The 'wealth effect' explained

Household and individual wealth is a very influential factor for property markets and is very topical in today's markets, so let's drill down into this topic further to show exactly why it drives prices higher.

In every society, property is generally considered the major store of wealth.

And in Australia gross housing assets account for more than half of total personal wealth.

Owner-occupiers and property investors feel wealthier when prices of existing houses rise - this is called the ‘wealth effect’ which leads to an increase in consumption expenditure.

As a result, aggregate demand, and thus economic growth, occurs which in turn support rising housing prices through a self-reinforcing cycle.

And it’s this factor that also contributed to the recent 2020-21 property price boom.

Many of those lobbying for more affordable housing forget the ‘wealth effect’ of rising house prices.

And I’m not just talking about the importance of the building sector in our economy.

There is a flow-on effect when someone buys a property - they buy new carpets, a television, refrigerators, etc.

Increased property values have a positive effect on the nation’s GDP because when people feel wealthier, they spend more.

The RBA has published a range of research that calculates the benefits of a change in wealth when house prices increase.

The data shows changes in household wealth due to changes in house prices impact the growth of household consumption - in other words, as I said above, people spend more.

In simple terms, they found that when wealth increases as house prices rise, spending grows and helps the economy and when house prices fall spending growth slows.

And I guess that makes intuitive sense.

If a property owner feels the ‘wealth effect’ as their property increases in value, they are inclined to borrow against their wealth and in turn, increase their consumption spending.

What does this mean?

It means the rising housing wealth and the associated growth in household consumption feeds through to the other parts of the economy and creates jobs.

It increases the level of employment which in turn feeds into better-than-otherwise wage increases (better than in a scenario where house price growth is weak or non-existent).

In my opinion, the high house prices in Australia are a reflection of living in the best country in the world with large coastal cities.

There are long queues of people wanting to live in this country - you don't see people queuing up for 20 years to live in Indonesia.

So rather than wishing for cheaper house prices, we should be looking to improve the financial situation of Australians.

Because when house prices fall it leads to a weaker economy, high unemployment, problems in the banking system, and slumping construction.

And who would want that?

Sure, property affordability may improve, but crashing house prices will not build homeownership rates.

In fact, on the contrary, a house price crash may lead to even lower homeownership rates if unemployment is higher and banks continue to tighten lending.

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Jason Gwerder
Friday, 29 July 2022

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