Ominous side of added wealth

The Economy

Stock drop could hit free spenders hard

July 25, 1999|By William Patalon III

MOST of the nation's spend-a-holic consumers gaze at our booming economy and see reason for continued optimism.

But Lyle K. Benson sees cause for concern.

Consumers are "generally upbeat still," says Benson, who, as a financial planner in Towson, sees a lot of them. "People generally feel that things are going to keep going along pretty much as they are. That scares me, because I know that they won't."

Too much of a good thing can be bad. Even with wealth.

The ascending value of our retirement plans, brokerage accounts and homes has helped fuel an economic expansion of stunning strength, longevity and resilience. Many economists say that's the work of the "wealth effect," the belief that as our net worth increases, we feel richer and spend more.

The wealth effect has an evil twin -- sometimes labeled the "reverse-wealth effect," or "wealth shock." The reverse-wealth effect occurs when net worth sharply contracts. We feel poorer and clamp down on spending.

Consumers react more severely to bad news than to good. Thus, a wealth shock hurts the economy more quickly -- and to a greater degree -- than the wealth effect helps it, economists say.

Combine a Federal Reserve that has raised interest rates once (and appears ready to do so again) with a stock market most say is vastly overvalued, and it's clear our wealth is vulnerable. And so is the economy. Many economists say a sudden plunge in stock prices could blindside the ebullient American consumer, causing a big drop in spending and tipping our $8.8 trillion economy into a downward spiral.

According to the wealth-effect theory, for each $1 stock prices rise, consumers boost spending from a penny to 3 cents, though the increase might take two years.

For each $1 decline, spending is believed to fall 7 to 8 cents within six to 12 months.

Critics of the hypothesis say stocks aren't like a bank account. Wealth-effect proponents say that misses the point. The fatter those retirement or brokerage-accounts appear, they say, the more confident consumers are about dipping into savings, using their credit cards or borrowing against their homes.

Not afraid to borrow

That's the wealth effect's power: If consumers feel flush, they're not afraid to borrow and spend, said Maureen F. Allyn, chief economist for Scudder, Stevens & Clark Inc.

Wealth-effect disbelievers point to the crash of 1987 and the market's big decline last year as evidence that stock-price drops do not end the party. But in both cases, the Fed immediately cut interest rates, nurturing a rebound in stock prices.

By contrast, the Fed is now raising rates.

Wealth-effect naysayers also contend that stock prices matter only to the rich. That was once true, but not today. In 1987, stocks made up less than 26 percent of a typical family's assets. By last year, that figure exceeded 40 percent. Some economists believe it's now half.

That makes sense. First, stock ownership has grown as employers increasingly offer 401(k) retirement accounts that put their workers into stock mutual funds. Second, the market's value has surged from $2.9 trillion in 1990 to about $13 trillion now.

Drop-off in economy

Clearly, a steep drop in stock prices would shock a lot of now-buoyant consumers. And that could translate into a drop-off in the economy. With a 15 percent stock market decline, spending could fall by $140 billion over the next year, an amount equal to 1.6 percent of overall gross domestic product. In other words, with an economy expected to grow 4 percent this year after similar jumps of 3.9 percent in 1997 and last year, the "wealth shock" of a 15 percent market drop could spawn a falloff equal to 40 percent of the nation's total growth.

That's probably an oversimplification, but there's plenty of evidence underscoring how the consumer is playing a greater-than-usual role in economic growth.

Historically, consumer spending accounts for 65 percent of the total economy. Now, it's 69 percent, said Sung Won Sohn, chief economic officer for Wells Fargo & Co. in Minneapolis.

What's more, thanks to the wealth effect, consumer spending is accelerating.

Starting in October, and continuing every month since, spending increases have outpaced wage increases, says the Commerce Department, meaning consumers are dipping into savings or taking on more debt, which is at record levels.

Increased freedom

The wealth effect has made life better for Americans, but the increased freedom to borrow and spend it has placed consumers in a precarious spot.

Benson, the Towson-based financial planner, has seen that vulnerability firsthand, particularly with too-confident consumers who, emboldened by the gains in their portfolios, stretched themselves to buy the biggest houses they could afford. In doing so, these consumers didn't consider the day when the stock market experiences one of its periodic -- and unavoidable -- declines.

"The value of some of these houses, it scares me," says Benson. "These people mortgaged to the max to do that because they wanted to trade up. But they haven't stepped back to consider [what would happen] when their asset base inevitably declines."

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