Friday, May 29, 2009

Wealth effect channels: up and down

All signs point to a continued draw on home values, as foreclosures drive the markets and inventories start to creep back up. In contrast, equity markets have experienced a significant boom since January, but a struggling Treasury market harps its tune of economic uncertainty.

The question is: has enough wealth been recovered in equity markets to offset the losses in the Treasury and housing markets in order to stabilize consumption?

We will have to wait and see the exact Q1 wealth measure until the Fed's flow of funds realease on June 11. But for now, the chart illustrates a crude measure of the wealth effect on a monthly basis as the ratio of asset prices across two asset classes, tangible (housing) and financial (equity), to disposable personal income spanning October 2008 through March 2009.

Two tales are forming: equities are rising relative to income and housing maintains its descent relative to income. The diverging paths of the different asset holdings imply opposite wealth effects on consumption: rising equity values may possibly stabilize consumption, while reduced home values imply further consumption destruction.

Wealth is not the only determinant of consumption, but financial wealth is over 60% of the the households balance sheet (anywhere from pensions to 401k holdings to direct equity holdings), and its recovery will likely be important in consumption behavior going foward, especially in the upper income classes (see the B.100 household balance sheet). However, one cannot discount the ongoing negative effects on consumption coming from sharp declines of the remaining 38% of household assets, housing, and the very large effects from reduced home equity extraction.

To be sure, consumption grew an annualized 1.5% in Q1 2009; however, retail sales suggest otherwise for Q2 (April sales fell 0.4%). Likewise, the adverse wealth effects will only harm the economy further if wealth destruction causes households to reduce consumption further, raising the saving rate above the 4.4% in Q1 2009. I suspect that the saving rate still has a little upward momentum left in the pipeline.

Rebecca Wilder


  1. I would think the wealth effects from housing are more complicated than a price to income ratio. Wealth comes from both an increase in assets value and a decrease in debt value.

    Homes values are continuing to decline. However, foreclosures and sales of homes without taking on a new mortgage should increase wealth through a reduction in the value of mortgages.

    As an example, a $200,000 home that decreases in value by ten percent will lose $20,000 in value. If there were a mortgage for $200,000, the homeowner will have a negative $20,000 of wealth (180,000 minus 200,000).

    If the home is foreclosed, the mortgage is extinguished and the homeowner loses the $180,000 value of the house on the asset side and loses the $200,000 mortgage on the liability side. The foreclosure should therefore increase wealth for the underwater individual of the example by $20,000.

    It is a question of which is dominant. Is the decrease in wealth through the loss in home value of all homes, greater than the increase in wealth through the retirement of underwater mortgages of foreclosed homes?

  2. Hi Milton,

    Sorry to get back to you so late - had a lot of catching up to do at work, which precluded much posting and comments.

    At any rate, I totally agree. However, data on net worth is available only on the quarterly level (which releases on June 11).

    Have a wonderful Sunday, Rebecca