Greenspan at Jackson Hole

["Ian Murray" <seamus2001@xxxxxxxx>]

[wishing we were there...]

Remarks by Chairman Alan Greenspan
Opening remarks
At a symposium sponsored by the Federal Reserve Bank of Kansas City,
Jackson Hole, Wyoming
August 31, 2001

The rapid technological innovation that spurred the advancement of the
"information economy" has resulted in some dramatic capital gains and
losses in equity markets in recent years. These remarkable
developments have attracted considerable attention from economists and
from macroeconomic policymakers. At the same time, movements in the
prices of some other assets in the economy--changes in house prices,
for example--have been steadier, less dramatic, but perhaps no less
significant.

There can be little doubt that sizable swings in the market values of
business and household assets have created important challenges for
policymakers. After having been relatively stable for a number of
decades, the aggregate ratio of household net worth to income rose
steeply over the second half of the 1990s and reached an unprecedented
level by early last year. That ratio has subsequently retraced some of
its earlier gains.

But we must ask whether the aggregate ratio of net worth to income is
a sufficient statistic for summarizing the effect of capital gains on
economic behavior or, alternatively, whether the distribution of
capital gains across assets and the manner in which those gains are
realized also are significant determinants of spending. To answer
these questions, we need far more information than we currently
possess about the nature and the sources of capital gains and the
interaction of these gains with credit markets and consumer behavior.

Analysts have long factored changing asset values into models that
seek to explain consumption and investment. Indeed, in recent years,
household wealth variables have become increasingly important
quantitatively in endeavors to track consumer spending. The importance
of household balance sheet variables for explaining consumption and
the possibility that not all these variables influence spending
identically suggest the need for greater disaggregation than is
typically employed in most models.

Observing that, over the past half century, consumer spending has
amounted to about 90 percent of income, it might appear that income is
largely sufficient to explain consumption. However, econometric
evidence suggests that such numbers may be deceptive. Wealth by itself
now appears to explain about one-fifth of the total level of consumer
outlays, according to the Board's large-scale econometric model,
leaving disposable income and other factors to explain only
four-fifths of consumption. Indeed, if capital gains have any effect
on consumption, the propensity of households to spend out of income
must be less, possibly much less, than 90 percent.

If income and wealth moved tightly together over time, the distinction
between them might not be meaningful for predicting the future path of
consumption. And, over very long periods of time, capital gains on
physical assets are not independent of the trends in disposable
income. But the relationship of wealth to income is demonstrably not
stable over time spans relevant for the conduct of policy. As a
consequence, a statistical system that augments income as a
determinant of consumer spending with information about wealth can
significantly assist our understanding of this key economic
relationship.

Conventional regression analysis suggests that a permanent one-dollar
increase in the level of household wealth raises the annual level of
personal consumption expenditures approximately 3 to 5 cents after due
consideration of lags. Arguably, it would not be important to draw
distinctions among various types of wealth if all assets were
engendering similar rates of capital gains. Owing to collinearity in
such instances, all wealth proxies would produce similar estimates of
overall wealth effects on consumer spending.

At times, however, the rates of change in key asset prices have
diverged. For example, over the past year and a half, home values have
appreciated, whereas equity values have contracted significantly. In
such circumstances, differences in the propensities to consume out of
the capital gains and losses on different types of assets could have
significant implications for aggregate demand.

Assuming that the underlying propensities are, in fact, stable and
given enough time-series data with sufficient variation, standard
regression procedures should be able to extract reasonably robust
estimates of any differential in spending propensities--for example,
out of stock market wealth and home wealth. But, in practice, these
circumstances do not prevail. As a consequence, we at the Federal
Reserve Board are in the process of developing balance-sheet
disaggregations that should help us infer the propensities to spend
out of capital gains across different classes of assets.

In carrying out this analysis, we have been especially mindful of the
possibility that the amount by which a capital gain affects spending
may well be a function of whether or not the gain has been realized.
On the buyer's side, when an asset is transferred, the acquisition
cost is its new book value and, by definition, its market value. On
the seller's side, the proceeds from the sale are available for asset
accumulation, debt repayment, and consumption. In this way, a capital
gain is realized and made liquid, with the potential to affect
spending, assets, or debt. The capital gain in the process disappears
as an element in the householder's balance sheet.

