We have had an ongoing discussion of the “wealth effect” here, spurred by my colleague Margie Fernandez, including some good outside discussion. Current orthodox thinking is that there is significant downstream economic benefits from inducing rising “wealth”, such as can be done. Van Hoisington and Lacy Hunt, PhD from Hoisington Investment Management summarize it as:
FOMC leaders may feel justified in taking such a position [acknowledging the wealth effect] based upon the FRB/US, a large-scale econometric model. In part of this model, employed by the FOMC in their decision making, household consumption behavior is expressed as a function of total wealth as well as other variables. The model predicts that an increase in wealth of one dollar will boost consumer spending by five to ten cents (see page 8-9 “Housing Wealth and Consumption” by Matteo Iacoviello, International Finance Discussion Papers, #1027, Board of Governors of the Federal Reserve System, August 2011).
But, as Hoisington and Hunt examine further, the actual literature and data analysis is far less certain. In fact, as they show, the actual determination of any such wealth effect is both limited and, more importantly, tends to be idiosyncratic.
My own views on the wealth effect are very much like gravity in physics. Gravity is, by far, the weakest of the natural and basic forces in the universe. It is so weak relative to the other three forces that some of the more exotic or advanced (depending on your perspective) comprehensive theories of the universe have had to input as many as seven additional physical dimensions just to account for gravity’s feebleness. The electrostatic repulsion between two electrons is 10^39 times as strong as gravitational attraction. A small magnet can move objects with relative ease at close proximity to the Earth’s gravitation. And that is really the point I am trying to make; with gravity you need an object of immense proportions (mass) in order to feel its effects in any meaningful way.
We know unambiguously that the recovery and “boom” period after the 2001/dot-com recession was, by far, the worst in American history to that point – particularly with regard to the labor market. Yet, that occurred directly alongside an asset bubble of biblical proportions. In other words, it took asset inflation on an immense scale to generate even the relatively weak economy that we saw last decade.
That is because the “wealth” effect has nothing to do with wealth at all, rather it is properly defined as an inflation/credit system. Thus any relationship between asset inflation and consumer spending is indirect.
Outside of perhaps day traders, it is unrealistic to expect individual investors to “cash in” high prices of stock positions to directly fund spending. That is not only due to the “let it ride” mentality that pervades such episodes, but more directly due to the nature of investing as it actually exists – retirement accounts. Outside of the ultra-wealthy, the effects of stock inflation cannot be direct in a widespread manner. Instead, the best that can be hoped for is that such psychology over rising retirement account values might induce some to take on loans. If your 401(k) is up 30% in one year, you might (stress on might) feel good enough to take on a car loan or additional credit card debt. But there is no direct linkage there.
That is evidently true of any housing inflation. You are not likely to sell your entire house to take advantage of rising prices. Home sales are rather reinvested, like stocks, in that “let it ride” philosophy of what is really churning. Instead, we see the widespread usage of home equity loans as the link to consumerism. Credit is the channel.
That is why you have to attain an immense “mass” of inflationary madness in order to achieve any “leakage” as it is an incredibly inefficient arrangement. It also explains in general terms why 2008 was such a disaster; because the costs of that inefficiency far, far outweighed the minimal gains in terms of economic growth (artificial, at the margins, as it was). So to appeal to this inflation/credit system is to be largely and strikingly inefficient on its face.
But it is much worse than that in these circumstances post-2007. There is no wide and broad credit channel right now. Thus, any inflation/credit dynamic tends to concentrate the “positive” effects in even greater proportion than in previous periods. That is the second primary factor driving bubble inefficiency, the tendency to concentrate inflation in only those with direct exposure and hope that these indirect downstream effects propagate enough economic momentum. Since 2008, there has been very little downstream and indirect thrust, but extreme concentration.
That is why I appealed yesterday to the idea that we need to stop focusing on monetarism and credit, and instead allow direct economic expansion through the wages of actual capitalism. This convoluted monetarist system is simply too inefficient to sustain and nurture long-term economic success.
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