The “wealth effect” isn’t what it used to be. For those who have forgotten, this refers to households’ tendency to spend some part of their increased real estate and stock market wealth and thereby boost the economy. During the boom years, Americans borrowed lavishly against rapidly appreciating home values. One Federal Reserve study estimated the extra cash at $700 billion annually from 2001 to 2005. Now psychology has changed. Careless optimism has given way to stubborn cautiousness. Wealth gains don’t translate into similar amounts of higher spending.
The gist of what follows is that, having experienced the Great Recession, folks are of the mind that "lavishly" spending their equity leads to, well, great recessions. And that awareness somehow presents a challenging backdrop for the economy, or at least for the Fed, going forward.
His final two paragraphs:
There has been a stunning shift in behavior, notes Zandi. In 2006, at the peak of the housing boom, almost 90 percent of homeowners who were refinancing mortgages increased the size of their loan, according to data from Freddie Mac; they were borrowing against higher housing values. In 2012, 83 percent of refinancing homeowners either didn’t change the mortgage amount or lowered it. They were striving to pay off debt.
So the wealth effect varies by time and circumstances. Now it is a casualty of the financial crisis and Great Recession. We have yet another example of risk aversion dominating the economy. People eager to borrow have faith in the future; people eager to repay debts worry about the future. We are prisoners of psychology, which can change but is hard to manipulate. That is the predicament for policy and politics.
Now think about it; leading up to the recession, folks were cashing in their equity and spending galore, and, somehow, the fact that they're acting in what in their 2013 view they deem responsibly presents a political predicament? Hmm... The consumer, for the moment, apparently understands what policymakers do not; that economic success comes from saving and spending wisely. The fact that real world experience makes for a consumer who is hard for sheltered academics to manipulate should be music to our ears!