The poverty of the wealth effect
The Federal Reserve Bank of Dallas in a recent 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”.
Many of the Fed’s recent monetary policy decisions, including quantitative easing and zero interest rates, 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 in turn leads to an increase in retail spending. On the corporate side, that same improvement in sentiment leads to more capital expenditure and increased 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.
The rule of thumb 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 even greater: consumer spending increases 9 cents to 15 cents (depending upon the study you use) for every dollar of gain.
The correlation is there; the problem is the lack of causation.
What these observations attempt to capture is the relationship between increased spending and rising asset prices. Only it confuses which causes which. Indeed, the longstanding economic theory has the historical relationship exactly backward: more spending (and profits) cause higher asset prices and improved sentiment, not the other way around.
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 the central bank 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 on non-traditional terms, enabling a huge run up in consumer spending. Rather than praise the housing boom, the true engine of growth during that period was lax lending and easy credit. Since we all know how that turned out, I doubt we want to revisit that any time soon.
Ed Gramlich, a former Fed governor was prescient about this. He had warned repeatedly about the impact of predatory lending and declining credit standards, and was a noted sceptic of the wealth effect. In a 2002 speech to the International Bond Congress in London, he questioned the wealth effect’s theoretical basis for both stock prices and home values.
The fallout from the credit bubble—the ongoing deleveraging that is curtailing spending—is with us to this day and “still dominates the public mood three elections later”, as Bloomberg News reported.
Unfortunately, the Fed seems committed to fight this drag on growth with policy remedies that are based upon what is probably a false economic belief. BLOOMBERG