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ECONOMIC ANALYSIS: How consumers respond when paper profits vanish

March 5, 2007

Most market sages know it already, but there is always a new generation of investors that needs to relearn the lesson taught by this latest financial market volatility. Namely, that paper wealth is subject to change. Turning your financial wealth into something else of value-like a house, or a car, or even a bond-always contains an element of uncertainty. If you want to take it literally, more than a trillion dollars of wealth was wiped out in the first five hours of the Feb. 27 market decline in this country alone. At first blush, this would appear to have a serious impact on the overall economy, as consumers and businesses cut back on spending plans to reflect their new wealth positions.

It's a sensible enough conclusion. After all, most of us would behave differently if we had money in the bank than we would if we did not, even if we didn't touch our savings. We'd be more likely to spend a little more freely, and to set aside a little less for tomorrow, knowing we already had something salted away, than would be the case otherwise.

Economists call that the wealth effect, and in making projections for the economy's future, there is no question it is important. But in assessing the impact of events like the Feb. 27 market plunge on the economy, another question must be answered. That is, how do individuals perceive their wealth?

The evidence suggests consumers apply a pretty large grain of salt to the news they get from their stockbrokers on transitory changes in their financial wealth, in both directions. If our broker tells us we're worth 5 percent more today than we were three months ago, any new spending and consumption plans we might contemplate are tempered by the knowledge that markets can gobble up those gains as quickly as they are served in the days to come. To put it another way, we treat $1,000 of stocks a little differently than we do, say, $1,000 of cash in our pockets, simply because it could be worth $50 more or $50 less tomorrow.

When it comes to stocks, the impact is further minimized by the fact that stock ownership is much more concentrated among a smaller number of wealthy individuals, whose spending is proportionately smaller and less likely to change, than is the distribution of earnings.

It is this last point, together with new developments in the financial services industry, that have caused some economists to believe fluctuations in wealth caused by changes in housing prices are more to be feared than stock market volatility, at least as far as their impact on consumer spending is concerned. Since homeownership rates are at record highs, the possibility that fluctuations in housing values might work their way into our collective consumption patterns raises another source of volatility to worry about for those who manage the economy.

On its face, that would seem rather farfetched. In most situations, we can convert our stock portfolios into cash with a phone call, but in earlier times, at least, turning increased real estate wealth into cash meant selling the home.

As we've all become aware, that's hardly the case today. Especially in the big boom of 2005, and in the go-go markets on the coasts and in Florida, folks have been tapping into their rising real estate equity values almost as easily as they might use an ATM card. Which has made those charged with managing the U.S. economy plenty nervous now that those values have, in some markets at least, been heading the other way.

But the economy always gives us plenty to worry about, doesn't it? Let's hope a brief lapse of confidence on Wall Street isn't one of them.



Barkey is an economist and director of economic and policy study at the College of Business, Ball State University. His column appears weekly. He can be reached by e-mail at pbarkey@ibj.com.
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