Im­pov­er­ished Think­ing Props Up the Wealth Ef­fect

The Economic Times - - Money & Banking -

The Fed­eral Re­serve Bank of Dal­las in a re­port noted that sev­eral fac­tors af­fect consumer spend­ing: “Higher in­comes and house­hold wealth boost spend­ing. Higher, real (in­fla­tion-ad­justed) in­ter­est rates — which en­cour­age con­sumers to save — re­duce cur­rent spend­ing.” I em­pha­sised “and house­hold wealth” for a rea­son. Many of the Fed’s re­cent mon­e­tary pol­icy de­ci­sions, in­clud­ingquan­ti­ta­tive eas­ing, were driven by a be­lief in the so-called wealth ef­fect. It is a no­tion that is very likely wrong.

Be­fore I ex­plain why this is much more likely a case of cor­re­la­tion than cau­sa­tion, a quick def­i­ni­tion and back­ground: The wealth ef­fect is an eco­nomic the­ory that ap­plies to both con­sumers and cor­po­ra­tions. On the consumer side, it’s the idea that ris­ing as­set prices — es­pe­cially for hous­ing — boost consumer con­fi­dence, which leads to an in­crease in re- tail spend­ing. On the cor­po­rate side, the same im­prove­ment in sen­ti­ment leads to more cap­i­tal ex­pen­di­ture and hir­ing. Once in mo­tion, this vir­tu­ous cy­cle of higher prices leads to greater eco­nomic ac­tiv­ity, more prof­its and still more pos­i­tive sen­ti­ment. Re­peat un­til re­ces­sion or cri­sis in­ter­rupts.Therule­ofthumb has been that for ev­ery $1 in­crease in a house­hold’s equity wealth, spend­ing in­creased 2 cents to 4 cents. For res­i­den­tial real es­tate, the in­crease is greater: Consumer spend­ing in­creases 9 cents to 15 cents (de­pendin­gupon­thes­tudyy­ou­use)forevery dol­larof­gain.Thecor­re­la­tion­is­there;the prob­lem is the lack of cau­sa­tion.

What th­ese ob­ser­va­tions at­tempt to cap­ture is the re­la­tion­ship be­tween in­creased­spendin­gan­drisin­gas­set­prices. Only it con­fuses which causes which. And the highly un­even dis­tri­bu­tion of equity own­er­ship in the US strongly sug­gests that most Amer­i­cans are un­af­fected per­son­ally in a sig­nif­i­cant way by ris­ing equity prices. With four-fifths of Amer­i­can fam­i­lies hold­ing less than a 10% stake in the stock mar­ket, the im­pact of ris­ing equity mar­kets on house­hold wealth is muted.

And so this leads us to the con­clu­sion that there is no mid­dle ground: Ei­ther the Fed is ad­vo­cat­ing trickle-down eco­nom­ics, on the as­sump­tion that ris­ing wealth of the rich­est Amer­i­cans will lead to more spend­ing that ben­e­fits ev­ery­one; or it has a mis­placed faith in how the wealth ef­fect helps the av­er­age Amer­i­can. Maybe we can gain in­sight into where the Fed’s think­ing goes astray by look­ing fur­ther at home prices and consumer spend­ing. In the pre-cri­sis 2000s, it wasn’t ris­ing home prices that led to greater eco­nomic ac­tiv­ity. In­stead, it was ac­cess to cheap credit, en­abling huge run up in consumer spend­ing. The fall­out from the credit bub­ble — the on­go­ing delever­ag­ing that is cur­tail­ing spend­ing — is with us to this day. Un­for­tu­nately,theFed­seem­scom­mit­ted to fight this drag on growth with pol­icy reme­dies based upon what is prob­a­bly a false eco­nomic be­lief.

Many of the Fed’s de­ci­sions were driven by a be­lief in the wealth ef­fect. It is a no­tion that is likely wrong

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