Long-expected reverse wealth effect may become reality but it still isn't clear what its impact may be
For months, economists have been waiting for the US economy to feel the impact of the 'reverse wealth effect' that was supposed to have resulted from the past year's stock market slide.
The stock boom of the 1990s enriched American households, launching consumers on a prolonged spending spree. When the market turned down last year, consumers should have pulled in their horns. They haven't, at least so far.
'For consumption, it seems as though the stock market decline never happened,' said Wall Street economist Albert Wojnilower. Americans usually stop spending and save more when the market slumps, he said. Instead, they've continued to spend.
Wojnilower finds the anomaly easy enough to explain: the real spending boom has been concentrated mainly among upper-income households, earning $80,000 a year or more. They've financed it by selling stocks and re-mortgaging their homes. Nevertheless, those who believe there'll be a 'negative' wealth effect haven't given up. If the stock market boom spawned a consumer binge on the way up, it should prompt a retrenchment on the way down, they say. And they predict it will show up soon.
'The main reason it hasn't been felt so far is that stock market bubbles historically have provided a positive impulse to household consumption for more than a year after the market peaks,' said Robert Dugger, a Washington hedge-fund specialist.
Given that it's been 15 months since the Nasdaq Composite Index turned down and 10 months since the Wilshire 5000 peaked, we should know by October whether the so-called negative wealth effect will actually arrive, Dugger said.
The issue is important because continued spending by consumers is considered a major factor in how the economy performs over the next several months. A large retrenchment could throw the economy into a recession.
So far, consumer spending has held up far better than most analysts had predicted. Commerce Department figures show personal consumption rose at just below a 3% annual rate in the final quarter of last year and the first three months of 2001.
Yet, Dugger believes it's wise to wait a few more months before declaring that the danger is over. Once the momentum from the stock bubble wanes, he argues, even wealthier consumers will begin thinking about cutting back.
Moreover, they'll face a whole raft of tax and financial incentives that will be pressuring them to save, he said.
For one thing, marginal tax rates are low, which makes the value of home mortgage deductions lower than it was 20 years ago. Credit card interest no longer is tax-deductible. And there is a wide range of tax-incentive savings plans. If the savings rate goes back to where it was only three years ago, when it was about 3%, that would represent a decline in household consumption of between $200bn and $250bn, he estimates.
'That would dwarf any of the tax-cut stimulus that Congress has enacted so far,' he said. Moreover, much of the stimulus that the tax cut will provide this year will go to middle-income Americans.
'The rich won't get much for several more years. While some economists were quick to forecast a wealth effect impact when the stock market was rising, any semblance of unanimity has disappeared since the market began to slump.
'The reverse wealth effect is real, but it essentially has run its course, and the danger is over,' said James Bianco, head of Bianco Research LLP in Barrington, Ill. The slide hasn't prompted consumers to cut back, and it isn't apt to now, he said.
The Conference Board's survey of consumer confidence has returned to its January levels after declining briefly in February and April. The figures are well below last year's highs, but overall confidence is holding its own.
Last April, some analysts saw new reasons that consumer spending finally would begin to collapse: The economy actually started to lose jobs then, and the earlier decline in household wealth reached worrisome proportions. Yet, it didn't happen.
'Doubtless it's impacting on consumer confidence, but we have not yet seen any serious deterioration in the actions people take,' Federal Reserve Chairman Alan Greenspan said last week, referring to the increase in job losses.
Others argue that while the wealth effect has proven important, it's not quite as potent as some analysts have contended, partly because, as Wojnilower points out, its greatest impact has been on the rich.
Kevin Hassett, an American Enterprise Institute economist, asserts that while middle-income families had been buying stocks in droves during the late 1990s, much of their holdings have been in retirement portfolios, which they're loath to tap.
'I've never seen anything that suggests that such swings affect consumption,' he said.
There are, however, faint hints that at least some wealthier Americans may soon feel the squeeze: the real estate market has begun to slow in a few cities and a survey by US Trust suggests that affluents are becoming concerned.
If the bear market were to continue, the survey showed a substantial proportion would begin belt-tightening by cutting back on big-ticket purchases, going to dinner less often, or putting off major home improvements.
If that happens, the long-expected reverse wealth effect might finally become a reality, says Jeffrey Maurer, US Trust's chief executive officer. Yet, it still isn't clear what its impact might be.
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