Unrealized gains, to be sure, can be borrowed against, and the
proceeds of the loan can be spent or used for repayment of other debt.
Alternatively, the unrealized gain could induce households to finance
additional outlays by selling other assets or by reducing their saving
out of current income. But unless, or until, this gain is realized or
is extinguished by a fall in market price, it will remain on the asset
side of the householder's balance sheet, exposed to price change and
uncertainty.

Equity extraction through realized gains creates liquid funds with
certain value. Indeed, a significant proportion of sellers do not
purchase another home. In contrast, extraction of unrealized gains
does not reduce the householders' uncertainty about their net worth or
their exposure to market price changes. This suggests that the
propensity to spend out of realized gains is likely to be greater than
the propensity to spend out of unrealized gains.

Although our asset-class analysis of detailed disaggregated data is
still at an early stage, preliminary examination finds that the data
are consistent with the hypothesis of differential spending
propensities by asset type and by whether or not capital gains have
been realized. For example, purchasers of existing homes, on average,
appear to take out mortgages about twice the size of the unamortized
mortgage that the typical seller cancels on sale. After accounting for
closing expenses, the remaining unencumbered cash is available for
debt repayment, acquisition of financial and nonfinancial assets, and
spending.

We have no direct evidence, of which I am aware, on the way that such
funds are used. However, we can make use of several surveys that have
explored how cash-outs associated with mortgage refinancing and home
equity loans are expended. Typically, these surveys indicate that
households allocate so-called cash-outs--that is, the amount by which
a refinanced mortgage exceeds the pre-refinanced outstanding debt--to
repayment of nonmortgage debt, acquisition of financial assets,
outlays for home improvement, and personal consumption expenditures in
roughly equal proportions.

Our interest, of course, is primarily on spending; extracting home
equity to repay debt or to purchase financial assets merely reshuffles
balance sheets and, at least immediately, does little to affect
economic activity. If these survey results are taken at face value and
are applied to the case in which the home changes hands--as distinct
from, say, a refinancing-- the amount of personal consumption
expenditures generated from realized capital gains on the sale of
homes, financed through the mortgage market, represents approximately
10 to 15 cents on the dollar. 1

Of course, in addition to realized capital gains from the turnover of
existing homes, there is a considerable amount of cash that is
extracted from home equity without a home sale, principally from
refinancing cash-outs and from home equity loans. Both types of equity
extraction have risen considerably in recent years, in line with the
marked rise in unrealized capital gains on homes. Some preliminary
calculations suggest that the total of equity extractions from
unrealized capital gains on homes that is spent on consumer goods and
services per dollar of capital gains is a fraction of the spending
engendered by the gains realized through the sale of a home. 2 3 This
difference occurs, to a large extent, because the net extraction of
equity is much higher among homes that have turned over than among
those that have not.

While data on home mortgage debt and house turnover can be used to
analyze the particular channels through which capital gains on homes
spur consumer outlays, the financing linkages between stock market
capital gains and consumer spending are less clear. Homeowners
typically own one home, which they hold, on average, for nearly a
decade. Financing is almost exclusively through the mortgage market,
and equity extractions for spending, accordingly, are readily
identified. Stocks, in contrast, tend to be held in portfolios that
have far greater rates of turnover than homes, and financing sources
are much more diverse and changeable. Moreover, although gains in
defined contribution plans, IRAs, and other tax-deferred accounts
almost surely affect consumer spending, the complicated tax treatment
and restrictions on the use of those funds make the connections
between capital gains in these accounts and spending quite indirect.

Nonetheless, even setting aside all pension-type assets, household
capital gains on directly held equities and mutual funds in recent
years have been two to four times the size of overall gains on homes.
The sheer size of such gains suggests that capital gains on equities
have been a more potent factor in determining spending than gains on
homes. In fact, if we accept a total net wealth effect on consumption
of 3 to 5 cents on the dollar, and if further analysis supports the
larger net spending propensities from capital gains on homes suggested
by mortgage and survey data, then the propensity to spend out of each
dollar of stock market gains would be less than the propensity to
spend out of a dollar from gains on homes, but still larger in overall
dollar magnitude.

