FRBSF Economic
Letter
2007-02; January 19, 2007
Disentangling the Wealth Effect: Some International
Evidence
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 Over the past several years, movements in asset prices
have substantially raised household wealth. For the
U.S. and many other industrialized countries, the most
recent boost has come more from the appreciation of
house prices than financial assets. In the U.S. housing
wealth has moved back above financial wealth in terms
of the share of assets. In a number of other industrialized
countries, including three examined in this Economic
Letter, housing wealth makes up an even larger share
of individuals' portfolios than is the case for the
U.S. (see Figure 1).
Movements in housing value and other asset prices
can have implications for economic outlook for a number
of reasons. One is the so-called wealth effect channel—the
extent to which consumer spending responds to changes
in wealth (asset values). With the recent cooling in
the U.S. single family housing sector and potential "correction" in
other countries, analysis of the possible wealth effects
from housing have moved front and center.
In this Economic Letter, we report on research that
takes advantage of newly available international
data and examines in some detail the wealth effect
in three
countries, Canada, Finland, and Italy (Sierminska
and Takhtamanova 2007). First, we investigate whether
consumption
responds differently to changes in housing and financial
wealth. Second, we investigate whether there are
differences in consumption responses to changes in
wealth across
different age groups.
Theoretical considerations
The life cycle theory of consumption, which underpins
most efforts to model wealth effects, argues that
consumers try to smooth consumption over their life
span. For
example, because incomes are expected to rise at
least over a typical person's initial working years,
consumers
are likely to borrow against their future earnings
when they are young, build wealth (save) and pay
their debts during middle age, and run down their wealth
in retirement. In this framework, a typical consumer
will spread out the benefit or deficit from an unexpected
gain or loss in wealth by boosting or cutting current
spending by a fraction of the value of the change
in
wealth and maintain that new level of spending over
time.
Not all wealth is the same, however, and researchers
have argued that it makes sense to distinguish between
financial asset wealth and housing wealth, because
the characteristics of each may have different effects
on people's propensity to consume. Economic theory
suggests that the consumption response to a positive
asset shock is larger if the asset is more liquid
(easier to buy and sell). The response is also larger
if households
think the asset value is easier to measure, if they
perceive the asset to be more appropriate for financing
current consumption, and if they view the shock to
be more permanent.
Given these characteristics, it is not obvious whether
to expect a larger wealth effect out of changes to
housing or financial wealth. For example, traditionally,
financial assets have been viewed as more liquid
(though financial innovations have made it easier for
homeowners
in many countries to extract equity from their houses),
more trackable (because they are more homogeneous
and traded more frequently than houses), and more appropriate
to use for current consumption. On the other hand,
shocks to housing wealth might be viewed as more
permanent
(Pichette and Tremblay 2003). Finally, the relative
effect of the two types of wealth may depend on how
broadly they are distributed across the country.
Furthermore, as already mentioned, the life cycle
theory predicts that the marginal propensity to consume
out
of wealth increases with the consumer's age. This
insight is especially important given that the share
of older
households is rising in many countries, including
the U.S., because it implies that wealth shocks would
be
expected to cause a larger aggregate consumption response
Financial and housing wealth effects
Previous studies attempting to assess wealth effects
have relied on either aggregated data or data on
individual households. In recent studies using time
series data
aggregated at the national or regional level for
the U.S. and Canada, the estimated wealth effect out
of
housing wealth has been found to exceed that of financial
asset wealth consistently (Davis and Palumbo 2001,
Carroll 2004, Pichette and Tremblay 2003). The macroeconomic
evidence on the relative sizes of financial and housing
wealth effects in other OECD countries is mixed (Carroll
2004). A concern with the evidence from studies using
aggregated data is that estimates of the wealth effects
may reflect spurious relationships; that is, wealth
fluctuations can be affected by many factors that
also affect fluctuations in expenditures (such as overall
macroeconomic prospects).
An alternative approach is to use survey data on
individual households (micro data), as household wealth
may be
less influenced by macroeconomic circumstances. However,
existing estimates of the wealth effect for different
countries are obtained using different methods and,
for the most part, the data are not comparable. We
use data available through the Luxembourg Wealth
Study (LWS), a project under development within the
larger
Luxembourg
Income Study (LIS), which makes
cross-country analysis with more comparable data
possible. Based on the availability of expenditure
data, our
analysis focuses on a sample of homeowners in three
countries, Canada (1999), Finland (1998), and Italy
(2002).
In our framework, at any given period, the amount
a consumer spends depends on his or her expected remaining
life span (age), expected future labor income stream
(permanent income), net financial asset holdings
and
net housing holdings (wealth), and rate of time preference.
