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A friend sent me this. Seems by this explanation that even a 30% permanent hit
on the market will have little or no effect on life as we know it. Which sure
seems at odds with those pictures of people wiping sweat from their brows and
wringing their hands in front of the public stock tickers when the markets were
plunging <g>. Comments?
JW
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April 24, 2000
Barron's Features
The Wealth Defect
If stocks crumble, the economy may not be hit as hard as some theorize
By GENE EPSTEIN
Let's suppose the greatest show on earth really does fold its tents: The S&P
500 plummets 30% from its late-March high and stubbornly refuses to
rebound. With the euphoria suddenly gone from their lives, what will the world's
equity investors end up doing? What else but resort to the only other source of
instant gratification known to modern man: shopping. Buying that SUV,
acquiring that yacht, moving to a bigger home (especially since mortgages will
also be cheaper), or trading up to a Lexus -- even though no status symbol can
ever produce the joy that comes with owning a dot.com that doubles in price
every month.
For the truth is, through the last several legs of this bull market, it looks as
though investors were mainly keeping score. According to conventional theory,
there is a psychological transmission mechanism through which a rise in share
prices makes a person feel wealthier, even if he doesn't turn paper profits into
real ones by selling stock. And feeling wealthier, he then spends more on
consumer goods. That's the theory of the wealth effect. But this time around,
the voltage must have been such that the mechanism blew a fuse.
It does appear that equity prices have surged so far and so fast that most paper
millionaires haven't quite advanced to the big-spender phase. So if all those
gains get vaporized, maybe these investors will start going to the track more
often in order to fill the void, but otherwise, the rate of consumption won't
decline. Why? Because it never rose in the first place.
A similar view can be found in a recent scholarly paper, "How Important Is the
Stock Market Effect on Consumption?" by economists Sydney Ludvigson and
Charles Steindel of the Federal Reserve Bank of New York. After running the
relevant numbers through a standard econometric model, they wryly remark
that "if all pre-1988 data were destroyed, we would be hard-pressed
to conclude that there is a link between the stock market and consumer
spending."
While former New York Federal Reserve Bank research head Stephen
Cecchetti doesn't go that far, he does take a similar view. In his own recent
survey of this topic, he writes: "Given that the market is currently at 11,000
and
people are behaving as if it is at 8500, simple computation shows that they are
discounting the gains of the last few years significantly."
Indeed, there seems to be a disconnect between the recent surge in equity
values and consumption growth. It may even be that the bull market has helped
suppress consumer spending by inducing people to put their extra cash into
stocks.
On the other side of the conceptual divide, there's the widely held belief in
the
terrible revenge of the wealth effect. According to the rule of thumb codified
by
the utterances of Alan Greenspan, every $1 of additional stock-market wealth
has been boosting consumer spending by three to four cents; so every dollar of
lost wealth will clobber it by that amount.
But as we'll soon see, the Fed chairman has been snookered by a faulty model.
While Jason Benderly of Benderly Economics does believe there has been a
wealth effect from the bull market, he puts it more plausibly at one and a half
cents.
And we're not just quibbling over pennies. One and a half cents on the dollar of
a sustained $3 trillion loss in household holdings of equities, which is what
would happen if the market plunged 30%, translates into a $45 billion hit to
consumer spending. That $45 billion would shave a mere one-half of 1% from
gross domestic product, which is now valued at more than $9.5 trillion. Assume
instead that the hit comes to as much as three or four cents on the dollar, and
then you might be talking real money.
But we're not talking real money, because even that cent-and-a-half estimate
could
easily be too high. If Wall Street analysts would only look beyond the Hudson
or,
in the Fed chairman's case, the Potomac, they'd stop attributing so much of the
consumption boom to the bull market. Two other far more note-worthy trends
have done the heavy lifting: the lowest unemployment rate in 30 years and the
highest housing affordability in a quarter-century.
The tight labor market has brought a surge in wages and salaries, putting huge
amounts of cash in the hands of the lower 80% of consumers who live
hand-to-mouth, and who can be counted on to spend it -- and then some.
