Wealth and consumption bubbles

Black Monday marked the start of a dip in the stock market that reportedly shaved off over Rs 2 lakh crore of investor wealth in two days. To what extent will these losses channel through consumption, hurting growth and increasing macroeconomic volatility?

It is undeniable that consumption for fun has been on the rise. Quite likely, the booming demand for new toys had a lot to do with booming asset prices. That the wealth effect of a bubbly stock market is a determinant of demand is consistent with economic theory dating back to the writings of Metzler, Friedman and Modgliani over the past 50 years.

The impact of wealth on consumption is visible nowhere more than in the US. The rapid growth of equity-based wealth and millionaires in the US through the 1990s led to booming consumption of durables. It also led to debate on whether asset prices should be an instrument of monetary policy (Greenspan, 1999). Such issues are quickly becoming relevant subjects of discussion here as well.

Upper-end consumer spending in India is a symptom of frothy asset markets and brisk increases in real purchasing power, thanks to heated job markets. The dip in the stock market is less likely to have a direct impact on consumer confidence than hardening interest rates.

But a sharp fall in private spending could depress growth rates. It's been suggested that unlike the Chinese, Indians are happy to party. Is this creating transmission mechanisms for additional macroeconomic volatility in India? How much of a hangover are we in for?

The answer is not much. The correlations between durables IIP and stock indices are high in India relative to the US, but a crude back-of-the-envelope computation of the point elasticities of durables production with respect to the Nifty suggests that it peaked end-2002 at 1.2 and was only about 0.6 at the end of 2005.

A one per cent decline in the stock market could coincide with a 0.6 per cent decrease in spending on durables. These numbers don't imply causality, so we are saying that a fall of 6 per cent in the stock market is consistent with a 3-4 per cent fall in durables production, statistically not significantly different from a seasonal downturn.

Even more important, spending on durable consumer goods is still not as volatile as in industrialised countries. Over 1998-2005, it was less volatile than income growth or household financial asset accumulation, of which equity is a small fraction.

The effect on income or volatility of a fall in the stock market index through consumption spending is therefore likely to be small. The share of durables in private consumption expenditure is small and stable, and no research supports the idea of sustainable demand-driven growth, despite the increasing enthusiasm of the Indian consumer.