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- 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

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