The "Wealth Effect" refers to the propensity of people to spend more if they have more assets. The premise is that when the value of equities rises so does our wealth and disposable income, thus we feel more comfortable about spending.
The wealth effect has helped power the US economy over 1999 and part of 2000, but what happens to the economy if the market tanks? The Federal Reserve has reported that for every $1 billion in increase in the value of equities, Americans will spend an additional $40 million a year. The wealth effect has become a growing concern because more and more people are investing; furthermore the Federal Reserve has very little direct control over stock prices. The numbers are staggering. Since the end of 1995, household stock holdings have doubled to more than $12 trillion dollars. And, for the first time, equities are the most valuable asset of the typical American household, not the home. When it comes to spending money, consumers take all their financial resources into consideration, from their income to their home. When an asset surges in value for a sustained period of time, such as the stock market in the 1990s, people feel flush and are willing to spend some additional money, perhaps by buying a fancy car or by taking a more expensive vacation. A good number of Wall Street analysts blame the wealth effect for today's negative savings rate.
Declining stock prices affect firms in several ways. First, lower stock prices, especially induced by profit warnings, increase shareholder pressure on managers to cut costs by laying off workers and scaling back investment. Second, the recent correction has put many stock options underwater, and it is unclear to what extent workers will bargain for more cash in place of options and how this might affect payroll costs and inflation. Third, the factors dragging down stock prices typically spur investors to demand higher risk premiums, which boosts the cost of financing business investment. This takes the form of increased spreads of corporate bond and commercial paper interest rates relative to Treasury yields and lower prices for any new stock that any firm dares to offer. Aside from raising the going price of new finance, the increased uncertainty associated with lower stock prices can spook investors so much, that the availability of finance is reduced. Since the fall, this has been manifested in tighter standards for bank loans, a drying up of lower grade corporate bond issuance, increased difficulty in using stock swaps to finance mergers, a dearth of IPOs, and a sharp slowing of venture capital investment.
One source of uncertainty about the stock wealth effect is that we lack enough experience to pinpoint how much the decline of the Nasdaq will impact small business formation by affecting the venture capital market. Venture capitalists live for the day when companies in which they have invested can issue stock on the Nasdaq. At that point, the liquidity and marketability of their investments rise, allowing them to cash in their winning investments. However, when the Nasdaq tanksthe red lineIPOs and start-ups typically slow any new venture capital investmentsthe blue linedry up because venture firms see lower expected returns. Along with the Nasdaq, overall venture capital investing has fallen off from the rapid pace of the late 1990s, particularly for high tech ventures, shown by the green line (1). Other venture capital investment, reflected by the gap between the blue and green lines, also trended with the Nasdaq. Nevertheless, because most of this investment is in business and consumer services, particularly in e-business and e-consumer service firms, the drop in other venture capital investment largely stems from the tech-wreck and the dot com bust. How Lower Stock Prices Affect Households
Now let's turn to how lower stock prices affect household spending through two main channels. One is that lower...