It is inevitable that if incomes fail to keep pace with a 6.8 per cent inflation rate, more Canadian wage earners will be forced to scrimp. 

But economists who study financial behaviour have found that even those who can afford to keep spending are also looking for ways to cut back.

Anyone who got a pay hike of less than 1.8 per cent this year actually took a more than five per cent cut in their “real” or after-inflation income. It means that those without savings, who spend what they earn, have no choice but to buy less — or go into debt.

And retailers have begun to notice. Earlier this month, shares in U.S. chains Target and Walmart, and Canadian Tire in Canada, declined sharply as falling sales showed up in the bottom line, leading markets lower.

Urge to economize

But there are increasing signs it is not just those without savings who are looking for ways to spend less. Research on something called “the wealth effect” has shown that the many Canadians who have savings invested in real estate, stocks or cryptocurrency are not exempt from the urge to economize.

“What we expect is that as wealth goes up, consumption would increase and as wealth declines, we would expect a decrease,” said Mark Kamstra, an economist who studies behavioural finance at York University’s Schulich School of Business in Toronto.

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Though originally based on economic ideas of how people should behave, the wealth effect actually happens in the real world, repeated studies have found.

While at first some economists insisted the effect only applied to liquid investments, like stocks or bonds where returns could be extracted and spent, there is a growing body of research showing the notional value of your home — even if you have no plans to sell it and extract the value — can change your willingness to spend.

Those who have studied the wealth effect, including Bank of Canada governor Tiff Macklem in 1994 when he was but a humble researcher for the central bank, have concluded the phenomenon is real. Nonetheless, there is still debate, and even contradictory studies, over exactly how it works. As Kamstra explained, while theory proposes a simple model with a few variables, the real world is inevitably complicated and messy. 

“There are well-known reasons to fear that constant or declining share prices may exacerbate a slowdown in the economy by depressing the consumption spending of households,” said the report for the U.S. National Bureau of Economic research.

House rich

The report’s conclusions, however, were that “the housing market appears to be more important than the stock market in influencing consumption in developed countries.”

Certainly the classic anecdotal example for the wealth effect is housing and car sales, where, as the price of relatively modest houses begins to rise in a neighbourhood, new and sometimes expensive cars begin to appear in driveways.

WATCH | Home sales are slowing, as are prices:

Canada’s housing market sees signs of cooling as interest rates rise

1 month ago

Duration 2:03

Experts say higher interest rates are causing a slowdown in Canada’s hot housing market, leading to fewer sales and a slight drop in the average selling price in March.

The anecdote has research to back it up from the Reserve Bank of Australia (RBA), the Down Under equivalent of the Bank of Canada.

In 2015, when Aussie house prices were rising at about 10 per cent a year, the RBA study showed that, “there is a robust cross-sectional relationship between changes in housing wealth and new vehicle registrations.”

Not only that, but the authors put a number on it, showing that every one per cent jump in housing wealth led to a half per cent rise in new car purchases.

Psychology of wealth

The reason why the housing example is especially interesting is because for the most part, those homeowners who bought the cars were not planning to sell their houses to realize the increase in value. That indicates a psychological effect.

“I mean, really, are you wealthier if you are a 50-year-old and your house has doubled in value?” Kamstra asked rhetorically. “What are you going to do? You still have kids in high school. You’re not going to move from the neighbourhood. You can’t downsize. How is that wealth in any sense?”

He points to another study from Britain, that, quite reasonably, shows the strength of the wealth effect depends on individual circumstances. For example, older homeowners who are considering downsizing respond more to the notional value of their homes when making spending choices.

Similarly, those who own securities such as stocks, or have taken a cryptocurrency stake, are the ones who most feel the effects as those investments rise and fall. A 2018 study from the University of Ottawa has shown that “both financial and housing wealth have significant effects on Canadian consumption,” and that homeowners only tend to use their house as the proverbial piggy bank when house prices are rising and interest rates are low. 

That window may be closing.

As many commentators on home equity lines of credit, or HELOCS, have observed, Canadians may have gone overboard in borrowing up to 65 per cent of their homes’ value to spend on things like renovations. As interest rates rise and home prices fall, that kind of borrowing and spending is likely to decline.

Buying frenzy

As the conflicting studies have shown, even with access to historic data, teasing out the impact of the inverse wealth effect is not easy. Measuring it in real time is even harder, but according to pollster Nik Nanos there are signs we may already be seeing its effect. 

“Canadian consumer confidence continues to decline with negative pressure on all dimensions tracked, including job security, real estate values, personal finances and forward-look on the economy,” said Nanos in a release of confidence data this week.

And whether you spend less because you actually are poorer or just feel that way, pinching pennies when your future wealth seems uncertain may be a natural impulse that’s hard to resist.

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