How much do we care about the Dow's crossing into record territory? Enough to mention it in this post, but not so much that we're going to strain our brain for anything original rather than just reproducing this par from last year, when the Dow crossed 13,000 (but which applies just as well today): Cue the already-deflating* bubble in a) people pointing out that the Dow hit 13,000, then b) people who point out the irrelevance of the Dow's crossing 13,000, followed by c) people who get annoyed at people who point out the irrelevance of the Dow's crossing 13,000 because it's so bleeding obvious, which of course then leads to - oh hell, never mind. Yeah, the Dow's hitting a new nominal high on Tuesday is just our excuse to mention that we've come across a few new items recently about the all-important wealth effect, and wanted to note them here. 1) First up is a paper by Karl Case, John Quigley, and Robert Shiller (emphasis ours in all cases): We find at best weak evidence of a link between stock market wealth and consumption. In contrast, we do find strong evidence that variations in housing market wealth have important effects upon consumption. This evidence arises consistently using thirty-one year panels of U.S. states, and this finding is robust to differences in model specification. As for the magnitude of the effects, consider a few of the most recent changes in housing wealth. The decline in housing wealth from 2005-2009 was roughly thirty percent (somewhat more in real terms). Estimates of the elasticity of consumer spending range from 0.03 to 0.18, but those that are estimated with separate coefficients for up markets and down markets are consistently about 0.10 in down markets. That figure implies that a decline of thirty-five percent in housing wealth would lower consumer spending by 3.5 percent. Consumption is about $10 trillion, and that, in turn, implies a decline in consumption of about $350 billion annually. To put those figures into context, consider the effects of the decline in housing production from 2.3 million units to 600 thousand, at $150,000 each. This implies reduced spending on residential capital of about $255 billion. Either has a large impact on the economy; together they have a very large impact. 2) Next is a note by Neal Soss of Credit Suisse concluding that the wealth effect has declined in recent years: Our study finds that changes in housing wealth have a greater influence on consumer spending than changes in stock market wealth. This is consistent with other researchers" findings. FTAV: Soss refers to specifically to the first paper above in his note. Our most novel finding is that wealth effects appear to have shrunk since the 2007-2008 financial crisis, and more so for housing wealth than for stock market wealth. One implication of this result is that the Federal Reserve will need to "engineer" even larger bull markets in house prices and stock prices for any given desired pick-up in economic growth. The great financial crisis is proving to have a long tail. The potential stimulus to consumption from increasing housing wealth could be substantial in the medium term. But given our estimation results, it is unlikely that the improvement in housing this year will spur consumption enough to fully offset the effect of lower disposable income growth associated with the restoration of the payroll tax. The three potential reasons given by Soss for the decline in the housing wealth effect are the higher perceived volatility of housing wealth since the crisis; a "non-linear" relationship between housing wealth and consumption (the decline in consumption resulting from a fall in housing wealth is bigger than the increase in consumption that results from a rise in housing wealth); and less mortgage equity withdrawal than before the crisis, because of stricter lending standards and greater hesitancy on the part of mortgage-holders. 3) And finally, The Economist last week wrote the following based on some work by Capital Economics: Rising home prices and a stockmarket at near-record levels added $4.8 trillion to household wealth last year, reckons Paul Dales of Capital Economics, bringing it to around $65 trillion, close to its pre-crisis peak. He figures the "wealth effect" of stable stocks and modestly higher home prices should lift consumer spending enough to add 0.7% to GDP this year (see chart 2). The recovery of household wealth, if it continues, is a countervailing force against the decline in disposable income resulting from the payroll tax cut expiry and the parts of ongoing government austerity measures (including parts the sequestration cuts) that will directly influence consumer spending. So, obviously, the higher the effect the better.