June 14, 2010
There is a well-known stock wealth effect. Economists usually estimate that annual consumption increases by 3-4 cents for each additional dollar of stock wealth. This was the basis for the strong growth of the late 90s. The stock bubble created $10 trillion of wealth causing consumption to soar and savings to plummet.
Robert Samuelson notes this stock wealth effect in his column today and tells us that we have keep the stock market happy in order to have a recovery. Actually, he’s missed most of the story. Consumption in the last decade was driven by the housing bubble, not the stock market. At its peak in 2007, the stock market had just reached the same nominal level that it had been at 7 years earlier at the peak of the bubble. Since the economy was more than 40 percent larger in 2007 (in nominal dollars) than it had been in 2000, the stock market was not a big factor in driving the extraordinary consumption boom that was in turn driving the economy.
This instead was explained by the housing bubble, that gets only passing mention in Samuelson’t piece. The housing wealth effect is usually estimated at 5-7 cents on the dollar. At its peak in 2006, the bubble had created $8 trillion in housing wealth. This translates into $400 to $560 billion in additional consumption each year. If the bubble does not reinflate, this consumption is not coming back. (It’s not clear that it would be desirable in any case, baby boomers need to save for retirement.)
By comparison, the wealth that will be generated by modest increases in stock prices will have relatively limited effect on consumption. The market was valued at close to $20 trillion at its peak in 2007. Its current valuation is around $14 trillion. If it were to rise by 10 percent, this would generate another $1.4 trillion in stock wealth, which would translate into $42 billion to $56 billion in annual demand, after a lag of 1-2 years. This will have a very limited impact on the economy, so the idea that we have to keep the stock market happy to sustain the economy has no basis in reality.
Samuelson also somehow has the saving rate having increased to 16 percent following the stock market’s crash in 2008-2009. This is his invention, it does not show up in the data. The saving rate peaked at 5.4 percent in the second quarter of 2009. The main reason for the uptick that quarter was the distribution of tax rebates from the stimulus, much of which was not spent right away.
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