Robert Samuelson gives a simple explanation of why recessions happen — and how a recession can turn into a depression.
The “wealth effect” refers to the tendency of people to adjust their spending as their wealth — concentrated heavily in housing and stocks — changes. When wealth rises, spending strengthens; when wealth falls, spending weakens. For the past quarter-century, higher stock prices and home values propelled the economy forward by inducing Americans to spend more of their incomes and to borrow more. , , , ,
But now the wealth effect is reversing. As stock and home values drop, Americans are scrambling to increase savings and curb spending. . . . Everywhere, financial commentators urge “belt tightening” and more thrift. If the swing toward saving is too sharp, consumer spending wouldn’t just weaken; it would collapse.
But the solution is not a return to binge spending. We just need to be patient.
With time, economic slumps correct themselves as borrowers repay debts, surplus inventories are sold, industries consolidate and government policies promote recovery.