Nov 14, 2008

The negative wealth effect

The wealth effect is an economic concept that says consumers will increase spending given a real or perceived increase in their assets. The same effect works in reverse if consumers feel they have lost value. One estimate says that GDP will decline $0.05 over the next two years for every $1.00 of wealth that is lost. If the equity markets have lost $4T and consumers perceive a similar loss in evaporated home equity (some think it could be three times as much) then that is $8T up in smoke. This translates to about $400B of disappearing GDP, which is enough to decrease GDP by 3%. I think the effect could be even more pronounced right now, given that holiday spending is about to begin. If retailers can't make it into the black this year due to lackluster sales, there could be a spill-over effect into other sectors of the economy in 2009, further worsening our economic condition.

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