The Uncertain Wealth Effect

If stocks fall, will spending crash?

Only a few months ago, economists were speculating that a long-awaited pickup in savings by baby boomers had finally arrived. After falling for a dozen years, the personal savings rate began trending higher in 1995 and hit a four-year peak earlier this year.

Then, as part of its annual revisions of the national accounts, the government lowered the rate for each of the previous seven quarters--changing its trajectory in recent years from a steady rise to a continuing decline. The upshot is that the savings rate for 1997 is now on track to finish the year at less than 4% for the first time in 50 years.

What's more, economist John Hancock of Regional Financial Associates points out that the true rate may be even lower. That's because there is currently a sizable discrepancy between the government's measure of gross domestic product, which is dominated by consumer spending, and its higher measure of national income, which is dominated by household income. Assuming consumption is understated and/or household income is overstated, the savings rate may now be less than 3%.

Statistical problems aside, the falling savings rate suggests that the stock market boom has generated a powerful wealth effect that has buoyed consumer spending and economic growth. As Hancock notes, stocks are now the largest asset in household balance sheets, accounting for a third of net worth and surpassing the value of real estate holdings for the first time ever. With more and more households owning stock via mutual funds or savings plans, it's no surprise that many regard their new wealth as reason to spend more freely out of current income.

But the critical question is whether the depressed savings rate and the current wealth euphoria mean trouble ahead. Many economists don't think so. With savings so low and stock market gains harder to come by, they see a healthy slowdown in consumer spending developing--in line with a more sustainable pace of economic growth.

Even a market drop of 15%, notes Hancock, would leave prices above where they were at the start of the year. Given the pileup of capital gains in previous years, he doubts whether such a correction would panic investors and spark the kind of spending decline that might trigger a recession.

But others aren't so sure. Stephen S. Roach of Morgan Stanley Dean Witter worries about a reverse wealth effect that is "asymmetrical"--causing a consumption contraction far greater than the spending surge generated by the market boom. "No one really knows," he says, "how consumers would react to a serious market correction."

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