Rising oil prices, tensions in the Middle East, and weaker-than-expected earnings reports from major corporations have worked together to reduce stock prices from their levels in the summer of 2000. The Standard and Poor’s 500 stock index, a broad gauge of stock market valuation, is more than 10 percent below its peak, and some market sectors such as technology have experienced sharper declines. The recent pullback comes after years of favorable stock market returns, which generated much discussion of the “wealth effect” and the stock market’s role in sustaining the 1990s economic expansion. But just how important is the stock market in affecting the real economy and consumer spending in particular? Is the concern that a decline in share prices could end the economic expansion justified?
The existence of a wealth effect associated with stock market fluctuations is beyond dispute. If the value of the stock market rises, the household sector will have greater resources available to finance spending. What is open to question is the timing and magnitude of the wealth effect. It is difficult to measure the effect of stock market movements on consumer spending. Although the stock market affects wealth, it is also possible for spending decisions to affect the stock market. A systematic uptick in consumer spending, for reasons unrelated to stock market wealth, could boost share prices, as investors see higher profits flowing from greater product demand. Studies of consumer spending and stock prices, using both long spans of historical data and short-term market movements such as the 1987 stock market crash, suggest that each trillion-dollar increase in stock market wealth raises annual consumer spending by between twenty and forty billion dollars.
To provide perspective on both wealth and consumer spending, it is useful to know that, at the beginning of 2000, U.S. households owned corporate stock worth roughly 13.3 trillion dollars. Household net worth was much larger—just over $42 trillion. Even after the rise of share prices in the 1990s, tangible assets account for roughly the same share of household net worth as corporate stock. But corporate stock represents twice as large a share of wealth today as it did a decade ago, meaning that share price movements can have a larger effect on consumer spending than they did in the past.
If past patterns can be used to forecast the future, then one can gauge how a 10 percent stock market correction might affect consumer spending. Such a market drop translates into a wealth reduction of about 1.3 trillion dollars. This translates into a drop in consumer spending of between 25 and 50 billion dollars, or between 0.4 and 0.8 percent of total outlays. This is a significant drop, but such a wealth effect does not seem large enough by itself to derail the current expansion. If consumers react to a decline in share values by losing confidence in economic policy, and consequently reduce their spending by more than the simple wealth effect calculus suggests, stock market changes could have a more substantial effect.