Consumers Take Stock of Asia’s Economic Crisis
Could a prolonged decline in stock prices finally derail the U.S. economy after seven years of expansion?
As the stock market continues to slide, some economists worry that Wall Street’s weakness may sap the consumer’s will to spend.
With U.S. exports hit hard by the Asian financial crisis, the burden of spurring growth in the economy is falling almost entirely on consumer spending and business investment.
American consumers, in the words of economist Mark M. Zandi, are “arguably the global economy’s principal source of growth.”
But just as consumer spending has been boosted in recent years by rising household wealth from the spectacular, nearly 8-year-old bull market in stocks, the same process can work in reverse.
Economists call it the wealth effect: some people’s tendency to open their pocketbooks as the value of their stock holdings climbs--and snap them shut when the market tumbles.
By most estimates, spending rises by about a nickel for every $1 gain in stock-market wealth--even though such gains may be purely on paper.
Since 1994 alone, stocks’ surge has added nearly $5 trillion to American household wealth, according to M. Carey Leahey, chief U.S. economist for High Frequency Economics in Valhalla, N.Y.
What Wall Street gives, however, it also takes away. Leahey calculated that the 900-point, or 9.8%, slide thus far in the Dow Jones industrial average from its July 17 peak has sliced $700 billion from household wealth.
Assuming the wealth effect also works in reverse, that would translate into a $35-billion reduction in consumer spending, which would slash about a half percentage point from U.S. gross domestic product growth.
It wouldn’t be enough to push the economy into recession, but it certainly would add to the slowing underway since spring.
The down market may already have let some of the helium out of the consumer’s balloon. The University of Michigan’s preliminary index of August consumer confidence edged down slightly, to 104.5 from 105.2 in July.
The index peaked at 108.7 in April, which also was the month when the U.S. stock market overall peaked, even though the Dow went on to new highs in July.
Economists say a consumer pullback would first hit sales of homes, autos and other big-ticket items that can easily be deferred in times of belt-tightening.
Consumers aren’t the only spenders affected by stock swings.
“We’ve had four consecutive quarters of [corporate] profit declines,” noted economist Albert Wojnilower of the Clipper Group in New York. “When that happens, we see a decrease in what [economist John Maynard] Keynes called the ‘animal spirits’ of business executives, whose power and pay rise with the stock market.”
Executives who aren’t feeling good about their stock options may hesitate to spend money on new plants and equipment.
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Economists generally believe it will take a much steeper stock market drop than has occurred in the last month to produce a true recession, defined as two consecutive quarters of declines in the gross domestic product.
A Dow tumble of 20% to 30%--which would officially qualify as a bear market, the first since 1990--could produce a mild recession, said David Blitzer, chief economist at Standard & Poor’s.
For a deep recession, though, Wall Street can’t do it alone. “To get a nightmare, you’ve got to have a dumb Fed,” said Blitzer, referring to the Federal Reserve Board, which oversees interest rate policy. “They’d have to tighten monetary policy just as the economy was failing.”
Most observers think the Fed reacted superbly to one of its biggest stock market tests, the October 1987 crash, when the Dow plummeted 22% in a single day, capping a 36% slide overall.
The plunge did not severely affect consumer spending, economists say, in part because the Fed pumped money into the financial system, pushing interest rates sharply lower for several months after the crash.
Indeed, the U.S. economy boomed in 1988.
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But the stock market’s value relative to the total economy, and the proportion of Americans who own stock, have both grown significantly since 1987.
As of a year ago, the $8 billion in household stock holdings represented 25% of all household assets, compared with $2 billion, or 10% of household assets, a decade earlier, according to Zandi, chief economist at Regional Financial Associates in West Chester, Pa.
Studies of stock ownership indicate that four to five of every 10 American adults now have money in stocks, versus about 2 in 10 in 1987. That growth reflects the rise of 401(k) and other self-directed retirement plans.
“The stock market has moved into Americans’ homes like a rich uncle, and it will be sorely missed if it moves out,” said James Grant, editor of Grant’s Interest Rate Observer newsletter in New York.
Zandi speculated that the wealth effect may actually be greater now in a falling market than in a rising one because so much of stock market wealth is held in retirement accounts.
About one-third of household stock holdings are in tax-deferred retirement accounts today, as compared with only one-fifth in 1989, according to the latest Fed study.
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While conventional wisdom is that many investors tend to be solidly committed to the stock market with their retirement savings--that is, they are prepared to ride the market’s ups and downs in the short term, without worrying--that may be far less true for people whose retirement is on the horizon, experts warn.
“Households approaching retirement age are sure to be very sensitive to any erosion in their retirement nest egg, crimping their spending quickly to make up for any loss in wealth,” Zandi said.