Of course, these quantitative magnitudes are tentative, and a great
deal of additional work will be necessary to better understand and to
confirm the nature and magnitudes of the relationships between capital
gains on houses and stocks--realized and unrealized--and consumer
spending.

* * *

No matter how one differentiates the effects on consumer spending of
capital gains on stock market and housing wealth, it is clear that the
massive increase in capital values over the past five years had a
profound impact on output and income. The influence of capital gains
on economic behavior also is likely to be of substantial consequence
for the prospective performance of the economy.

That influence also can be seen in our national income and product
accounts (NIPA). By design, these accounts measure the market value of
the output of goods and services and its distribution to the factors
of production. As such, they exclude capital gains and losses. This
exclusion is especially relevant for personal saving, where our
accounting conventions result in capital gains having a large effect
on the published figures. In part, the reason is that the NIPA deduct
taxes paid on realized capital gains from personal income and treat
them, in effect, as a transfer to the government sector, even though
the capital gains that generated those taxes are excluded from income.
4 This issue is not trivial. As best we can determine, of the 4.6
percentage point decline in the personal saving rate between 1995 and
2000, a full percentage point is attributable to the increase in
federal and state capital gains taxes paid over that period.

Capital gains have also significantly influenced the measured personal
saving rate as a result of the NIPA treatment of the pension fund
sector. In particular, because defined-benefit pensions are considered
part of the "personal sector," employer contributions to such plans
are included in disposable income, as are the interest, dividend, and
rental incomes received by these plans. In contrast, benefit payments
to individuals are not part of personal income because they are
considered intrasectoral transfers.

Neither households nor corporations, however, are likely to view their
own financial activities in that manner. Surely, for defined-benefit
pensions, it is the benefit payments to retirees rather than the
employer inflows into the pension sector that individuals perceive as
personal income. For their part, businesses have often viewed
defined-benefit pension plans, in effect, as business-sector profit
centers because capital gains affect corporate defined-benefit pension
contributions and, hence, earnings.

This consideration is relevant in the measurement and interpretation
of the personal saving rate. In recent years, contributions to private
defined-benefit plans have declined significantly as an increasing
part of these plans' accrued benefit liabilities have been met through
a rise in the market value of their equity holdings. Offsetting this
decline, to some extent, has been an increase in dividend and other
capital income.

If private and state and local defined-benefit pension plans had been
separated from the personal sector, the personal saving rate would
have fallen about 3/4 percentage point less from 1995 to 2000, all
else being equal.

All told, if households viewed taxes on capital gains as a subtraction
 from those gains and not from income and, further, if households
viewed benefit payments received from defined-benefit plans as income
rather than their employers' contributions (as well as the investment
income of the plans), perceived disposable income in 2000 would have
been higher as would the personal saving rate.

In short, roughly two-fifths of the measured decline in the personal
saving rate since 1995 reflects the foregoing NIPA income-accounting
conventions.

I should emphasize that any accounting adjustments made to personal
saving because of changes in the definition of disposable income are
exactly offset in business and government saving so that national
saving is unaffected. The increment to personal saving associated with
a treatment of the private defined-benefit pension sector as a
business profit center would be offset by a decline in corporate
profits and business saving. In addition, a designation of taxes on
capital gains as capital transfers (in a manner similar to estate and
gift taxes) would raise measured personal saving and lower overall tax
receipts and, hence, government saving. 5 Thus, while total national
saving would be unaffected by these specific accounting adjustments
for capital gains, the distribution of NIPA saving among households,
businesses, and governments would be significantly influenced.

One must recognize that no single way to array information on income,
production, and capital gains is best. The particular array employed
depends on the specific purposes to which the data set is to be
applied. The treatment of capital gains in the NIPA, for example, is
intended to allow the accounts to most accurately attribute national
saving to the various sectors in the accounts. Indeed, when that is
the objective, the removal of capital gains is essential. For analysis
of issues related to consumer spending, though, the NIPA personal
saving rate presents an incomplete picture of the financial state of
the household sector in the aggregate, and an adjustment along the
lines previously suggested may be informative.

