“The ‘wealth effect’ is the notion that when households become richer as a result of a rise in asset values, such as corporate stock prices or home values, they spend more and stimulate the broader economy.”
It also has the opposite effect, when wealth declines, people spend less.
When central banks increase interest rates, making credit more expensive, people borrow less to buy financial and real assets, and those assets start to decline in price.
As stock, crypto, and real asset prices fall, peoples’ net worth decline as well. This decrease in net worth, makes people feel less wealthy, so they spend less. Plus, this drops the value of their collateral that they would secure with future debt.
Banks naturally want collateral and income to assure them that the borrower will pay them back. When that collateral declines in value, borrowers are less credit-worthy, therefore the bank won't lend them as much money.
This slows peoples’ spending also, because most people use credit to buy things in an expansion. And since one person's spending is another person's income, income begins to decline.
Now those same people have less income, and less collateral, then their collateral value falls under the value of their debt. Now they don't even have the collateral nor the income to service or pay for their debt.
At this point, the bank’s income (interest payment) and asset (collection of the debt) must be reduced in value. And since banks are the primary lenders of credit, they start to lend less, because a lot of the money they thought they had, now does not exist, because they're not being paid back.
Banks become hesitant to lend even more money out, or they raise interest rates because there's more risk. Companies cannot borrow as much money to fund their daily operations or pay salaries, so they make less stuff and lay people off.
Unemployment rises, people become more scared, they spend even less, which further declines the economy into a recession.
Save as much cash as you can and don’t buy assets until interest rates stop increasing or begin to drop.
Oh yeah, pay off your debt. A house is the only exception to that, but it's helpful if you pay that off too, before asset prices decline.
Stay frosty and solvent people.
