It's All in Our Heads - the Negative Wealth Effect

DECEMBER 2, 2008, 12:01 P.M. ET
Essay
It's All in Our Heads
We spend how we feel -- even when our reality hasn't changed much at all

By DAVE KANSAS
My workaday financial life hasn't changed much in the past year. So why am I acting as if it has?
I don't splurge on expensive dinners anymore, and I walk rather than drive places. I compare grocery prices for the first time in years.
In fact, as I look around, I find my friends and I are making all kinds of thrifty decisions that would never have crossed our minds just a few months ago. And it's a stark reminder that the way we think about money can often be detached from our immediate, personal situation.
It doesn't make any difference that most of us continue to hold down the same jobs we had before unemployment rates started to rise. It doesn't matter that our personal circumstances are the same as they've been for the past few years. What matters, instead, is the vague uncertainty that has descended on us. What matters is our unknown future.
So even if our own lives have changed little, we cite a friend's lost job as a reason to worry afresh about our own financial situation. We forget -- or ignore -- that our friends also lost jobs during periods of robust economic health. But our fiscal lens shifts when we see dark headlines barking about dire problems at General Motors or the government coughing up hundreds of billions to try to save former titans like AIG.

Reversing the Wealth Effect

All of this, of course, is well known to economists. They call it the wealth effect, and it maintains that when people feel wealthier, because of rising home values or a climbing stock market, they tend to spend more freely. Many people don't extract money from their home or their investment accounts during such periods, but the simple sense of having more money opens up the wallet. More trips are taken, more meals are eaten at nice restaurants. The economy has benefited greatly from this wealth effect in recent years.
Until now, though, many of us have never lived through the wealth effect's evil cousin: the negative wealth effect that is roiling the economy as the consumer retrenches. Everything -- homes, portfolios, blue-chip companies, the local bank -- seems to be losing value. We still aren't extracting money from our homes or our investment accounts. But the simple sense of having less money closes the wallet. And the future -- always unknown -- seems a whole lot scarier.

That fear has certainly permeated my life. It first hit me this summer when shopping for produce at the grocery store. Though I had once worked as a dairy manager at a grocery store, I had seldom checked prices on everyday items. I just kind of assumed that prices were what they were and you got what you got.
Strolling through the produce department, I found myself comparing prices of fresh cherries, and deciding they were too expensive to buy. I also realized that I had stopped buying nice bottles of wine for dinner; it seemed silly to spend that much money when a cheaper wine would be just fine.
This same scenario played out in countless other small ways -- in what I no longer did or bought.
Home for the Holidays
Many other people I know, regardless of financial circumstance, are going through a similar process. My family in Minnesota has a big Thanksgiving event every two years. In the past, people have come from all over the U.S. and from Europe. We once had to use the kitchen of a local school to include everyone. This year, the confab had fewer attendees. Despite everyone doing well, and in some cases actually doing far better financially than in the past, they balked at the high cost of air travel.
My friends are also finding their spending and saving psychology changing. Most of them still have the same jobs and same basic costs as before, but their mind-set has changed. A friend of mine in finance talked about how he and his office have set up sandwich-making contests for lunch. They order in the basics from a supermarket and have at them. In better times, he'd talk about treating colleagues to lunch at a nice restaurant. He also recently said he's thinking about leaving New York. He figures taxes are headed sharply higher and the financial crisis will bite hard. And thinking about raising his family in New York causes too much economic "brain damage," he says.
A friend who works on a sports Web site in New York, recently married, has started questioning whether to close on a recently purchased apartment. Even though she and her husband have good jobs and can't get the deposit back, she's wondering if putting so much of her family money into real estate is the right move in the current climate. A colleague of mine at work is going through the identical math in almost the identical situation.
Everyone seems to have caught the same bug, with minds switching off the spend gene almost in unison. Walking past a posh French restaurant (prix fixe lunch: $45) near a fund manager friend's office, I asked if he'd ever gone there for lunch. He hadn't and added that it seemed like a "pre-crisis" kind of place.

Thrift and Fear

Thrift, of course, can be a good notion. Americans have for some time spent more than they've made, leading to the first so-called negative savings rates since the 1930s. This overspending, largely driven by borrowed money, occurred in the corporate and financial sector as well. It got us into the mess we're in.
Now, as individuals rediscover thrift, companies are going through their own process of "deleveraging," or reducing their credit-bingeing ways. And this is what has sent the economy into its downward spiral.
Upon taking office in 1933, Franklin Roosevelt declared that "the only thing we have to fear is fear itself." He was talking directly to people's psychology about money. If everyone put their money under a mattress and banks feared to lend, growth would not return.
It's hard to envision things getting to that level today, but fear, once it takes hold, can be difficult to turn around. And there's little question that fear about the future is having a negative impact on our financial psychology.
How to reverse things? For me, an increase in my savings will give me more confidence and less fear (although it certainly isn't going to do much to help the economy in the short run). I suspect that's true for a great many other people as well. The headlines will also play a role. Until the news moves from "crisis" to "confidence," it's hard to erase fear and concern about what's around the next bend.
Ultimately, things will get better, as they always have. Then we will once again be optimists and less afraid of risks. Until then, though, I think I'll just pass on the cherries.—Mr. Kansas is the president of FiLife.com, a personal-finance Web site owned by Dow Jones & Co. and IAC Corp.
Write to Dave Kansas at dave.kansas@wsj.com

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