October 12, 2005
So Long to the Wealth Effect?
By Robert Samuelson

WASHINGTON -- Ours is a wealth-driven era, when huge increases in home values and (before that) stock prices make people feel richer and cause them to buy more. They spend more of their regular incomes, borrow more or sell something, most likely stocks. You can imagine this ``wealth effect'' as a powerful afterburner that's boosted the economy for roughly 20 years.

While everyone is now worrying about the economic impact of Katrina and Rita -- on consumer confidence, energy prices, inflation and the federal budget -- the real story may be whether the afterburner is flaming out.

Just recently, Federal Reserve Chairman Alan Greenspan gave a speech suggesting precisely that. Greenspan disclosed the results of a study he had done with Fed staff economist James Kennedy. The study estimated the amount of cash that homeowners have extracted from rising housing prices (those prices are up 53 percent over five years, according to government figures). Homeowners could convert higher real estate values into cash in three ways, reasoned Greenspan and Kennedy: (1) sell their homes and grab the surplus, deducting any amounts paid for other homes; (2) refinance their existing mortgage for a higher amount and pocket the extra money (a ``cash out'' refinancing), and (3) take out a home-equity loan against the higher house value.

By estimating all three sources, Greenspan and Kennedy reached annual grand totals, shown on the table below. It provides the figures both in billions of dollars and as a percentage of people's ordinary disposable (after-tax) personal income. The housing money is extra, on top of personal income.

Year	Money	% of Disposable Personal Income
2000	$204 bil.	2.8
2001	262	3.5
2002	398	5.1
2003	439	5.4
2004	599	6.9

Whoa! Consumers had a lot more to spend than ordinary income, almost $600 billion more in 2004. How much of that was actually spent (as opposed to being put into bank deposits, stocks or mutual funds) is unclear. Consumer surveys cited by Greenspan suggest perhaps two-thirds, a big chunk of it on remodeling. The economy has depended heavily on all this extra cash. And, before the housing bonanza, there was the stock boom. From year-end 1985 to year-end 1999 -- just before the market peaked -- the value of households' stocks and mutual funds grew from $1.4 trillion to $12.8 trillion. Economists figure that consumers spend between 2 percent and 3 percent of their extra stock-market wealth. That's also a lot of purchasing power.

No one has fully explained what caused these immense wealth gains. My own oft-stated belief is that lower inflation is the main cause, because it gradually reduced interest rates. Investors shifted more money from bonds to stocks; homeowners could afford pricier houses. Remember: mortgage rates averaged 15 percent in 1982. But there are many other possible explanations, including financial speculation. Whatever the root causes, the result has been a marathon shopping orgy. In 1980, consumption spending was 63 percent of national income (gross domestic product); today it's 70 percent.

Could the wealth effect now subside? For stocks, it already has. At the end of 2004, households' stocks and mutual funds were worth 21 percent less than five years earlier. Greenspan has warned that the rapid run-up in home prices won't go on forever. In his recent speech, he also indicated that mortgage rates would probably rise from present lows and make it harder for homeowners to cash out profits. Growth in consumer spending would then presumably slow, he said.

This need not be a disaster. On paper, the economy could compensate in many ways: more exports and fewer imports (much U.S. consumer spending went to imports); stronger business investment; extra government spending for hurricane rebuilding. Britain's recent experience could be suggestive. Two years ago, home prices were soaring (roughly 20 percent annual increases), interest rates were low, homeowners were extracting huge cash profits (equal to 9 percent of disposable income at the peak) and consumer spending was high, says economist Howard Archer of Global Insight in London. Worried about inflation, the Bank of England raised interest rates. Consumer spending, economic growth and home-price increases (now about 3 percent annually) all abated. Unemployment has edged up; still, there's been no recession.

The fading of America's wealth effect, should it occur, might be equally dull and benign. But there are grimmer possibilities. One is that many adverse forces are now converging: higher energy prices, higher interest rates and debt payments, higher inflation, falling wealth gains. None matters much alone, but ``their combination is creating more consumer risk,'' writes Susan Sterne of Economic Analysis Associates. For two decades, free-spending American consumers have anchored the U.S. and world economies. If they no longer play that role, it's an open and worrisome question of who will.

© 2005, Washington Post Writers Group

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