Our measure of consumption is total expenditures,
created by summing the available expenditure components
in
the surveys (see the Appendix in Sierminska and Takhtamanova
2007). Finland and Italy have an extensive list of
expenditure components. Canada includes housing,
transportation, and child care. Our measure of wealth
focuses on consumers'
financial and housing wealth. Our measure of financial
assets includes deposit accounts, stocks, bonds,
and mutual funds. Nonfinancial assets include consumers'
principal residence and investment real estate. Housing
wealth refers to nonfinancial assets net of home-secured
debt. We also account for a variety of demographic
variables, such as education, the gender of the head
of household, marital status, and the number of children.
 As a first pass, we allow age and the other demographic
and socioeconomic variables to affect only the average
level of consumption. Our estimates show that, for
all three countries, the housing wealth effect is
substantially larger than the financial wealth effect.
The estimated
effects are the percent change in consumption caused
by a 1% change in wealth. As shown in Figure 2, our
estimate with respect to financial wealth is negligible
in Canada, about 2% in Finland, and 4% in Italy.
The housing wealth effect is much stronger. A 1% increase
in households' housing wealth raises households'
expenditure
by about 12% in Canada, 10% in Finland, and 13% in
Italy.
Although our results are significant, it is possible
that the reason housing wealth has such a large effect
is that it serves as a proxy for permanent income,
which is an important determinant of household consumption.
Nonetheless, our estimates are broadly consistent
with some other studies using micro data (Bostic et
al.
2006 for the U.S. and Guiso et al. 2005 for Italy).
Moreover, we make an extensive effort to control
for permanent income by including a variety of sociodemographic
characteristics of the households.
Wealth effects across age groups
Recent studies that address differences in wealth
effects across ages tend to focus only on housing wealth
(see,
for instance, Lehnert 2004 for the U.S.; Grant and
Peltonen 2005 for Italy) and find stronger wealth
effects for older households.
 We divide our sample into several age groups and
find no clear pattern in the financial wealth effects
among
them. However, a clear pattern emerges for the housing
wealth effect, as Figure 3 shows. In all three countries,
the housing wealth effect is significantly lower
for younger households and is strongest for those aged
55-64 in Finland and Italy and those aged 75 and
over
in Canada. In Canada the effect consistently increases
from age 55 onwards, and in Finland and Italy the
effect increases up to the group aged 55-64 and then
is lower
in the two oldest age groups.
Conclusion
In our study we consistently find that the housing
wealth effect is greater than the financial wealth
effect for homeowners in three industrialized countries—Canada,
Finland, and Italy. We caution, however, that our
estimates must be considered tentative as the analysis
is based
on the beta version of a developing data source and
as the existing econometric evidence does not completely
agree on this subject. Our finding that the housing
wealth effect is consistently stronger for older
households in the three countries we examine also lends
some support
to the life cycle theory and bolsters the results
of other studies.
These results suggest that it is important for policymakers
to keep an eye on housing market developments separately
from financial markets. If it is true that the housing
wealth effect dominates the financial wealth effect,
at least in some countries, then the effects of a
softening in the housing market in a number of industrialized
countries could have a more dramatic impact than
the
historically large stock market declines that began
in 2000. Additionally, if the wealth effect is stronger
for older households, the demographic changes around
the world could make housing wealth effects even
more important in the future. Eva Sierminska
Luxembourg Income Study and DIW Berlin
Yelena Takhtamanova
Economist, FRBSF
References
Bostic, R., S. Gabriel, and G. Painter. 2006. "Housing
Wealth, Financial Wealth, and Consumption: New Evidence
from Micro Data." University of Southern California,
Lusk Center for Real Estate Working Paper.
Carroll, C. 2004. "Housing Wealth and Consumption
Expenditure." Unpublished manuscript, Johns Hopkins
University.
Davis, M., and M. Palumbo. 2001. "A Primer on
the Economics and Time Series Econometrics of Wealth
Effects." Federal Reserve Board, Finance and Economics
Discussion Series 2001-09.
Grant, C., and T. Peltonen. 2005. "Housing and
Equity Wealth Effects of Italian Households." De
Nederlandsche Bank Working Paper 43.
Guiso, L., M. Paiella, and I. Visco. 2005. "Do
Capital Gains Affect Consumption? Estimates of Wealth
Effects from Italian Households' Behavior." Banca
d'Italia Working Paper 555 (June).
Lehnert, A. 2004. "Housing,
Consumption, and Credit Constraints." Federal
Reserve Board, Finance and Economic Discussion Series
2004-63. Pichette, L., and D. Tremblay. 2003. "Are Wealth
Effects Important for Canada." Bank of Canada
Working Paper 2003-30.
Sierminska, E., Brandolini, A. and T. Smeeding. 2006. "Comparing
Wealth Distribution across Rich Countries: First Results
from the Luxembourg Wealth Study" Luxembourg Wealth
Study Working Paper 1.
Sierminska, E., and Y. Takhtamanova. 2007. "Wealth
Effect out of Financial and Housing Wealth: Cross-Country
and Age Group Comparisons." FRBSF Working
Paper 2007-01 (updated).
Opinions expressed in this newsletter do not necessarily
reflect the views of the management of the Federal
Reserve Bank of San Francisco or of the Board of
Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
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