Last weekend, I happened to meet a senior IT professional, aged 48yr. This gentleman has worked with many global IT services companies like IBM, Google, etc. He has his wife and two teenage daughters in his family. Four years ago, he quit his job and took to equity and derivative trading as his full-time occupation. He even developed an algorithm of his own for trading in options. He did very well till March 2024, earning an IRR of over 54% on his capital deployed in the trading business. With a material growth in his earnings, his lifestyle changed dramatically. He bought a bigger house, bought a luxury sedan for himself and a car for his daughters' use. They travelled business class on their Europe and America trips.
In April 2024, he grew in confidence and increased his exposure materially, deploying all his savings in the market. In the past 6 months, he has lost 70% of his enhanced capital in option trading; and is close to defaulting on his house EMI. The losses in the market are not his primary worry presently. He is more concerned about convincing his family for a downgrade in their lifestyle.
After discussing various aspects of his problem, I concluded that he may not be an isolated case. There may be hundreds of other full-time traders who have witnessed this ‘wealth effect’ in the past 3-4 years and may be fearful now.
Wealth effect
Arthur Pigou, an American economist, coined the term “the wealth effect” in a 1943 article. The idea was to measure the changes in consumption based on the change in the values of housing and financial assets. He argued when asset values are high consumers feel wealthy and go shopping: when asset values are low consumers slow spending. As a result of the concentration of American wealth in home equity, the level of housing prices can dramatically impact consumer confidence.
Daniel Cooper (Federal Reserve Bank of Boston) and Karen Dynan analyzed the Wealth Effects and Macroeconomic Dynamics in a 2016 research paper. The paper stated that “The effect of wealth on consumption is an issue of long-standing interest to economists. The relationship is particularly important from a policy perspective, given the large swings in financial asset prices and property values over the last few decades in both the United States and many other developed countries. The conventional wisdom is that the resulting fluctuations in household wealth have driven major swings in economic activity. Indeed, the plunge in asset prices during the financial crisis is frequently cited as an important contributing factor to the unusually slow economic recoveries in the United States and some other developed countries. Similarly, the large drop in asset prices in Japan following their peak in 1990 is viewed as having restrained growth during the subsequent decade in that country.”
The paper also highlighted that a great deal of empirical research over the last 25 years has focused on the so-called wealth effects – the impact of changes in wealth on household consumption and the overall macroeconomy. The research has yielded some important findings about the nature of household wealth effects, but consensus has yet to be reached on many important issues.
The authors concluded that “Understanding wealth effects is critical not only for forecasting consumption and broader economic growth well, but also for gauging the risks to the economic outlook and setting appropriate macroeconomic policy. Such issues are particularly important during periods of large fluctuations in asset prices.”
I could not find any noteworthy research related to the wealth effect specifically in the Indian context. However, anecdotally we can find several cases like the gentleman referred to earlier in this post. In my view, the policymakers in India need to take cognizance of the wealth effect generated by the supernormal returns from the equity investments and real estate in the past four years.
I also note, in this context, the outcome of the latest Consumer Confidence Survey (CCS) of the RBI. Despite several headwinds in terms of slowing growth, rising cost of living, slower real wage growth, and challenging employment environment, and pessimism about the current situation, the consumers’ future expectations remain optimistic. This might send erroneous signals to the policymakers, producers, sellers and service providers.
