Personal finance

Will the banking crisis cause a recession? It may depend on the ‘wealth effect,’ economist says

When it comes to the U.S. economy, confidence is key. But the banking crisis has threatened to upset how most people feel about their financial picture.

“The bank problems are probably making a lot of people think twice,” said Diana Furchtgott-Roth, an economics professor at George Washington University and former chief economist at the U.S. Department of Labor.

“People are not as confident,” she said, referring to the “wealth effect,” or the theory that people spend less when they feel less well-off than they did before.

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As recent events prove, the line between Wall Street and Main Street has become increasingly blurred: When stocks fall, people tend to rein in their spending.

A decline in spending slows retail sales and that, in turn, triggers a market reaction that spills back onto consumers.

At the same time, income is going down, after adjusting for inflation; interest rates are going up; and Federal Reserve Chair Jerome Powell says turmoil in the financial sector will cause banks to tighten their lending standards, making it even harder to borrow.

That leaves consumers with less access to cash to cover the rising cost of food, housing and other expenses. As households feel increasingly squeezed, that weighs on their confidence in the overall economic picture.

What it takes to feel financially secure

Americans now say they would need an average net worth of $774,000 to feel ”financially comfortable,” but more than $2 million to feel “wealthy,” according to Charles Schwab’s annual Modern Wealth Survey

However, “it’s not how many dollar bills you have, it’s what you can buy with them,” said Tomas Philipson, University of Chicago economist and the former chair of the White House Council of Economic Advisers.

Any money earning less than the rate of inflation loses purchasing power over time.

The University of Michigan’s closely watched index of consumer sentiment recently fell for the first time in months. The Conference Board’s consumer confidence index is also down, according to the latest data.

Fewer consumers are planning to buy a home or car or spend money on other big-ticket items such as a major appliance or vacation. That decline in spending paired with rising interest rates could likely push the economy into a recession in the near term, the Conference Board found.

Wall Street has been debating whether the country is heading into a recession for months, although many economists expect it to occur in the second half of this year.

Still, thanks, in part, to a strong labor market, the economy has remained remarkably resilient, dodging a downturn so far. 

“It remains to be seen if we will continue to do so, and partly it comes down to consumer confidence,” Furchtgott-Roth said. “People are definitely shaken up.”

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