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Commentary: The Opposite Of The "Wealth Effect"


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Commentary: The Opposite of the "Wealth Effect"

Feeling flush? It's hard not to. The value of stock market investments held by American households has grown by an astonishing $6.6 trillion during the past four years, or about $60,000 in spare change for each household. With a windfall like that, there's no reason to skimp on the new car; no reason to sweat over savings.

If this sounds like what's happening in your house, you're in good company. Consumer spending, buoyed by the wealth effect, grew by 4.8% in real terms in 1998, while savings slid into negative territory. During the four-year period just ended, economists estimate that consumers spent an extra $200 billion to $330 billion, or about $3 to $5 for every $100 of net worth they added.TERRA INCOGNITA. The big fear is that the wealth effect will work in reverse if the market tanks. There are two ways to think about this possibility, one of them reassuring, the other far less so. First, the good news: History shows that consumers are unmoved by fleeting changes in stock prices. Changes in wealth have to be sustained to bring about a change in behavior. There were fears last fall that a new bear market was in the offing, but stock prices rebounded--and spending grew 4.4% in the final quarter of 1998. Similarly, stock prices recovered within six months after the October, 1987, crash, and there was only a small impact on spending. But the 1973-74 bear market dented consumption (chart).

Now, the bad news: While it takes a sustained decline in stock prices to make consumers change their spending habits, it's far less certain how great the reaction might be if it comes. Economist Mark M. Zandi of Regional Financial Associates Inc. in West Chester, Pa., warns that while rising net worth boosts spending $4 for every $100 gain, spending might fall by as much as $7 for every $100 decline in wealth.

There are a couple of reasons why this might be the case. First of all, stock ownership is much more widespread than it once was, with millions of Americans now investing in the market through 401(k) retirement plans and other vehicles. The very rich can see their portfolios devastated yet manage to maintain spending levels. But Americans with incomes of middle and upper-middle levels may have been counting on those recent stock market gains. As the market soared, they may have reached "target" wealth levels far more rapidly than they had expected to--then commenced to spend and borrow more freely as a result. If these investors see their nest eggs evaporating, they may cut spending sharply and pay down debt.

Then, too, there's the confidence factor. In recent years, says Christopher D. Carroll, an economist at Johns Hopkins University, consumer spending seems to depend more on how confident about the future consumers feel. A decline in sentiment linked to a sustained plunge in stock prices could eventually provoke "a fairly vicious decline in consumption," warns Carroll.

Life-cycle and permanent income theories of consumption posit that people base their spending and saving decisions on what they believe their financial resources and needs will be over the long haul. The stock market's huge gains have been accumulating for long enough to be included in such long-run assumptions, making the wealth effect a powerful force in the economy. But it is a force whose impact on the downside has yet be reckoned.By Karen PennarReturn to top

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