Wealth effect is but a dream

Barry Ritholz has penned a piece at Bloomberg shaming the Federal Reserve – and the economic establishment – about their slavish devotion to the so-called “wealth effect”. This is something that is bandied about as the reason why high house prices are always “good”, as mortgage holders feel good about the ephemeral equity, boosting consumer confidence and hence spending, which of course is the hallmark of a “prosperous” economy. Inflation results, which means higher wages which means higher asset prices and everyone benefits! Huzzah!

But successive crises and financial repression due to the non-clearing of an orgy of personal debt, with fiscal policies flapping in the wind, leaving monetary policy the only bullet in the chamber. Which is now shooting blanks:

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, as noted before, that is very likely wrong.

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.

Last week I pointed to the dramatic reversal in share ownership in the US, now the lowest in 20 years, with a similar trend here locally, as most Australians prefer to put their savings into cash or property.  Thus rising share prices really don’t have that much of an impact, although locally – aside from those who play the casino that is our stock market – “investors” prefer dividends over capital gains. They leave that to house prices…

More from Ritholz, where its less about wealth effect and more about debt effect:

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.

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.

Its the hangover from this orgy of debt – created by banks, not by savings or real wealth – that is curtailing the monetary stimulus effect, which is a boon for the diminishing ranks of stock holders, i.e the top 10%, not those still burdened with mountains of personal debt.

As Ritholz concludes, the Fed remains committed however to fight debt deflation with a policy regime that is based on a false belief that as long as you inflate asset prices, everything will be fine. The RBA has adopted the same, hoping and praying that house prices stay high long enough for our own deflationary bubble to deflate calmly.

Meanwhile, real wealth creation and prosperity fitters away as fiscal and taxation policies descend into a farce.


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  1. In Australia, wealth effect just translates into a growing foreign debt.

    That (overseas) is where the financing that funds out increased spending comes from. That’s where the products that we direct our spending to come from.

    In a self sufficient economy there is might be some semblance of sanity in talking about wealth effect as increased spending might boost domestic peoduction, jobs, etc. For us, who import everything – it’s ridiculous.

  2. The Wealth Effect won’t work when the holders of the assets being inflated can’t or won’t access the equity by assuming more debt – the only way to release the newfound ‘wealth’. As our societies age, there are two things they all have in common (1) the asset holder already have all the ‘things’ they need – a home; a car or 4; they’ve seen the Pyramids etc, and (2) the capacity to service new debt from income is gone/diminished, as asset holders retire and quit the day job. Once ‘those who have the assets’ neither need, want or can take on more debt to tap The Wealth Effect, no amount of asset appreciation is going to convince them to do so. All that’s left is debt assumption by those who can least afford it – the new owners of what assets come to market as the current owners ‘downsize’ and the net Negative Wealth Effect that brings with it.

    • What are some of the behaviours we will see during this new “Negative Wealth Effect” period?

      • The first time you walk into (Country Road), do a re-stock for the new season/fashion, head to the check-out and realise that ‘from now on, it’s only going out and not coming in’ is something that most people aren’t ready for, never mind think about. But when they do it, then they will understand what Negative Wealth Effect is. That is coming to all developed economies as they age. It’s funny. No matter how much you have, that first ‘shock’ is one you won’t forget!
        (Answer to your question! Spending will be curtailed, and become less and less the lower that disposable income becomes. That….is why ZIRP is killing our economies. The disposable income that an aging society was reliant upon, has been snatched away, and has closed the purses of a retiring generation. They have stopped spending now. It’s become a new habit. It’s going to take something special to get them carnsoomin’ again, and convincing them to take on more debt, isn’t it!)

    • @Janet I think you have captured this well. The wealth/debt effect is so pervasive as it is seen as a means to offset both the unpleasant need for structural fiscal reform and demographic declines in formerly pre-eminent western economies. I think the premise of Ritholz that this is an offensive measure is wrong footed:

      “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.”

      The Fed sees the structural failings and demographic declines and needs to delay/offset the inevitable and destabilizing political discontent as we sink down to meet the Chinese/etc on the way up. Wealth or debt effect it doesn’t matter. Extend and pretend by whatever means necessary. This crisis (real or perceived) benefits the banks who can clip endless tickets as the debt bubble goes up and up.

      • The Chinese rise is mostly done. Their working age population peaks this year. Total population will peak approximately 10 years from now. From then it will decline for decades to centuries.

        South Korea is facing an extremely steep demographic bust.

        Meanwhile, there is no discernable date for even the peak of the US working age population.

        Demographics is destiny, and China’s aren’t looking good. When their population begins contracting (and keeps ageing), they will do what all countries in such a situation have done; look inward and be extremely risk averse.

