08 March 2013

The Wealth Effect Will Boost 2013 GDP

The wealth effect could make 2013 a boom year.

It's probably the most obvious prediction of economics: as wealth rises or falls, people spend more or less. Your home goes up $100,000? You feel more relaxed about taking that vacation in Hawaii. Your retirement portfolio drops by 20%? You may feel too tense to even dine out that week.

The Great Recession of 2008-09 destroyed $16 to $18 trillion in net worth. Indices tracking the stock market and home prices both showed a drop of about half. A drop of even 20% in house prices can wipe out the net worth of many households. A drop of half is catastrophic. It wasn't just that incomes fell with rising unemployment: the wealth effect pulled down spending by staggering amounts. (And of course this creates a vicious cycle as dropping incomes erodes wealth which drags down incomes which .... )

So what happens when the economy reverses direction and the wealth effect begins to work to our advantage? This year we find out. And my prediction is that it's going to make for a great year.

From the Atlantic, http://www.theatlantic.com/business/archive/2013/03/this-is-america-now-the-dow-hits-a-record-high-with-household-income-at-a-decade-low/273719/

The job numbers are up and look strong. In February, the economy created 236,000 jobs - nearly 2 million in the last 12 months. 

Unemployment dropped to 7.7%, down from 8.3% a year ago and down from 7.9% the month before.

But more importantly, Americans are restoring their wealth.

This week, the Dow hit an all-time high. It has more than recovered the 50% it lost during the Great Recession.

Home prices are up nearly 10% in the last year, and have recovered about half of what they lost during the Great Recession. This means an increase in net worth of about $17,000 for the typical home owner in the last year, an increase of double that since the low. Zillow estimates that about 2 million homeowners were freed from negative equity in 2012 and forecasts that another million will climb above zero in 2013. The combined effect of getting out of the red with an improving job market will likely trigger more buying, particularly of big ticket items like cars, TVs, and, of course, homes. 

Fears of financial catastrophe in Europe are receding. State and local governments are beginning to stabilize and are now as likely to hire workers as lay them off. Combine that with the boost of the wealth effect and it looks as though 2013 could be a great year.

Economists were incredibly aligned on their 2013 forecast, which is ridiculous given the amount of uncertainty in the economy. In a typical year, the gap between economic forecasts is about 2% (predictions ranging from, say, 0% to 2% for growth). For 2013, the gap was only .4%, predictions ranging from 2.1% to 2.5%. I'm going to separate from the herd on this one. My prediction is GDP growth of over 3% for the US economy in 2013. One of the biggest reasons is the wealth effect.

US GDP is $15 trillion. The US lost about $17 trillion in the Great Recession. A recovery of all the stock value and about a half of the home value ends up improving wealth by nearly one year of GDP. And wealth is nearly back to its peak. Additionally, debt services as percentage of income has dropped about 3.5% of income - freeing up nearly $2,000 a year of extra income for each household. That's huge. The difference in debt service alone totals $200 billion, which is more than one percent of GDP. And additional wealth effects could add to that. In my mind, that alone could justify my additional one percent of GDP growth that I'm forecasting in comparison to real economists. Whether for good or bad, a wealth swing equal to one year's GDP can't help but have a huge effect on GDP growth.

Now go buy something and prove me right. It's time to go shopping.

Lots of other charts like the one above and other interesting numbers from Matt Phillips of the Atlantic (who reports with greater objectivity and less optimism than me) here


PlugNPlay said...

Funny. I got my tax refund and while my home is still under water and I put half of it towards debt payments, we are using the other half to stop putting off stuff we need like new van tires and such, as well as a couple fun things like a used video game console. We're also planning some date nights, for the first time in like 2 years... I hope that's enough spending to make you happy Ron. -Geordie

Ron Davison said...

Geordie - multiply your actions by 100 million households and this could be an interesting year. Nothing drives GDP like aggregate demand - essentially people and organizations buying stuff - so all the more reason for optimism.