Consumer Spending Is Up: Is the 'Wealth Effect' Back?

The news that retail sales rose in March for the fifth month in a row sparked a surge of optimism that the recession is over -- at least for those who still have jobs. Personal consumption expenditures increased 0.3% or $34.7 billion in February compared with January, and according to the retail sales tracking firm SpendingPulse, purchases of luxury goods climbed 22.7% in March compared with a year ago.

It looks like at least some consumers are partying like it's 1999 again, but not everybody is buying into "the consumer is back" hype.

As for that big percentage jump in luxury goods, observers note that last year's sales were so abysmal that these large percentage gains are simply a return to normal spending patterns: Retail sales are still well below the highs of 2006 and 2007.

And while the modest 0.3% month-over-month increase is welcome news for retailers, household incomes remained flat -- there's not much of a foundation for future retail sales increases.

In fact, according to a report which came out Wednesday, consumer borrowing declined by $11.5 billion in February, the 12th decrease in the past 13 months as consumers reduced consumer debt.

These numbers paint a confusing picture. Sales are up modestly, even as consumer credit falls and incomes are flat. Does flat income and falling consumer debt provide a foundation for future consumer spending? The common-sense answer is "no." With incomes flat, then if households are paying down debt and not borrowing more, then that would leave them less cash to spend.

One possible explanation is what's known as the "wealth effect." When people see their homes and 401(k) stock portfolios rising in value -- and the stock market is up an astonishing 70% since its March 2009 lows -- they feel wealthier even if their incomes haven't improved much. That feeling of being wealthier improves their confidence in the future and encourages them to spend more freely.

Let's look at the big picture for evidence that the wealth effect might be returning.

The Federal Reserve Flow of Funds: A Snapshot of Household Income and Net Worth

In terms of net worth -- the total wealth owned by households -- the nation experienced what might be called a "reverse wealth effect" from 2007 to 2009 as real estate and stocks both suffered tremendous losses in the housing bust and the global financial crisis.

Total household net worth fell from $64.48 trillion at the end of 2007 to $54.17 trillion at the end of 2009: a decline of $10.3 trillion. That's a loss of 16% of our wealth, so it's no wonder that Americans felt and acted poorer: They were, by a staggering amount.

Asset Deflation and the "Reverse Wealth Effect"

The chief store of wealth for many U.S. households is their home, and so any examination of the wealth effect (and the reverse wealth effect) must consider the housing market.

It's not a pretty picture. According the Fed Flow of Funds data, homeowners' equity fell from $13.1 trillion in 2006 to $6.3 trillion at the end of 2009. That's a decline of almost $7 trillion. As a percentage of real estate owned, homeowner equity has fallen from about 60% to less than 40%.

Simply put, the real estate assets of U.S. households deflated significantly.

I've prepared a chart which illustrates how the low interest rates, easy lending standards and speculative excesses of the 2003-2007 period fed a rise in wealth which has vanished as the assets which rose in value have deflated.

When money is easy to borrow and growing numbers of people are buying assets speculatively, a "virtuous cycle" of leverage fires up: The more your assets rise in value, the more you can borrow to buy more assets. That cycle creates the wealth effect as people see their wealth on paper rising.

Americans didn't just watch their collective home equity rise on paper; they extracted trillions of dollars from it through refinancing, second mortgages and home equity lines of credit. The equity withdrawal party went on for years, but it went negative in early 2008. Not only were people no longer taking equity out of their homes, they were adding to equity by paying down the principal on their mortgages to the tune of $75 billion.

Rebounding Assets Renew Confidence

How could this mass extinction of wealth feed any sense of rising prosperity? If we look at the past three years, there certainly isn't much to be cheerful about. But if we zero in on the data from last year, we see that homeowner equity rose from a nadir of $5.3 trillion in early 2009 to $6.3 trillion by year's end-a substantial rise of $1 trillion.

Corporate equities (Fed-speak for stocks) did even better, rising from $5.2 trillion in the first quarter of 2009 to $7.7 trillion by year's end -- an increase of $2.5 trillion.

So even though the economy was mired in a low-growth, high-unemployment swamp, the stabilization of the housing and stock markets added back $3.5 trillion in household wealth, giving a substantial boost to household confidence.

But we can also surmise that this welcome rise in wealth is not evenly distributed over the entire population. As I noted back in February in the DailyFinance article Are the Rich Getting Richer? The Data Say Yes, the vast majority of financial assets such as stocks and bonds are held by the wealthiest 20% of households.

That might help explain why sales of luxury goods saw such a big jump when retail sales overall experienced only a so-so rise. Perhaps members of the top tier of U.S. households are indeed cheered by the recovery in their net worth, bringing back the "wealth effect" specifically for that prosperous demographic.

The 80% of households that are less fortunate may not be experiencing the same relative rise in wealth, which might explain why retail sales as a whole rose by a modest 0.3%. Of course, looking at that figure side by side with the 22.7% rise in luxury goods is an apples-to-oranges comparison. The luxury goods statistic reflects a year-over-year increase, while the 0.3% retail sales jump is a month-over-month rise. A better contrast would be to look at the rise from last March in apparel sales (up 5.2%,) or home furnishings (up 13.8%), according to the same report. And when the complete retail sales report for March comes out, the projections are for an overall increase of up to 10% from March 2009. Those numbers still don't compare with the luxury spending figure, but the contrast is far less bleak.

How About Income?

Income remained much more stable than assets. Total disposable income in the second quarter of 2008 was $10.96 trillion, compared to $11.05 trillion at the end of 2009 -- a meager gain of $83 billion, less than 1% and a modest sum compared to the $10 trillion reduction in net worth.

So if the wealth effect is coming back into the national psyche, it's not coming from increases in incomes. That suggests that rising consumer confidence is based on improvements in the values of stock and housing assets. From this we can predict that If those markets keep improving, then so will consumer spending. But if they flatten out again, consumer spending might flatten out as well.
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