The Wealth Effect

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We live in very prosperous times. The economy has been expanding at a very steady rate over the past eight years. More people, 138 million, are employed than ever before. The unemployment rate is at a 29-year low of only 4.5 percent. Inflation is under 2 percent. As a consequence, standards of living are improving for most people, and the times, they are good.

Academics often use the “misery” index to measure the state of the economy and the well-being of a society. This index, the addition of the unemployment and inflation rate, currently measures a very low 6.5 percent. In the early ’80s, we suffered triple the misery level of today as the index hit 24, with inflation at 14 percent and unemployment at double digit levels.

So, we should conclude that there is nothing to worry about, right? Wrong! The chief worrier in the U. S. is Federal Reserve Board Chairman Alan Greenspan. In recent testimony before the Congress, he again told of his worry about the level of the stock market and the “wealth effect” that it might be creating.

Just what is this wealth effect and what are its consequences? Simply put, Greenspan is worried that the increased value of stocks held by families will cause consumers to spend more with the result that prices may increase, labor costs may go up and inflation may return.

Over the past four years (1995 through 1998), common stocks have appreciated each year over 20 percent. In terms of the dollar value of all publicly-traded stocks, total market capitalization has more than doubled in the last four years, from $4.5 trillion at the end of 1994 to $11.3 trillion at the end of last year.

I must admit that, even for one who works constantly with numbers, these figures are numbing! Assuming our annual gross domestic product totals $8 trillion, the value of all traded stocks now represents 141 percent of GDP. To put that number in perspective, the value of stocks in relation to GDP is usually about 60 percent and has exceeded 100 percent only once before. I am hesitant to mention (for fear of discouraging the current bull market) that the only previous exception was right before the 1929 market crash!

Another way to measure the wealth effect is to divide the increase in market value of all traded stocks over the past four years, $6.8 trillion, by our population, 270 million. This results in $25,000 for every man, woman and child in our country. Of course, equity wealth is not that evenly divided, but you get the idea. Assuming equal distribution and a family of three, equity values have added $75,000 to each family’s wealth in just four-years.

These figures are reflected in the very high rate of consumer spending which is the largest item in the economy. The wealth effect has contributed to an almost a zero savings rate and the lowest for any industrialized country. This is partly because the World War II generation is spending down their savings in retirement which offsets their boomer children’s’ saving for their retirement.

The wealth effect is also evident in the current record level of consumer debt of $1.3 trillion. Except for a third of that which is financing car purchases, most of the rest is credit card revolving debt. Because many are exceeding their credit-carrying capacity, we are experiencing a record level of personal bankruptcies.

By all common measures of stock market value, the current market is very-highly priced. Those measures are price-earnings ratios (currently 25 whereas the average ratio is 14), dividend yield (1.6 percent versus the average yield of 4.5 percent), price to book ratio (6 compared with the average of 2.5).

What is the stock market telling us? It likes baby boomers putting money away for their retirement, it likes low interest and inflation rates, it likes the decrease in federal government deficits, it likes low unemployment, it likes the high confidence level of Americans, it likes the technological and productivity increases, it likes the fact that we won the cold war and other countries are emulating our economic and political systems and are investing in our economy, and lastly, it likes the prospect that some future social security retirement monies might be invested in the stock market.

The U. S. makes up the largest share of the world economy. In terms of product and equity, we are over a quarter of the world’s total. If Greenspan did not have to worry about the effect of our interest rates on the world economy (with problems in Southeast Asia, Brazil and Russia), the Federal Reserve Bank might have already increased domestic interest rates as the economy expanded at the relatively torrid rate of 6 percent in the last quarter of 1998.

When (not if) the Federal Reserve Board increases interest rates, this will bring the stock-market party to an end as higher interest will cause both stocks and bonds to fall in value. Then, we will feel less wealthy and this will contribute to the downturn and prove, once again, that the business cycle is alive and well. Let us hope that our recession and bear market does not last as long as it has in Japan: almost a whole decade.

Photo by Alvin Mahmudov on Unsplash

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George Marotta served in the U.S. Army in the Pacific, graduated from Syracuse University, worked in U.S. foreign affairs and Stanford's Hoover Institution, and founded a financial firm in Palo Alto. He is mentor and father of David Marotta.

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