In addition to the effect of income-accounting conventions, of course,
we must consider the real economy influence of capital gains on the
level of consumption. The estimates of the effect of household capital
gains on consumer spending of 3 to 5 cents on the dollar suggest that,
directly and indirectly, capital gains easily account for the
remainder of the measured five-year decline in the saving rate.

Obviously, this is not to say that had asset prices been flat for an
extended period the personal saving rate would have been unchanged, on
net, over the past five years. If asset prices had not risen, real
incomes would surely have been altered, and the vast array of
secondary and tertiary effects of asset-price changes would have been
different. Nonetheless, this exercise fosters additional important
insights into the dynamics of household behavior and the relationships
among asset prices, income, and consumption.

The complexity of these relationships underscores the potential
usefulness of developing separate sets of accounts to track capital
gains. These accounts could supplement the income and product
accounts, the flow of funds accounts, and the balance of payments
accounts. The last two currently exhibit, in part, the effect of
capital gains and can be separated into special accounts. A
supplementary set of detailed tables on capital gains exclusions from
the national income and product accounts also would be a useful
addition to our overall system of economic accounts.

* * *

This morning I have not endeavored to discuss the effects of capital
gains, other than peripherally, on investment in plant and equipment,
home improvement, tax revenues, and government surpluses, and their
obvious significance in tracking international economic flows.
Clearly, these also are relevant to any evaluation of macroeconomic
events and warrant further study.

* * *

In closing, accounting systems are not ends in themselves. We
construct them because they have a function in aiding our
understanding of some particular aspect of a business operation at a
company level or for an economy as a whole. As we endeavor to better
understand how changes in the level and composition of wealth affect
economic behavior, new accounting systems may be required to
supplement those that have long served us so well. Technology has
facilitated the production of information at a far faster rate than at
any time in the past. But in the information economy, it remains up to
us to organize and use that information in ways that improve the
quality of decision making.



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Footnotes
1. The realized capital gain on a home sale in recent years has
engendered a net increase in the mortgage debt (that is, net equity
extraction) on that home averaging nine-tenths of the capital gain. Of
the net equity extraction, almost half has been expended on closing
and related expenses. The remainder, we assume, is distributed as
indicated by the consumer surveys. Return to text

2. However, the consumption financed through mortgage debt extension
somewhat overestimates the net influence of housing capital gains on
consumption. Debt must be repaid, and presumably, consumption is
reduced as a consequence of the repayment. In the absence of capital
gains, borrowing merely moves up a purchase rather than augmenting
total purchases through time.

However, in the presence of increased capital gains, unrealized but
still perceived as permanent, debt capacity and levels are likely to
rise. The consequently lowered debt repayment relative to debt
extensions suggests that the rate of offset to the initial consumption
expenditures at the time of repayment is also likely to be a good deal
less. Our preliminary estimates, in fact, suggest that such
subtractions from the gross effects on spending are modest. Return to
text

3. The time sequence of the emergence of capital gains and their
effect on consumer spending is a function of the channel through which
equity is extracted from homes. For sales of existing homes, equity
extraction is generally concurrent with a realization of a capital
gain. Presumably, however, the cash extracted influences consumer
spending only over time. Unrealized gains can build up over time
without any obvious effect on spending. But a cash-out refinancing or
a home equity loan is presumably initiated for a specific current
purpose. Thus, the lags between the emergence of a capital gain and
spending may be a function of the degree of gains realization and the
particular mortgage vehicle employed for equity extraction. Another
means of equity extraction of unrealized gains for which data are
scarce outside of decennial censuses are long-term first lien
mortgages on residences previously free of debt. Return to text

4. Capital gains, however, have not been fully stripped from personal
income. The capital gains embedded in exercised stock options, for
example, are included in compensation of employees (and as a charge
against profits) in the NIPA. These gains are taxed as regular income.
Return to text

5. This is not done in the NIPA owing, in part, to a desire by the
Bureau of Economic Analysis (BEA) to conform with international
standards for national accounts. Return to text