Less Wealth Won't Kill Spending

Despite the housing bust, stock market gains have kept household balance sheets in good shape so far. The real dangers to consumers are tight credit and a weak job market

Economists have always considered the housing slump's impact on household wealth one of the key risks in the outlook for consumer spending. Studies show that people eventually spend about 5 cents of every dollar increase in their overall net worth, which can be fueled by a range of assets from stocks to bonds to real estate. It also works in the opposite direction, and the effects of the housing bust are beginning to take a toll on household balance sheets. The situation will get worse in 2008, as home prices fall further. The question is, how hard will consumers be hit?

So far the effect has been small. New data from the Federal Reserve show the value of household assets minus liabilities rose in the third quarter by $625 billion, to $58.6 trillion. The increase was less than the $1 trillion per quarter averaged over the past two years but still a solid gain. Housing wealth, which is home values minus mortgages, fell for the second quarter in a row. Net worth from all other sources, which is heavily influenced by the ups and downs in stock prices, accounted for all of the advance.

Therein lies a critical risk for 2008. How the stock market holds up will be crucial to overall wealth. Economists generally expect home values to drop roughly 10%. That translates into about $2 trillion in lost real estate value. It would take about a 10% rise in stock prices in the coming year just to offset those losses. Still, overall gains to net worth would ease from the pace in recent quarters, and that slowdown would mean less support for consumer spending.

The interplay between stock and real estate values will be clear this quarter, as home equity slides further. Even after the Fed's quarter-point cut in rates on Dec. 11 and its Dec. 12 move to increase liquidity, the broad DJ Wilshire 5000 (DWC) stock index was below its Sept. 30 level, implying household net worth is on track to drop this quarter for the first time since 2002.

Also, the Fed's data may overstate the value of real estate. The Fed's measure of home prices comes from the Office of Federal Housing Enterprise Oversight (OFHEO). It excludes jumbo mortgages and has very limited coverage of subprime loans, meaning the high and low ends of the market are underrepresented. The OFHEO index is up 1.8% from a year ago, while the S&P Case-Shiller index, which includes both subprime and jumbo categories, is down 4.5%.

Although falling household wealth will be a negative influence on spending, the effect in the coming year will be mitigated by the time it takes a decline to work its way through. Economists estimate it can take two to three years for shifts in wealth to affect spending. That means outlays in 2008 will continue to be shored up by past gains. However, studies show that changes in housing wealth, which consumers tend to view as long-lasting, move through faster than shifts in financial assets, which individuals often see as more transitory.

Recent history suggests it would take a very large and lasting drop in overall net worth to have a big impact on spending. After large gains in the late 1990s, household wealth fell by about $5 trillion from early 2000 to late 2002. Growth in consumer spending, however, slowed sharply but didn't contract.

The more important threats to consumer spending in 2008 are tighter credit and a weak job market. At least through November, credit market turmoil has not yet had a major effect on either job growth or buying. November car sales rose from 16 million in October to a decent annual rate of 16.2 million, and November retail reports were much better than expected. The same was true for last month's payrolls. They rose by 94,000 from October, and hourly earnings increased a strong 0.5%, suggesting income growth remains firm.

Ultimately, the wealth effect is not the biggest danger consumers face. In the coming year, while a weaker balance sheet will be a drag on household spending, it will not by itself bring this crucial sector down.

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