US Economic Woes & the Wealth Effect

The U.S. economy is suffering. The reasons for an economic slowdown are never singular, but a lot of what is happening in the U.S. today has to do with the credit crunch: the lack of liquidity in the financial system that results in less investment dollars available for the activities that usually grow the economy.  On a personal level, this has mean fewer dollar available for home buyers, which in turn has led in lower demand for home buying. The consequence... home prices are have been falling and continue to fall. The strange thing this, for folks like me over the border in Canada, we have thus far been insulated from much of it. How long can that possibly last?

The answer has a lot to do with what is known as the Wealth Effect in economic theory. The theory is about how people make decisions in spending (consumption) and saving (and investment). As home equity represents the bulk of people's savings, a decrease in the value of their homes represents a decrease in their net worth ...or wealth. Moreover, because the vast majority of homes are mortgaged financed, there is a leverage effect that further enhances this reduction in equity and wealth. In other words, the more home prices fall, the faster is the reduction in individuals' net worth and wealth. So, how does affect the economy?

As anyone's net worth (wealth) is reduced, there is a growing need to save rather than consume. Lower consumption means lower spending at stores, which in-turn results in the falling sales and layoffs that we've all be hearing about in the news. The increased savings, however, instead of making investment dollars more available, are flowing into highly risk-averse alternatives and avoiding more risky (read mortgage-backed securities) because of the many mistakes made by the folks on Wall Street. The result is that we have lower spending, falling sales and investment dollars available only to the safest possible opportunities ...not for those new home buyers with short credit histories and budding careers.

So, what about us Canucks over the border?

Well, if you go back to the concept of the wealth effect, then you can begin to appreciate how there will necessarily be an impact on the Canadian economy, but also understand that there will be a delay. The delay is the result of the time it takes for companies to recognize the slowing demand for their products and services and to react by cutting staff. This rising unemployment combined with falling wealth will drive even further reductions in consumption ...on both sides of the border. The U.S. is our #1 trading partner. The question is not whether it will affect us here, but when.