Recently I was trying to explain to a 15 year old why the west is richer. Which eventually lead me to explain what being rich really means. Obviously rich is a relative term. Someone with a car and a house is richer than someone with just a car (same car of course). More generally a person is richer than another if he can consume more and still be better or as well off as the other. When I say as well off I mean the person can consume as much. The word consumption is most important here and I will elaborate it with an example. Assume that for some wierd reason Bill Gates cannot sell his stocks to anyone in the world. Then he can only consume as much as he draws in salary and his savings till date. Surely that is quite a lot but that will not make him the richest man in the world. What if he didnt get any salary or had all his wealth in Microsoft stocks. Then he wouldnt even be able to buy soda at McDonnalds. Surely not a definition of a rich man and definitely not for the richest man in the world.
This has interesting implications to wealth effects of real estate price inflation. I know many people who have seen their property prices go through the roof. Many of them have suddenly started to feel rich and their consumption pattern has thus changed. However there is a serious error in their thinking which I want to bring out through this post. As described earlier a person is rich only if he can consume more of one or more things while keeping the consumption of other things the same. Therefore if I could afford two candies and one car yesterday and today I can afford three candies and one car with no change in the amount of money I save then surely I am richer today than I was yesterday. However if the price of my house increases today then I am no richer than I was yesterday and let me explain why. If my property value has gone up then its highly likely that other properties have also gone up. The only way I can consume more due to my new found wealth is by selling the house and using it to fund purchase of other stuff (cars maybe). To be richer I have to move into another house that is equaly comfortable and still have more money to spare. But if other houses have also increased in value then I am no better off. I cant sell my house at the new price and be left with cash to spare to consume other things therefore the wealth effect is only notional. This however drives consumer behavior in a strange way. People who have seen their house prices double have started saving less taking comfort in the gain from property. This is obviously irrational because they havent got richer by a single cent unless they decide to sell their house and move to another location where property prices are much lower but this means change in lifestyle and may not be possible for people who have jobs.
People who own more than one house are sure to gain from property price increases for they can always sell one of houses without any change in comfort or consumption pattern and use the proceeds to buy other stuff (but not another house ofcourse).
So what does it mean to you and I.
1. If you own a house and it has gone up in value you are not any better off than you were earlier no matter how much you delude yourself into thinking that you are now richer
2. If you dont own a house you are not any poorer unless rental values have gone up.
