Don't Fear the Wealth Effect
Consumers aren't spending wildly
Two specters are haunting Alan Greenspan and his chary band of policymakers at the Federal Reserve: On the one hand, they worry that excessive consumer spending, inspired by the wealth-enhancing effect of the bull market, is about to ignite inflation. On the other, they worry that agressive Fed tightening could touch off a wealth-destroying market correction that causes a sharp contraction in household outlays. These related concerns help explain Greenspan's predilection to tread lightly on the monetary brakes.
But what if this scenario is wrong? What if the wealth effect is less than it's cracked up to be, and consumer spending is less exuberant than many believe? That is what Wall Street economist Peter L. Bernstein contends.
Greenspan has often cited the sharp decline in the personal savings rate, which measures savings as a share of aftertax income, as evidence of a wealth-induced consumer spending spree. Bernstein points out, however, that the decline in the rate--from more than 7% in 1993 to around 2% recently--occurred just as taxes began taking an increasing chunk out of personal income.
That suggests that the growing tax bite has somehow eaten into savings. Indeed, Bernstein notes that the rise in government savings as a share of gross domestic product has almost exactly offset the decline in personal savings (chart).
Several reasons for this development suggest themselves. First, the government's tax take as a share of national income has risen because real income growth in recent years has been concentrated among the wealthy, who face the highest tax rates. Second, measurement peculiarities have lowered estimates of personal savings.
In calculating the savings rate, for example, the government defines savings as what's left over after consumption outlays are subtracted from disposable income. But it doesn't count realized capital gains as income. And the fact that people spend some of those gains tends to lower measured savings.
Similarly, as Edward E. Yardeni of Deutsche Bank has noted, the government doesn't count private pension benefits as income, though it does count pension plan contributions. And last year, benefits paid to retirees (much of which were spent) exceeded corporate contributions by a record $216 billion.
As for consumption, Bernstein has calculated the growth in real consumer spending from 1964 through 1992, and he finds that its pickup since 1997 is in line with long-term trends. Moreover, the big rise in consumer outlays as a percent of pretax income actually occurred back in 1993, well before talk of a wealth effect surfaced.
In short, consumer spending is well within historical bounds, and the wealth effect appears exaggerated. "Consumption will weaken if the stock market declines," says Bernstein, "but fears of a sharp contraction are excessive."By Gene KoretzReturn to top
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Less Smoking, More Drinking
Are quitters trading cigs for booze?
Both smoking and excessive alcohol consumption impose heavy costs on society--from burdensome medical spending and lost productivity to alcohol-related motor-vehicle fatalities. Thus, economists have long advocated raising taxes on these items to curtail demand and force consumers to bear more of the costs of their use.
In the case of tobacco, such arguments have won out. Paced by rising taxes, the retail price of cigarettes has increased 57% since 1996. By contrast, the inflation-adjusted cost of a six-pack of beer has been falling since 1991.
Since smoking and drinking often go hand in hand, this raises an interesting question: Will a drop in smoking caused by rising cigarette prices also reduce demand for alcohol? That's what should happen if the two are complementary goods, like tea and crumpets. If they are substitutes for each other, however, demand for alcohol could tend to rise.
A study by Sandra L. Decker and Amy Ellen Schwartz of New York University sheds light on the issue. Using survey data, the two economists found that higher beer prices tend to reduce both beer drinking and the number of smokers, suggesting that booze and smokes are complementary goods. To their surprise, however, they found that higher cigarette prices actually seem to induce greater beer consumption.
Why these apparently contradictory results? The researchers speculate that higher beer prices may lead some people to stop drinking and thus avoid places like bars, where social smoking is the norm. By contast, smokers who have recently quit may turn to substances like alcohol to lessen the side effects of withdrawal. Whatever the reason, the results suggest that it might make sense to raise alcohol taxes in addition to cigarette taxes.By Gene KoretzReturn to top