Impoverished Thinking Props Up the Wealth Effect
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