Household Wealth in Freefall

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    Family wealth in the United States continues to take a beating as its housing market and financial markets suffer from the 16-month-and-running Bush recession. Household assets in our country dropped sharply after reaching an $81 trillion peak in June 2007. By the end of December 2008—the last full quarter for which data are available and one full year into the current recession—about $15 trillion in private family assets and wealth had evaporated.

    This is the sharpest relative wealth decline in more than 50 years. Between June 2007 and December 2008, inflation-adjusted personal wealth fell by 22.8 percent—the fastest decline since the Federal Reserve began collecting this information in 1952. And what a drop it was. The previous record for an 18-month decline in wealth—between March 1973 and September 1974 amid the first oil price crisis—was only 12 percent.

    Our financial markets and the U.S. housing market continue to plummet since the end of last year, which suggests that family wealth continues to decrease as well. This is an extremely serious crisis that deserves public policy attention. Private wealth serves critical functions in a free-market economy that relies heavily on individual initiative. Private wealth is the primary insurance against a range of economic risks.

    The more private wealth a typical family possesses, the less a family has to worry about the basic life necessities and can focus more on long-term economic growth. A family that has the basic necessities covered is better situated to send kids to college and to let them choose a degree that suits their abilities. With a store of private wealth, family members also can more easily switch jobs to match their particular skills. And a family with enough wealth is in a better position to let their creative spirits take hold and start a new business.

    In short, everyone in society wins when families have enough stored wealth to enable their members to gain more skills and apply those skills most effectively in their job or by starting a business.

    So how did we as a society allow such massive losses of wealth? And how can government policy help ensure that it doesn’t happen again? Let’s first consider some of the microeconomic causes of today’s private wealth crisis. First and foremost, price declines in housing and financial assets wreaked havoc on family wealth, but the losses might not have been so severe if the personal saving rate in the United States had not fallen to historic lows. Families simply did not prepare for the eventuality of bear markets by saving more.

    Second, the growth of wealth slowed after 2001 due to an unprecedented debt boom. Sharply higher debt levels meant that wealth rose more slowly than assets, leaving families with even less of a buffer if anything went wrong. This rising leverage—measured by the ratio of debts to assets—was driven by the upswing in asset prices, mainly housing prices, though the stock market also saw healthy gains during most of this period. While leverage during an upswing in asset prices means that families can invest in an asset with little of their own money at stake, the opposite is true for a downturn in assets. When asset prices fall, what little equity stake a family has in an investment—primarily its home—is quickly wiped out. This was especially true during the past boom, when leverage increased rapidly just before the crisis.

    The lack of financial diversification became a third factor that contributed to the massive loss of family wealth, accompanied by increasing leverage. Families went deeper into debt to afford ever more costly homes, leaving little or no money saved outside of their home. A drop in housing prices thus took a much bigger hit on total family wealth because homes had become a much larger share of total family wealth than was the case in the past.

    Lack of diversification also left those families with investments outside their homes more exposed to a crash in the stock market. Since the stock market bull run started in 1983, individual investors in equities have not rebalanced their portfolios appreciably into other financial assets besides houses as stock prices rose and fell before rising higher again amid the next stock market bull run. As a result, the share of families’ financial assets, especially those held in retirement account, was increasingly invested in stocks, either directly in brokerage accounts or indirectly through mutual funds. When the crisis struck, families stood to lose more of their total assets as a share of a fall in the stock market than was the case before, when families were better diversified.

    Policymakers need to address these problems facing average American families trying to accumulate enough private wealth to invest in their futures. The first order of business is to help families reverse their very low levels of savings by investing in more assets. Families also should be encouraged to diversify their assets to avoid losing too much in a market downturn. And finally, public policy should help families avoid excessive leveraging. Borrowing to get ahead in life can be a useful tool to build wealth. After all, you are buying assets with somebody else’s money. But the debt levels prior to the Bush recession were clearly unsustainable. Public policy should put the mechanisms in place now to prevent a similar situation from recurring.

    In the following pages, we will examine in detail the free fall in household wealth since the beginning of this current crisis to understand how that $15 trillion in lost wealth since June 2007 came about. In the end, we believe you’ll agree that increased savings, more asset diversification, and more prudent borrowing will enable American families to create more private wealth. We also believe you’ll agree government policymakers have a role to play making these things happen.

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