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.