- June 1, 2016; Vol. 3, Number 6

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Revisiting the ‘Wealth Effect’: Some theories go boom, but this one goes bust

by Elisabeth Dellinger

Here’s a back-and-forth you might have seen recently:

“Don’t fret stock market volatility — stocks have predicted 10 of the last three recessions.”

“Yeah, but falling stocks can cause a recession because the negative wealth effect kills consumer spending!”

One outfit took it a step further, arguing the world is about to get sucked into a “self-fulfilling” negative feedback loop of falling stocks and spending. Folks, this is a ghost story with zero factual support.

Here is a summary of the wealth effect myth: When stocks (or, 10 years ago, home prices) are rising, consumers feel wealthier and thus spend more, boosting the economy. When stocks are falling, consumers feel poorer, spend less and a recession could strike.

In one sense, you should be immediately skeptical of these kinds of theories. If this were actually true, we would not ever have recessions, because stocks and consumer spending would keep chasing each other

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