        When your population is shrinking and old, when you lose something, it’s almost impossible to get it back without then losing something else. The pie shrinks.

      • seen any with a high-water mark? Or any snorkels drifting through the water with a Landcruiser underneath them?

    • I somehow doubt they GAF about how the “wealth” was generated; they got theirs and Gen WHINE need to stop buying iphones.

      Or worse, “it’s not their fault, it’s the big bad neo-libs!”

  3. 1)From my understanding, wealth effect is a delusion. wealth can only be created or produced…
    2)anything to artificially inflate asset is just a vehicle of wealth redistribution, either from time to time or from one portion of people to the others…it is a zero sum game.
    3) the so called wealth effect from central bank theory is to create a sense of future hype ‘inflation’ and force people to spend…the result is
    a)debt booming ….
    b)wealth concentrate in a few people
    c)loss confidence in central bank

    • Ronin8317MEMBER

      The term ‘wealth effect’ was coined by Alan Greenspan in the late 90s just prior to the dot.com boom/bust. He was at a loss to explan what driving the US economy forward, and his conjecture was that stock market growth is driving US economy. Turns out he was wrong : it was a credit bubble which blew up spectacularly, yet the ‘wealth effect’ theory become entrenched anyway.

  4. If the wealth effect was real, then the authorities should be promoting Ponzi schemes on paper assets.

  5. Know IdeaMEMBER

    Thanks Chris, that is a good post and certainly one that helps to clarify my own objections to the notion that a wealth effect is worth pursuing. A zero sum game that is based upon a zero sum game. Neat.

    It was the whole notion of seeming to get something for nothing that grated with me. Where else could that be seen as a possibility other than the world of academic economics? And politics?

  6. ceteris paribus

    Yep, the cost of housing is built into the everyday cost of living. The only big winners from the property price boom are a narrowly defined property capital segment. The property price boom has been purgatory for the young and the battlers.

  7. Jumping jack flash

    “hoping and praying that house prices stay high long enough for our own deflationary bubble to deflate calmly”

    What? There will be no debt deflation. Any deflation will be recessionary. Nobody who is anybody in power will wear that. Can you imagine what it would do for the polls? This is the new economy and we have little else with which to provide growth.

    The only hoping and praying anyone is doing is for someone with deep enough pockets to come along and bail us out when we need it. At the moment it is all those “rich foreigners” who we can transfer our debt to and walk away freely, with more money in our pockets – that’s the magic of growth at work. Debt begets asset price inflation, begets more debt, and so on…

    But the article is generally correct. “Trickle down” was debunked ages ago and everyone knows it now. To stimulate an economy, you give money to the poorest, they are by far the most likely to spend it immediately.

    Rudd knew it when he threw $900 at the poor end of town, and even Howard knew it when he threw a ton of pork at pensioners every couple of years when he was in. Everyone knows it, and has for a long time.

    They still love “trickle down” because it gives them an excuse. When someone advocates “trickle down” what they’re really saying is that they’re going to give money away to their rich buddies and hope that everyone buys the line that they’ll spend it on additional services provided by poor people.

    In reality, however, this is rarely the case. Usually, the rich will take the money and then import even poorer, more desperate, people to do all the work, plus the additional work, for the same amount of money, or possibly less money, than they were paying the original batch of poor people for providing the original level of services for them.

    And if you look closely, this is pretty much what is happening.

  8. Kids…..Leave Australia and stop being enslavened to high rents courtesy of the baby boomer class.

  9. The net effect is Dick Smith closing down sale, coming soon to the rest of Australia, at least anything that requires discretionary spending.
    Also a huge amount of the pain will be back loaded on those currently living paycheck to paycheck (multi generational), who despite compulsory superannuation will still not have enough to retire on.

  10. “…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 mechanism here (and indeed the precondition), is urban land markets that are “rent-extractive”. The main reason for this is growth boundaries or proxies for them. When the supply of land able to be converted to urban use from lower value use is rationed to a degree that the rate of conversion is lower than the free market rate would be, land values are no longer set by “bid rents” at the margin between competing lower-value versus higher-value uses. Instead the land values are set by the maximum that can be “extracted” from the real economy. Furthermore the rate of extraction tends to be elastic; the land values inflate at a rate faster than increases in the fundamental inputs. Fundamental inputs would include income levels; allowed density; local amenity; local clustering effects / agglomeration economies; middle class welfare; public investments in transport, infrastructure, local education and other amenities; population growth; speculative mania; etc

    The “rentier” in urban land is on a gravy train where everything flows into his pockets at the expense of those who actually “deserved” the gains or were meant to benefit from them in politicians minds. It makes perfect sense that property values in such rigged local economies rise when consumer spending is up, and it makes perfect sense that the direction of causation is that way.