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The Wealth Effect and Stock Prices: Greenspan Redux

Wealth is good, right? The real question is whether the stock market is the beneficiary or the driver of those gains.

Is U.S. wealth in danger of causing a reversal of fortune?

The oft-debated, but tough-to-gauge, "wealth effect" waltzed back into the headlines last week, after

Federal Reserve


Alan Greenspan

gave it ample time in the first round of his


testimony. This is not the first time the "Big G" has pondered the role that rapidly rising stock prices have played in the turbo-charged economy. But, judging from the subsequent damage it inflicted on stocks, his message (combined with a handful of other warnings) seemed to resonate with investors this time around.

By itself, the notion that a sharp increase in equity values has fueled consumer spending, boosted aggregate demand and helped thrust the long-running economic expansion into record territory, hardly sounds like a bad thing.

Wealth is good, right? The real question is whether the stock market is the beneficiary, or the driver of those gains. Consumer spending accounts for about 2/3 of the nation's overall activity and it was up 7.5% to $6.5 trillion in 1999. So if the gains supposedly propelling robust spending were to quickly dry up, or worse, do an about face, things could get pretty ugly, pretty fast.

This is precisely the scenario the Fed chairman is worried about, and now apparently so are a lot of investors. In Greenspan's words:

How the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process.

It's All From Where You're Sitting

Among economists and other market observers, the importance of reining in the wealth effect seems to mirror the extent to which they believe it exists.

"People's attitudes about the stock market and the sustainability of gains," have increased along with stock holdings and the value of those holdings, said

Lehman Brothers

economist Joseph Abate.

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In early 1999, well before the major market indices -- and particularly the

Nasdaq Composite Index

-- began breathless run-ups, Abate speculated that the increased share of equities on household balance sheets and higher borrowing have made households more vulnerable to movements in financial markets, and consumer spending more responsive to financial events.

"As gains are sustained, it becomes viewed as part of a permanent base in

consumers' financial positions," said Robert DiClemente, co-head of U.S. economic research at

Salomon Smith Barney

. "Suddenly, I wake up and find that the money I saved over the last 10 years is a small," part of total assets. The urge to spend is "a very simple human response."

Traditional wealth models assume that consumers increase annual spending by about 4 cents for every dollar of additional equity wealth. Abate took a look at the effect of the booming market, and the tech sector in particular, in a recent paper he co-authored entitled

The Revenge of the Nerds

. Abate concludes the same percentage change in stock prices now has an even bigger impact because of something called "the elasticity of consumption with respect to wealth."

"A sustained 10% increase in the stock market caused a 0.3% hike in consumer spending in the late 1980s, a 0.5% hike in the mid-1990s and a huge 1.1% today," the report says.

Look no further than the recently released "1998 Survey of Consumer Finances" for proof of the leap in stock ownership. The survey found that the ownership rate of stocks has grown 17.2 percentage points since 1989, with nearly half that gain occurring since 1995. "In 1998, 48.8% of families owned stock equity through some means. ... Not surprisingly, the median value of stock holdings among those having any, rose 62.3%."

But some think the impact of that figure is exaggerated. Diane Swonk, deputy chief economist at

Bank One

in Chicago, argues that the stock market is "still not a dominant factor and is very hard to use as a faucet you turn on and off."

Swonk said the latest stock ownership figure revealed in the survey encompasses remote definitions of ownership such as stocks held in 401(k) plans and thus includes gains which are less influential on current spending decisions. In addition, she notes, the largest stock gains are concentrated among a small percentage of that ownership, so that the increased value and wealth are not as broad-based as one might assume. Lastly, "the other 52.2% of households

doesn't have a dime" in the market, said Swonk.

"I think it's important to keep it in context, how few folks still have access to the stock market. Once you get outside a 100-mile radius of Wall Street and hit Main Street," things are different, said Swonk. The majority of homeowners still say their home is their largest asset and, because of the mortgage refinancing boom in 1998, people had some additional money in their pockets that they evidently headed to the mall with, she said.

"People actually pulled out

their equity and were spending it" said Swonk, adding that refinancings tended to "artificially suppress" consumer savings rates.

Judging from overall sentiment and anecdotal evidence, though, Swonk is in the minority. "There are still some people who don't believe a wealth effect exists?" asked DiClemente. "There are also some people who still believe the earth is flat," he said. Greenspan quantified the wealth effect, estimating that "outlays prompted by capital gains in excess of increases in income have added about one percentage point to annual growth of gross domestic purchases."

"If the market were to turn off and just go sideways, there would still be residual wealth effect. Or if it just became volatile or unsettled, people won't know if they can count on those gains anymore," said DiClemente. He says there is a period of time after market swings that the consumer spending rate reacts. "The key here is to show how long the lags are," said DiClemente. Judging from the market action and horrible breadth over the last few weeks, as well as the reaction to recent Fedspeak, the answer may come sooner rather than later.