Don't Fear The Wealth Effect
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."