Economists Ponder the Wealth Effect
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May 28 1:30pm ET
By Ellen Freilich
NEW YORK (Reuters) - Yes, Virginia, there is a wealth effect.
Like the New York Sun editor who in 1897 urged eight-year-old Virginia O'Hanlon to ignore her friends' skepticism about the existence of Santa Claus, Federal Reserve economists have published several papers this spring saying stock market gains of the 1990s were a kind of Santa Claus for consumers, allowing them to save less and spend more.
The issue is significant because central bankers are trying to determine whether last year's big stock market losses, especially in the technology sector, will undo Santa's good work, prompting consumers to save more and spend less.
Economists say there are some reasons for doubting the role of the wealth effect. These analysts have questioned whether wealth drives consumption.
But right now, Fed policy makers appear to be believers. When the central bank's Federal Open Market Committee (FOMC) cut interest rates last week, members cited "the possible effects of earlier reductions in equity wealth on consumption" as a continued weight on the economy.
And in testimony before Congress earlier this year, Fed Chairman Alan Greenspan noted the "very prominent" role the "wealth effect" had played in the economic expansion, especially since 1995.
"Clearly, with the market reversing, that process does, indeed, reverse," he said.
SPENDING RISES WITH ASSET VALUES
For five years, beginning in 1995, the steadily rising value of stocks and real estate strengthened the balance sheets of millions of American households.
Household stock market wealth from 1995 through 1999 rose 31.5 percent, 17.6 percent, 25.5 percent, 15.5 percent and 17.7 percent, respectively, generating a 164 percent real rate of return including the effects of compounding over five years, according to Federal Reserve Board economist Michael Palumbo and economist Morris Davis, formerly at the Fed, but now chief economist at Ashburn, Va.-based returnbuy.com.
In their recent Fed study on the economics of wealth effects, Davis and Palumbo said in that five-year period, the dollar value of aggregate household net worth rose 68.6 percent or $17 trillion, to $41.8 trillion.
Rising asset values, most of that in stocks, contributed $15.5 trillion, or 91 percent, of that growth. Personal savings contributed just $1.6 trillion.
With their retirement account statements showing strong, steady gains, and their home values rising, Americans began to spend more and save less of their after-tax personal income.
The U.S. personal saving rate, as measured by the National Income and Product Accounts (NIPA), dropped to 0.3 percent early in 2000 from 6.5 percent at the beginning of 1995 as the ratio of household net worth to after-tax personal income increased dramatically.
Meanwhile, spending rose.
Economists figure consumers spend between three and five cents more for each dollar of new wealth, suggesting Americans spent between $250 billion and $500 billion as a result of the rise in household wealth that occurred from 1995 through 1999.
RICHEST SAVE LEAST
But Palumbo and another Fed colleague, Dean Maki, now at Putnam Investments, used Fed data to estimate the link between net worth and saving for different demographic groups during the 1990s stock market boom.
They found that the groups of households that benefited the most from the recent runup in equity wealth -- those with high incomes who had attained some college education -- were also the groups that substantially decreased their rates of saving, and increased their spending.
Families who owned relatively modest shares of corporate equity -- the vast majority of American households -- experienced fairly mild gains in net worth-income ratios over the 1990s and continued to save at about the same steady pace throughout the decade, Maki and Palumbo found.
And for families in the lowest 40 percent of the income distribution, saving rates rose noticeably, nearly doubling between 1992 and 2000, they said.
Those patterns offer "compelling evidence of a direct link" between the rise in household net worth caused by the stock market boom since the mid-1990s and the subsequent drop in the savings rate and rise in spending, Maki and Palumbo said.
In addition, they said, the well-documented decline in the economy-wide rate of personal saving over the 1990s can be attributed almost entirely to the sharply reduced savings rate of those families who enjoyed the largest capital gains.
STOCK WEALTH: THE VANISHING ACT
If direct wealth effects begin to show up relatively quickly and continue to boost consumption for a number of quarters, as Fed economists Karen Dynan and Maki found in a separate Fed paper published this month, then what happens when household net worth begins to shrink?
Goldman Sachs & Co. chief U.S. economist William Dudley noted in an analysis last week that the stock market crash in 1987 triggered a negative, or reverse, wealth effect.
"Households actually did respond to the stock market crash by cutting spending," he said. "The crash did not lead to a weak economy in 1988 due to the strong demand for U.S. exports engendered by a weak dollar and strong growth in domestic demand of the major U.S. trading partners."
Economists worry that the reduced household net worth will crimp consumer spending, perhaps for several quarters to come.
That is significant because consumer demand is responsible for two-thirds of the economy's growth; and business investment spending is already in a slump.
"If the stock market does not rebound quickly,... or real disposable income does not get a quick boost from tax cuts or a sharp drop in energy prices, (a rise in personal savings) will require a further pullback in consumer spending," Dudley said. |
