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Franco Modigliani (FM)
The consumer is at risk. Having said that, I must confess to being surprised about the resilience of consumption after the stock market bubble popped. I would have expected some retrenchment. I would have also expected some related damage in the real estate market and the dollar. I still believe at some point there must be some repercussions.
SR
What gives you such conviction?
FM
The key for the consumer response is not the immediate situation. Too much is made of the day-to-day developments, such as mortgage refinancing. My work shows that consumers frame decisions in the context of their life-cycle considerations. It is an intertemporal theory, whereby decisions in any period have implications for adjustments in the future. That’s why the wealth effect can be important. If the popping of the equity bubble results in a reduction of longer-term return expectations on an important asset, that has important implications for life-cycle saving and spending patterns.
SR
But there is more to household wealth than stocks. Hasn’t the property market saved the day?
FM
While it may seem that way right now, I have my doubts. I am suspicious of those studies that find the wealth effect is larger from real estate than equities. Theory tells me it should actually be the opposite. That’s because the house in part, produces a consumer good -- housing services, which we consume. When the value of the house I inhabit goes up, its implied rental value increases. But that does not significantly improve my spending power, because my imputed rent has gone up as much. Any wealth effect on individually-owned property must net out the consumption of the service we derive from living in our homes. Those adjustments need not be made for stock portfolios. It is possible that new refinancing instruments, such as home equity loans may have temporarily distorted this relationship. But I would view this as a one-time shift, not as a permanent realignment of the link between wealth and consumption.
SR
So how does it all end for the American consumer?
FM
A negative wealth effect tells me it can’t go on forever. And that’s when I revert to the life-cycle theory. Sadly, the large cohort of aging baby boomers is not adequately prepared for old age. The personal saving rate is too low. It has been depleted by individuals betting on asset markets. Life-cycle theory suggests that the saving rate should have gone up by now. Obviously, it hasn’t -- at least, not yet. While that puzzles me, it doesn’t dissuade me from the basic view that the balance between consumption and saving will have to adjust. It’s just a matter of when. That leads me to conclude that that the American consumer is the most dangerous portion of the picture. |
