The Outlook

NEW YORK

It has been one of the mysteries of the booming market and economy: Why aren't consumers flinging much of their newfound wealth around in the malls? Far from loosening purse strings, wealthier households seemed to be saving and investing more -- perhaps a sign that retirement and job insecurity have changed behavior.

But now it turns out that the wealth effect, as economists call the link between stock-market activity and spending, is alive and well. And that could be bad news for some of the "new paradigm" thinking about the stock market and the economy.

Until the Commerce Department revised a batch of economic data several weeks ago, economists had searched in vain for a wealth effect -- the tendency of households to spend a bigger share of their income as their wealth increases. The old data showed that as the stock market doubled, adding more than $2 trillion in new wealth to consumer balance sheets since the end of 1994, the personal savings rate rose.

Consumers seemed to be "reluctant to spend much of their added wealth because they see a greater need to keep it to support spending in retirement," Federal Reserve Chairman Alan Greenspan speculated at a congressional hearing in February. In his July testimony, he added, "Persisting [job] insecurity would help explain why measured personal-saving rates have not declined as would have been expected from the huge increase in stock-market wealth."

This became part of the new paradigm: Households were in the stock market for the long run, and Mr. Greenspan didn't have to worry that the runup in wealth would stoke a consumption boom and thus inflation. It also heartened economists who had fretted over America's low savings rate.

But the Commerce Department revisions weaken those arguments. Before the revisions, the data showed that in the first five months of 1997 the savings rate rose to 4.9% of personal disposable income from the four-quarter average of 4.6% at the end of 1995. In the same two periods, the revised data show the savings rate actually fell to about 4% from 4.8%, with the difference going into consumption.

"Most economists believe there is a wealth effect, and they were puzzled why, amidst the sustained strong performance of the market three years running, there wasn't one this time," says David Hensley, an economist at Salomon Brothers. "The puzzle has been eliminated."

Solving that puzzle, however, raises many other issues. That is because a rejuvenated wealth effect could leave the economy more vulnerable to booms and busts than previously believed.

As strong economic growth fuels profits and in turn stock prices, it feeds back into consumption and growth. Indeed, economists at Goldman, Sachs & Co. estimate it takes a year or more for new wealth creation to affect spending. So, the 37% advance in stock prices in the past 12 months could significantly lift spending in the months ahead. William Dudley, Goldman's director of U.S. economic research, thinks the recent capital-gains tax cut could trigger some profit taking and amplify the wealth effect.

But because the wealth effect also can work in reverse, as consumers respond to falling asset values by funneling more of their income into savings, tumbling stock prices could make a mild recession nasty. That would give the recent downdraft in stock prices, should it deepen, more ominous implications, a prospect raised at July's meeting of Federal Reserve policymakers.

The rediscovered wealth effect also chips away at one of the supports of the booming market. The new data suggest that investors, while pouring money into stocks, are taking it out of other assets, not just current income. Retirement worries don't seem to be increasing baby boomers' overall savings, often touted as a source of long-term demand for stocks. "It pulls the rug out from what we thought was evolving as a very positive secular argument," says Wayne Nordberg, a partner at mutual-fund managers Lord, Abbett & Co.

But these implications shouldn't be overstated. Some economists suggest most of the wealth effect may already have occurred, minimizing the future inflationary impact. Furthermore, while the wealth effect is still alive, it is weakening. Consumers annually spend an additional 3 1/2 cents to four cents for each dollar of new wealth, compared with five cents a decade ago, estimates Macroeconomic Advisers, a forecasting firm in St. Louis.

Even then, the 1987 crash was a temporary damper; the economy boomed the next year. The Fed helped by easing right after the crash, but perhaps another reason is that then, as now, the drop in stock prices paled next to its near-doubling in the preceding two years.

-- GREG IP