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: Falling house prices have been at the heart of the rich world’s economic troubles in the past year. They led to the surge in defaults on American subprime mortgages that poisoned the market for asset-backed securities and drove up inter-bank rates. Mortgage-related losses have made international banks wary of lending to even creditworthy borrowers. The drying-up of credit has meant fewer buyers for new homes, leading to construction busts in America, Spain and Ireland. Now even countries unaffected by the global housing boom, such as Germany and Japan, are suffering from weaker export demand.

In America the tangible impact of the housing slump is plain to see in the number of empty homes and in rising unemployment. There is greater uncertainty about the indirect effects of falling house prices, including the extent to which consumer spending will be held back by the “wealth effect”. Spending is largely driven by how much people earn in real terms today, but it is also affected by expectations about incomes tomorrow. An important part of future incomes is tied up in the assets—stocks, bonds, property—where household wealth is stored. When asset values fall, those who own them are poorer, hence they spend less and save more. When wealth increases, they spend more.

An OECD study in 2004 put the marginal propensity to spend out of financial wealth at between 0.01 and 0.07 for rich countries: that is, if wealth rises by $1, spending rises by between one and seven cents. The Federal Reserve’s model puts the wealth effect in America at 0.0375.

The Fed’s model assumes the same wealth effect for housing as for financial assets. From the perspective of lifetime income, a dollar of housing wealth is the same as a dollar of stockmarket wealth. But some argue that the negative wealth effect from falling home values may be larger than for other assets. One reason is that housing wealth is spread more evenly than financial wealth, which is concentrated among rich households whose spending is less sensitive to the changing tides. Another is that housing slumps are rarer than stockmarket downturns. Consumers are likely to consider a fall in house values as a durable change in wealth and may cut spending more sharply in response.