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Why the Treasury Secretary is Wrong on the Wealth Effect of Stocks vs Real Estate

Earlier this week, Treasury Secretary Hank Paulson had some interesting comments on the Housing Market reversal. He said he hoped declines in housing prices had been largely offset for Americans by higher stock prices:

"We had a retail housing market in this country that was growing at an unsustainable rate for a number of years, so we had to make that transition from...unsustainable growth to a more sustainable rate," he said in a radio interview by WTMJ Milwaukee.

"There's been a correction, a significant correction," he said. "I know the individual homeowner is feeling this concern as we have the correction. Hopefully some of that impact has been offset by an equity market that has added a trillion dollars of value and impacted positively peoples' 401K, their savings and other things."

This is a bit of wishful thinking on Paulson's part (perhaps cheerleading is part of the job description of his Office). When we look at the most recent studies, we learn stocks gains do not remotely come close to impacting the average family the way Home price do. 

There are numerous reasons for this, but the big ones are "percentage of net worth" and the wealth effect.

How much does housing values boost the wealth effect and consumer spending relative to equities? The surprising answer: more than twice stock market wealth. That's according to a new study by Christopher Carroll, Misuzu Otsuka and Jirka Slacalek. Their work led them to conclude that an increase in housing wealth of $100 in America eventually boosts spending by $9. A similar increase in stock market wealth produces less than half the result -- only $4 more spending.

That makes sense, when you consider that for most families, their homes are their single biggest asset. But the note that the distribution between the two is very different -- 68.5% of Americans live in their own homes (and some recent data puts this as high as 70%). While ownership of stocks is widespread -- studies put market participation at near 50% of all Americans -- for the typical family, they have a rather small percentage of their net worth in equities. Indeed, in most cases, stocks are only their second or third largest asset.

And while lots of people do own publicly traded issues, the average account was small -- only $35k or so $24,300, according to a Federal Reserve study earlier this year. Whether that is plus or minus a 10 or 20 percentage points has far less of an impact on the wealth effect than price appreciation in homes.

Why? The signficance of home prices that have doubled over the past 7 years is in the mortgage equity withdrawal that accompanied these asset price rises. MEW has fueled a massive spending binge, and has allowed "lifestyle changes." That's the wealth effect at work.

There is a small paradox regarding this distribution of equity ownership. The top 1% of the country owns about 50% of all property in the U.S., including equities. Ironically, the folks who are most aggravated about this are not the poor (who pretty much have accepted their lot in life) but rather, the bottom of the top percent. A recent article in Fortune discussed this phenomena: "America's income gap is arguably less likely to spark a retro fight between proletarians and capitalists than a war between what I call the "lower upper class" and the ultrarich."

The "Lower Uppers." How amusing is that for a class title? That article's author, Matt Miller, writes with some degree of amusement, that this class is seething about the ultrawealthy:

"Here's my outlandish theory: that economic resentment at the bottom of the top 1 percent of America's income distribution is the new wild card in public life. Ordinary workers won't rise up against ultras because they take it as given that "the rich get richer."

But the hopes and dreams of today's educated class are based on the idea that market capitalism is a meritocracy. The unreachable success of the superrich shreds those dreams.

"I've seen it in my research," says pollster Doug Schoen, who counsels Michael Bloomberg and Hillary Clinton, among others. "If you look at the lower part of the upper class or the upper part of the upper middle class, there's a great deal of frustration. These are people who assumed that their hard work and conventional 'success' would leave them with no worries. It's the type of rumbling that could lead to political volatility."

Lower uppers are professionals who by dint of schooling, hard work and luck are living better than 99 percent of the humans who have ever walked the planet. They're also people who can't help but notice how many folks with credentials like theirs are living in Gatsby-esque splendor they'll never enjoy.

But I digress. In response to the  hopefulness of Hank Paulson -- the wealthiest Treasury Secretary in history, he is clearly an Upper Upper -- the wealth effect from a rising equity market will replace some of the lost wealth effect from a falling housing market. But dollar for dollar, it will be less than half as much. And, it will be far less widely distributed than the gains from home price appreciation.

One would hope that the Treasury Secretary -- even one who is an Upper Upper -- would be up-to-date on the latest studies on wealth effects.

>

Sources:
US's Paulson says rising stocks offset house price drop
Reuters, Tue Oct 24, 2006 10:01am ET
http://tinyurl.com/ybgu42

Revolt of the fairly rich
Matt Miller
Fortune, October 25 2006: 8:43 AM EDT
http://money.cnn.com/magazines/fortune/fortune_archive/2006/10/30/8391806/

Recent Changes in U.S. Family Finances:
Evidence from the 2001 and 2004 Survey of Consumer Finances
Brian K. Bucks, Arthur B. Kennickell, and Kevin B. Moore
Federal Reserve Board, Division of Research and Statistics
February 2006
http://federalreserve.gov/pubs/bulletin/2006/financesurvey.pdf

Thursday, October 26, 2006 | 08:01 AM | Permalink | Comments (36) | TrackBack (0)
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Comments

most folks won't tap their stock market wealth as it's tied up in retirement savings so while you're happy to see your portfolio 'staying the course' and performing as expected it's not like i'm going to spend more today considering i'm doing well on money i won't see until i retire. houses on the other hand can be sold tomorrow and turned into instant cash to be spent. it's a world of difference that makes the correlation somewhat suspicious.

Posted by: Richard | Oct 26, 2006 9:07:18 AM