This piece below by Stephan Roach of Morgan Stanley is well worth reading. It addresses the question of when consumers are going to change their current "spend it and why worry" life-style. .
<>Global: A Warning from the Nobel Prize
Stephen Roach (New York)
This year's Nobel Prize in economics is of great relevance to the debate currently raging in policy circles and financial markets. It gave long overdue credit to the breakthroughs of behavioral finance. In doing so, it underscores the extraordinary shock just inflicted on the American consumer by a popped equity bubble. These implications dovetail nicely with those rewarded by an earlier Nobel Prize (1985) -- the life-cycle hypothesis of saving, which stresses that households can only defer saving for so long. The combination of these two theories sends a tough message: It tells me that the days of resilience could well be drawing to a close for the over-extended American consumer. Princeton professor Daniel Kahneman is unique in the long string of Nobel Prize winners in economics -- he is a psychologist. His path-breaking research was actually a collaborative effort with the late Amos Tversky, a renowned psychologist from Stanford who is generally credited as the father of behavioral finance/economics. More than 30 years ago, Tversky and Kahneman first started to question the wisdom of textbook theories of individual economic behavior. They conducted a series of controlled experiments, some of which were aimed at sampling investor responses to hypothetical and actual financial market situations. (The co-winner in this year's Nobel Prize is Vernon Smith, who wrote the book on experimental economics). Out of the path-breaking tests of behavioral economics came a powerful result -- the "loss aversion motive," finding that investors are far more sensitive to reductions in wealth than to increases in their portfolios. The pain of loss was found to be well in excess of the joy of gain -- a result that I have long believed hints at a powerful asymmetrical wealth effect for a post-bubble US economy (see my April 28, 2000 dispatch. "The Asymmetrical Wealth Effect," which ended with the suggestion, "remember the name, Amos Tversky"). The caveat came in what Tversky and Kahneman called "prospect theory" -- that investor responses are also influenced by recent asset performance. Individuals who lose only "house money" were found to be less inclined to alter their fundamental economic behavior. Conversely, once the accumulation of losses eats into original investor principal, it's a different matter altogether. There can be no mistaking the implications of prospect theory for today's bubble-battered American consumer. All the major equity market indexes -- the Nasdaq, the S&P 500, and the broader Wilshire 5000 -- have made round-trips back to levels prevailing in mid-1997. But the some $7 trillion loss in household equity values from peak levels prevailing in March 2000 are just in current dollars. Adjusting for the 12% inflation that has occurred over that same five-year period, the opportunity cost of the equity bet is staggering. That's especially the case when the inflation-adjusted setback of about -2.5% per annum is compared with historical real returns on US equities that have averaged around 7% since 1800, according to Professor Jeremy Siegel of the Wharton School. For index-based investors, that puts the cumulative underperformance of the past five years about 50 percentage points short of the longer-term return norm. That hurts. It hurts all the more when these results are set in the context of another Nobel Prize-winning theory -- the life-cycle hypothesis of saving developed in the 1950s by Franco Modigliani. By pure coincidence, I had the pleasure of spending several hours with Professor Modigliani this week. The behavior of the American consumer has puzzled most of us in recent years and I could think of no better person who might be able to shed light on this. (Note: We will publish a more complete account of this fascinating give-and-take with Professor Modigliani at some point in the next couple of weeks). Like all scientists, Professor Modigliani remains steeped in the rigor of his discipline. He is suspicious of dismissing the evidence of a low personal saving rate and a devastating loss of equity wealth. While he conceded that has been puzzled about the lack of a consumption response so far, he remains convinced that one is coming. In his words, "the consumer is the most dangerous portion of the picture." The life-cycle saving theory is an intertemporal model of consumer behavior -- it stresses that households eventually must align their spending and saving balances in a fashion that is compatible with the needs of youth, middle age, and ultimately retirement. With the aging cohort of US baby-boomers now starting to focus on late-stage life cycle considerations, Professor Modigliani worries that "consumers are not well prepared." His theory leads to an equally powerful conclusion: A shift in the preference for saving is the only way out. We also spent some time discussing the latest rage in Wall Street consumer theories -- that low interest rates would provide a windfall to household income that would keep the consumer afloat. The record refinancing bonanza now under way certainly seems to hint at just such an outcome. But Professor Modigliani sounded a note of caution on this count as well. "For every borrower who gets a boost in purchasing power, there is a lender who loses." He went on to add that "they may be different people (borrowers and lenders), but it is the net effect that matters for the macro economy." At that point, a light bulb went on in my own atrophied brain. Years ago, my research revealed that there was a certain perversity to the response of US consumers to fluctuations in interest rates -- rising rates didn't seem to hurt nearly as much as most of us thought. It turns out that's because consumers are net lenders to the rest of the economy -- their interest income is well in excess of their interest payments. That still holds true today. For example, in 2001, US Commerce Department data show that households received some $1,091 billion in interest income, well in excess of the $592 billion paid in interest expenses. In other words, while refis help in a lower interest rate climate, those dependent on interest income -- especially retirees -- are hurt. And to the extent that the consumer sector has more interest income than debt service, it may simply be wrong to conclude that surging refis are always accompanied by booming consumption. In my opinion, the combination of these two theories sends an unmistakable message: The carnage of a popped equity bubble spells a major adjustment for the saving-short American consumer. It's just a matter of when. Theories often suffer from the standpoint of timing -- they do fine in predicting the endgame but are often lacking in pinpointing the moment of adjustment. That lesson is equally important today. Just because the consumer hasn't adjusted yet, doesn't mean that won't be the case at some point in the not-so-distant future. Nobel Prizes are not to be taken lightly -- especially in this case.
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