Is the 'Negative Wealth Effect' All It's Cracked Up To Be?

Just how much more havoc will the slumping stock market cause? In a recent story, TSC considered the possibility that steep market losses would cause consumers to cut back sharply on spending. Such a "negative wealth effect," which might deepen over time, could worsen current economic woes. Of course, it isn't easy to predict what could happen, since more Americans hold stock than ever before.

But is it possible that fears about the wealth effect have been overstated? Supporters of the theory tend to gloss over a key fact: Only a small percentage of investors own the majority of stock and have taken the brunt of losses, and those wealthy stockowners are less likely to change their spending habits due to stock market fluctuations. So there's a chance that the wealth effect, on the downside, may not be all it's cracked up to be.

By many accounts, the economic impact of a wealth effect could be considerable. Credit Suisse First Boston, for example, estimates that the wealth effect added about $43 billion to consumer spending in 1999 and $22 billion last year. (Their model assumes that consumers spend around 5 cents of each extra dollar of wealth over a period of about two years.) On the downside, the firm says if the Wilshire 5000 were to stay flat for the rest of 2001, the negative wealth effect of this year's dismal market performance would shave $43 billion off consumer spending, knocking roughly one percentage point off spending growth.

If a negative wealth effect does occur, though, it's not likely to be led by average investors. That's because, for all of the hullabaloo about how investing has become democratized over the past few years, wealthier households still hold most of the nation's stock.

True, stock ownership is broadly dispersed, with many middle-class households owning equities. According to an analysis by the New York Stock Exchange, the median shareholder had a family income of $57,000, and nearly 60% of shareowners lived in families with incomes between $25,000 and $75,000.

But while many households may own stock, most of them don't own that much. According to the Federal Reserve Board's 1998 Survey of Consumer Finances, only 10% of all investors had portfolios worth $250,000 or more, but together they owned 72% of all stock held by individual investors. At the other end of the spectrum, roughly one-third of all shareholders had portfolios valued at less than $10,000, and together they accounted for less than 1% of outstanding stock holdings. The size of the median shareholder's stock portfolio in 1998 was only $28,000, including assets held in retirement accounts.

More importantly, the majority of most U.S. household's wealth is still in nonfinancial assets like homes, privately owned businesses and cars, rather than the stock market.

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If stock losses affect anyone, it will be the relatively well-heeled folks who still hold the majority of equity investments. "What that means is that when we're looking for the impact of stock market changes on consumer spending, one would expect it to be pretty concentrated as well," says James Poterba, an MIT economics professor and visiting fellow at Stanford's Hoover Institution.

Unfortunately, the spending habits of the wealthiest 1% or so of Americans who hold around half of all equity investments are famously difficult to uncover. "Many, many research economists would love to find this Holy Grail," Poterba says. "They are notoriously underrepresented in surveys. You can't get them to answer questionnaires as much."

At the very least, there's evidence showing that fluctuations in income affect the spending of upper-income people less than lower-income people, says Christopher Carroll, an assistant economics professor at Johns Hopkins University. "Low-income people don't have as much of a buffer of wealth, so if income goes down, spending goes down. That's less true for wealthy people. To some extent, if you offset the fact that rich people have more of their wealth in stocks, you'd expect them to be somewhat less responsive to changes in their wealth than lower-income people are."

One as-yet-unreleased academic study that economists are awaiting found that the spending habits of better-off households that own stock are relatively less affected by market downturns than are those of middle-income households that own stock. That research generally supported the existence of a wealth effect on consumption, finding that the spending of households that own stock was more closely related to market fluctuations than the spending of households that don't own stocks.

So there's no question that most stock is held by a fairly small number of rich households, and it's likely that well-off people don't change their spending habits as much as middle-income people in the face of a market downturn. What's still unclear is just how much those wealthy households drive overall consumption.

But let's at least consider the glass-half-full conclusion: If richer households are insulated by other forms of wealth, and their spending isn't that much affected by market losses, it's possible the negative wealth effect won't be nearly as destructive as it's been made out to be.