Amazingly enough, some economists don't even bother to consider the effects
of soaring wage-and-salary income on recent consumer behavior, as though
most households somehow live off their capital gains.
Ironically, the capital-gains effect lies at the heart of one of the fatal
errors
committed by Chairman Greenspan's model-builders. They do look at rising
incomes, but they walk away thinking that this factor isn't nearly as important
as
it really is. And that's because their estimates are artificially suppressed by
the
influence of capital-gains taxes.
There's no good way to explain this subtle point without a bit of math. (But
it's a
relatively painless way to be smarter than the Fed chairman.)
Suppose a salaried investor earns $100,000, out of which he pays a $30,000
tax, which leaves him with an after-tax income of $70,000. But now suppose,
as has been common these days, he realizes a $50,000 capital gain on stock he
owns. So he pays the $10,000 tax out of that cash and reinvests the remaining
$40,000.
Now, what happens in the national income accounts, and hence in the data
used by the Fed, is that this person's after-tax income gets reduced by that
extra $10,000 tax on the capital gain. So he is credited with only $60,000 in
income, instead of the original $70,000. That's because the accounting
perversely factors in the tax, but completely forgets that he had plenty of
extra
cash with which to pay it! And with capital-gains taxes recently bulging, this
distortion makes it look as though after-tax incomes aren't rising nearly as
fast
as they really are.
Fed economists also overlook the way consumer spending has been boosted
by the strong sales of new and existing homes.
The bull market in stocks has obviously helped fuel the housing boom. But the
more important factor has been the rise in the National Association of Realtors'
housing affordability index, which has been hovering at 25-year highs.
This index tracks the ratio between median household income and the true cost
of buying the median-priced home. The rise in costs has slowed mainly because
of the long-term decline in mortgage interest rates, while growth in income has
accelerated because of the tight labor market. This, in turn, has pushed the
nation's rate of homeownership to a record high, and has meant that sales of
new and existing homes have been running at nearly six million units a year, or
twice the level of the early 'Nineties.
And the point is, when people purchase homes, they also invest in rugs,
furniture, appliances, linens and dishes. Street economists are well aware of
this
spill-over effect, but what they overlook is that it also boosts the actual
level of
consumer spending. Since homeowners think of this kind of spending as a form
of investment, which in a very real sense it is, the dollars come out of funds
that
otherwise would be saved.
The decline in the personal savings rate to a record low is, of course, the flip
side of the leap in consumption, and it's been caused by exactly the same
factors.
To begin with, the savings rate has been understated because of the same
capital-gains distortion that befuddles the Fed. To go back to the same math, if
a taxpayer has an after-tax income of $70,000 and spends $60,000, he has a
relatively high savings rate. But if his after-tax income is put at $60,000
because
he paid a capital-gains tax of $10,000, his savings rate is misleadingly pegged
at
zero.
The savings rate has also declined because a higher proportion of household
income has been coming from wages and salaries, out of which consumers
spend heavily. (They spend a lot less out of interest and dividend income.) It's
also fallen because of the spill-over effect on consumption from rising home
sales.
In addition, the wealth effect from rising house prices has served to depress
the
savings rate. But, as noted, there's a wild card in the role played by the bull
market in equities. Perhaps it helped reduce the savings rate via the wealth
effect: Feeling wealthier, investors spent more on consumer goods. But the
rising market must have induced many investors to save more and consume
less. Cash taken out of income to buy stocks is counted as savings.
But as noted, even if the wealth effect from equities really has run as high as
one-and-a-half cents on the dollar, the hit to GDP growth from a 30% bear
market isn't likely to be very great.
Trim a half-percentage-point off GDP from the direct effect on consumption.
Then, take another half from indirect effects: Wall Street will start laying off
its
workers, the high end of the housing market will suffer and the tax take from
capital gains will contract, wiping out much of the budget surplus.
On the other hand, if people really are behaving as though the Dow is at 8500,
it won't be even that bad.
URL for this Article:
http://interactive.wsj.com/archive/retrieve.cgi?id=SB956364196179064205.djm
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