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Thursday 15 March 2001 The real crisis: confidence

Top economist warns of 'negative wealth effect' It could create worst recession since 1930s

James Baxter The Ottawa Citizen

Bernd Kammerer, The Associated Press / A Frankfurt trader cringes as the blue-chip DAX index falls 201 points, or 3.4 per cent, yesterday. All 30 companies in the DAX, led by Deutsche Bank, Volkswagen and BMW, shed value.

A "negative wealth effect" threatens to plunge the North American economy into its worst recession since the 1930s, one of Wall Street's most respected economists says.

After hundreds of billions of dollars of perceived wealth, much of it in retirement nest-eggs, vanished over the past 12 months amid relentless declines in world stock markets, North Americans, who once felt rich as their portfolios grew, are showing signs of preparing to tighten their belts.

Economists continue to be baffled by unabated consumer spending in recent months, but Steven Roach, the chief economist for Morgan Stanley DeanWitter, said a palpable fear is beginning to grip the population that could drive the economy into a deep and long recession.

"During the bubble years, there was little reason to fear -- everyone was Warren Buffet," Mr. Roach said in his latest submission to the MSDW Global Economic Forum. "Now, as the stock market shows that there is a downside after all, there is plenty to fear -- especially for an American consumer that has forsaken traditional wage-based saving tactics."

In recent months, as the Nasdaq's freefall turned many dot-com millionaires back into working stiffs, economists have been trying to measure what they expect will be a second crushing blow to the economy, a negative wealth effect.

As equity markets surged in the late 1990s, people began to feel rich and they spent accordingly, fuelling what is known as the wealth effect. Mr. Roach said human nature, which tends to dwell on negatives more than it relishes positives, means that the sense of lost wealth could drive consumer spending into the ground. "I have long argued that the negative wealth effect may well represent the greatest macro threat to the U.S. economy."

"I continue to harbour those concerns," Mr. Roach added. "Yet, I must confess to being amazed at the American consumer, who has yet to flinch fully one year after this stock market correction commenced."

Added to that is the lack of traditional saving for an aging and stock market-dependent population, and you have a recipe for disaster, he said.

"These are dangerous preconditions for an asymmetrical wealth effect, in my view, one that could deal a lethal blow to the U.S. economy."

That consumer spending has yet to cool is an even more ominous sign of what could be to come: "The average investor has not been willing to concede that the recent correction is for real. Up until very recently, dip-buying was considered the greatest opportunity of all in this secular bull market.

"The behavioural psychologist in me would suggest that denial might well be the most powerful human emotion of all ... . If that denial cracks -- and I fear that it will -- the negative wealth effect could be lethal on the downside."

He said current consumer spending statistics show that average investors are only now beginning to accept the possibility that the halcyon days of booming stock markets are gone and won't be back any time soon.

"America's equity culture has been a one-way bet for so long, the possibility of a sustained reversal seems almost impossible to accept. That wall of denial represents what I believe is America's greatest macro risk.

"Should it crack, all bets would be off."

http://www.ottawacitizen.com/business/010315/5006765.html

-- Martin Thompson (mthom1927@aol.com), March 15, 2001