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Feature What Goes Up In today's economic environment, measuring the "wealth effect" requires a new, more complex equation—and the housing industry's future is now a critical variable. By Mark Lieberman S ensitivity. Stability. Flexibility. These qualities are mandatory for the success of strong, complex partnerships, and the complicated relationship between economic factors that must merge to stimulate the "wealth effect" exemplifies the significance of such virtues. But the necessity of critical integrities doesn't make them any easier to attain or maintain. The "wealth effect"—derived from the balance between consumer spending and household net worth—is driven by a unique collision of tangible and intangible components, representing a dynamic combination of catalysts that profoundly impacts the nation's fiscal progress. Now, a new study proposes that in today's economic environment, a third variable should be introduced into the traditional wealth effect equation: home values. Not-So-Simple Addition W hile the recent report does not assert that the original calculation of the wealth effect is invalid, it suggests that the opposite is also true, a concept that existed only in theory prior to the current study, which was authored by Karl Case and Robert Shiller, founders of the eponymous home price index published monthly by Standard & Poor's, as well as the late John Quigley, who was an economics professor at the University of California at Berkeley. The survey, released in January by the National Bureau of Economic Research, revealed when household net worth drops, that decline is followed by a drop in personal consumption spending, an important finding as a contributor to the Great Recession since personal consumption spending represents about 70 percent of gross domestic product, the single most important barometer of the nation's economic health. According to Joseph Carson, director of Global Economic Research at Alliance Bernstein, the idea of a "negative wealth effect" from housing had not been studied empirically because there had not been a sustained drop in home values until the recent downturn. The study's finding were twofold: that changes in household wealth due to changes in house values "continue to exert a larger and more important impact upon household consumption than do changes in stock market values" and that when home values drop, so does consumption. "Estimates of the elasticity of consumer spending [its responsiveness to changes in net worth] range from 0.03 to 0.18," Case, Shiller, and Quigley wrote, "for up markets and are consistently about 0.10 in down markets. That figure implies that a decline of 35 percent in housing wealth would lower consumption by 3.5 percent. Consumption is about $10 trillion, and that, in turn, implies a decline in consumption of about $350 billion annually." Case, Shiller, and Quigley said the decline in housing wealth from 2005 to 2009 was about 30 percent. "The decline in housing production from 2.3 million units to 600,000 at $150,000 apiece," they wrote, "implies reduced spending on residential capital of about $255 billion." While either the drop in spending or lower residential investment, "has a large impact on the economy, taken together they have a very large impact," the authors wrote. Critics' Choice T he Case-Shiller-Quigley study is the first to quantify the downward impact on consumer spending when home values drop as they did just before and during the recession while at the same time confirming other studies, which suggested a different impact on spending from a change in housing and stock values. Understanding the impact the fall in housing wealth had on consumption is critical as the economy starts to turn around. "The business cycle is just starting to gain speed just as asset prices—stock and home—are beginning to increase," Carson said, adding the recovery still has four to five years to go. The wealth effect as a theory has its critics, among them economists Charles Calomiris of the Columbia Graduate School of Business, William Miles of Wichita State University, and Stanley D. Longhofer, director of the Center for Real Estate at the Barton School of Business in Wichita, who wrote that "housing wealth has a small and insignificant effect on consumption." The M Report | 35