in detail.
The savings rate and the one-off effect
When spending is financed by borrowing against assets or by selling assets, the household savings rate falls. The savings rate measures the share of current income that is not spent. It does not count borrowing or asset sales as income, so when people spend more than their income using these sources, the measured savings rate drops.
The fall in the savings rate is, in effect, the measure of the wealth effect. And here is a crucial point that is often overlooked: a fall in the savings rate has only a one-off effect on the growth of spending.
An illustration
This is an illustration with round numbers.
A household earns $100,000 a year after tax and normally saves 10% of it, spending $90,000. After a strong rise in the value of its home, it decides to save only 4%, spending $96,000.
| Year | Income | Savings rate | Spending | Growth in spending |
|---|---|---|---|---|
| Before | $100,000 | 10% | $90,000 | — |
| Year 1 | $100,000 | 4% | $96,000 | about 6.7% |
| Year 2 | $100,000 | 4% | $96,000 | 0% |
In the first year, spending jumps by about 6.7% even though income has not changed. In the second year, if the household keeps saving 4%, spending stays at $96,000. Spending growth returns to the growth of income, which in this simple example is zero.
The level of spending is permanently higher, but the boost to growth happened only once.
When borrowing or asset sales fund the spending
The effect is even more volatile if the extra spending is funded by borrowing or by selling assets, rather than by changing the regular savings rate.
Suppose the same household instead borrows $6,000 against its home to fund extra spending in year 1, while still saving 10% of its income. In year 1, spending rises to $96,000. In year 2, unless it borrows again, spending falls back to $90,000, a drop of more than 6%. Spending funded by one-off borrowing or asset sales must be repeated, and increased, just to keep spending growth steady.
The trap for central banks
This creates a difficult problem for monetary policy.
Central banks focus closely on the growth of the economy and on inflation. If many households cut their savings rates at the same time, consumer spending would jump suddenly. That jump could look like an economy overheating, prompting fears of higher inflation and a decision to raise interest rates.
But the following year, spending growth would fall back of its own accord, as the one-off effect passed. If the central bank had not recognised what was happening, it might have raised interest rates just as the boost was fading, slowing the economy more than intended.
The risk is greater when the extra spending is financed by borrowing or asset sales, because that spending actually reverses the following year unless it is repeated. Wealth effects can therefore make the economy harder to read and policy mistakes more likely.
When wealth effects reverse
Wealth effects work in both directions. When asset prices fall, people feel poorer. Some respond by:
- saving more, to rebuild their wealth
- paying down debt, especially if they borrowed against assets
- delaying large purchases, such as cars, renovations and holidays
- being unable to borrow, because their home equity has shrunk
These responses reduce spending just as the economy is already weakening after a bust. Businesses that benefited from boom-time spending can see demand fall sharply. The reversal is often faster than the original rise, because fear tends to act more quickly than optimism.
What wealth effects mean for businesses
For business owners, the most important lesson is that some demand is driven by asset prices rather than by income, and that demand is less reliable.
Know which of your customers are wealth-sensitive
Some products and services are especially sensitive to wealth effects:
- home renovation, building and furnishing
- new cars, boats and recreational vehicles
- luxury goods and discretionary travel
- fine dining and premium entertainment
- financial and real estate services that depend on transaction volumes
If your business sells into these markets, a portion of your demand probably depends on how wealthy customers feel. That portion can disappear quickly.
Separate trend growth from boom growth
During a period of rising asset prices, it is worth asking how much of your sales growth reflects lasting factors, such as more customers, better products or rising incomes, and how much reflects customers feeling richer. The second kind of growth is often a one-off lift that will not continue, and may reverse.
Plan capacity cautiously
Businesses that expand capacity to meet demand boosted by wealth effects can find themselves with too many staff, too much stock and too much space when the effect fades. Flexible capacity, such as contractors, short leases and outsourced production, reduces that risk. The article Running a business through a boom and bust develops this further.
Watch the signals
Some signals suggest wealth effects are strong: rapidly rising house or share prices, falling household savings, strong growth in borrowing against property, and booming sales of big-ticket discretionary items. When these appear together, it is a good time to strengthen reserves rather than stretch them.
Wealth effects on business owners themselves
Business owners are subject to wealth effects too. Many small businesses are funded, directly or indirectly, by the owner’s home equity: a loan secured against the family home, or personal savings that grew with the property market. When house prices rise, owners can borrow more easily and may feel more comfortable taking risks with the business.
That can be a sensible use of growing wealth. But it ties the business’s funding to the property market. If prices fall, the equity that supported the business shrinks, lenders may review facilities, and the owner’s personal finances come under pressure at the same time as the business’s customers spend less. Keeping an eye on how much of the business depends on property-backed borrowing helps owners avoid being squeezed from both sides.
A worked illustration
This is an illustration, not a real business.
A kitchen renovation business grows rapidly during a long period of rising house prices in its city. Many customers fund renovations by increasing their mortgages. Sales grow 25% a year for three years, and the owner considers opening a second showroom and doubling the installation team.
Before committing, the owner reviews where growth has come from. Most new jobs are funded by home equity. Enquiries rise and fall with local house-price reports. The owner concludes that a large share of recent growth depends on the property boom.
Instead of a second showroom, the business adds subcontracted installers on flexible terms and invests in marketing to landlords and property managers, whose renovation spending is driven more by tenancy needs than by price gains. When house prices later fall and equity-funded renovations slow, sales drop by a fifth, but the business adjusts by reducing subcontracted work rather than laying off staff or carrying an empty showroom.
Common mistakes
Treating boom-driven demand as permanent. It often fades or reverses.
Confusing a one-off rise in spending with ongoing growth. Lower savings lift spending once.
Ignoring how customers fund purchases. Equity-funded spending is especially sensitive to prices.
Expanding fixed capacity to meet wealth-driven demand. Flexible capacity is safer.
Overlooking the reverse effect. Falling asset prices cut spending, often quickly.
Questions to ask
- How much of your customers’ spending depends on rising asset prices?
- Are customers funding purchases by borrowing against their homes or investments?
- Is your recent growth a lasting trend or a one-off lift from a falling savings rate?
- Could you reduce capacity quickly if wealth-driven demand faded?
- For your own household or business: are you spending as though recent asset gains are permanent?
Bringing it together
Rising asset prices make people feel richer, and some respond by saving less, selling assets to spend, or borrowing against their homes. These wealth effects boost spending, but the boost to spending growth is often a one-off, and when it is funded by borrowing or asset sales it can reverse the following year.
For policymakers, wealth effects make the economy harder to read. For businesses, they create demand that is less reliable than it looks. Knowing which customers are wealth-sensitive, separating trend growth from boom growth and keeping capacity flexible help businesses benefit from good times without being caught when asset prices turn.
Sources: an introductory chapter on asset bubbles written in the mid-2000s and widely published research on wealth effects. Figures in the illustrations are not data. This article is general information, not financial or investment advice.
