The Wealth Effect

Economists often mention something called the ‘wealth effect’ - referring to the link between the level of personal wealth and our decisions about how much to spend or save on goods and services. In our AS macro lesson today we were flagging up ideas about what causes a recession. Some of the causes are from overseas, for example the impact on banks and businesses from the fall out after the global credit crisis. But many of the root causes of a recession are home-made.

And it seems for the UK that people across every region have been hit by a sharp reduction in the value of household wealth.

The BBC reports that “in the course of 2008 alone, £815bn was knocked off the wealth of households in the UK.That amounted to an average of nearly £31,000 for every household in the UK.”

How is wealth stored (and accumulated?)

In property - there has been 9% cut in the market value of all residential property, from £4,077bn to £3,693bn

In pension funds and other investments - the financial assets of households, such as the value of pension funds and investments, also dropped by 9%, to £3,687bn

Asset prices have been falling - but the borrowing used to finance much of this does not go away

Net financial wealth adjusts household wealth for unpaid credit card bills and outstanding mortgage debt. This has fallen by 12% in the last year.

Little wonder that for many people the priority at the moment is to cut back on borrowing, increase saving and try to rebuild their ‘balance sheets’.

Much the same applies to the banking system too! Lenders are making it tougher to borrow and accumulating deposits of cash to give themselves a stronger ‘capital base’ for the years ahead.

In recent months, share prices have surged ahead and the FTSE-100 is now back above 5,000. There are signs too of a revival in the property market.

Will the wealth effect now start to prompt a recovery in demand for goods and services? Keep a keen eye on the housing market and the stock market.