This page has been archived and commenting is disabled.

Guest Post: Why The Wealth Effect Doesn’t Work

Tyler Durden's picture




 

Submitted by Chris Casey of the Ludwig von Mises Institute,

Higher equity prices will boost consumer wealth and help increase confidence, which can spur spending. — Ben Bernanke, 2010

Across all financial media, between both political parties, and among most mainstream economists, the “wealth effect” is noted, promoted, and touted. The refrain is constant and the message seemingly simple: by increasing people wealth through rising stock and housing prices, the populace will increase their consumer spending which will spur economic growth. Its acceptance is as widespread as its justification is important, for it provides the rationale for the Federal Reserve’s unprecedented monetary expansion since 2008. While critics may dispute the wealth effect’s magnitude, few have challenged its conceptual soundness. Such is the purpose of this article. The wealth effect is but a mantra without merit.

The overarching pervasiveness of wealth effect acceptance is not wholly surprising, for it is a perfect blend of the Monetarist and Keynesian Schools. While its exact parentage and origin appears uncertain, its godfather is surely Milton Friedman who published his permanent income theory of consumption in 1957. In bifurcating disposable income into “transitory” and “permanent” income, Friedman argued the latter dictates our spending and consists of our expected income in perpetuity. If consumer spending is generated by expected income, then surely it must also be supported by current wealth?

But this may or may not be true. It will vary across time, place, and among various economic actors whose decisions about consumer spending are dictated by their time preferences. And time preferences — the degree to which an individual favors a good or service today (consumption) relative to future enjoyment — take into account far more variables than the current, unrealized wealth reported in brokerage statements and housing appraisals.

Regardless as to whether or not increased wealth will actually spur increased consumer spending, the most important component of the wealth effect is the assumption that increased consumer spending stimulates economic growth. It is this Keynesian concept which is critical to the wealth effect’s validity. If increased consumer spending fails to stimulate the economy, the theory of the wealth effect fails. Wealth effect turns into wealth defect.

Will increased consumer spending improve the economy? On one side of the argument, we have the aggregate individual conclusions of hundreds of millions of economic actors, each acting in their own best interest. These individuals and businesses are attempting to reduce consumer spending and increase savings.

Dissenting from their views are the seven members of the Board of Governors of the Federal Reserve. Each member believes in the paradox of thrift — the belief that increased savings, while beneficial for any particular economic actor, have deleterious effects for the economy as a whole. The paradox of thrift can essentially be described as such: decreased consumer spending lowers aggregate demand which reduces employment levels which negatively affects consumption which in turn lowers aggregate demand. The paradox predicts an economic death spiral from diminished demand. And mainstream economists believe we were (and potentially are) mired in such a spiral. As noted econo-sadist Paul Krugman noted in 2009: “we won’t always face the paradox of thrift. But right now it’s very, very real.”

The inverse of this “reality” predicts flourishing economic prosperity when a society increases its consumer spending. But history suggests the opposite: it is higher savings rates which lead to economic prosperity. Examine any economic success story such as modern China, nineteenth century America, or post-World War II Japan and South Korea: did their economic rise derive from unbridled consumption, or strict frugality? The answer is self-evident: it is the savings from the curtailment of consumption, combined with minimal government involvement in economic affairs, which generates economic growth.

So why do so many “preeminent” economists falsely believe in the paradox of thrift, and thus the wealth effect? It is because of their mistaken understanding of the nature of savings. The Austrian economist Mark Skousen addressed this in writing:

    Savings do not disappear from the economy; they are merely channeled into a different avenue. Savings are spent on investment capital now and then spent on consumer goods later.

Savings are spent. Not directly by consumers on electronics and espressos, but indirectly by businesses via banks on more efficient machinery and capital expansions. Increased savings may (initially) negatively affect retail shops, but it benefits producers who create the goods demanded from the increased pool of savings. On the whole, the economy is more efficient and prosperous.

Does this economic maxim hold even when the economy is in a recession? Even more so. As all Austrian economists know, business cycles derive from government manipulation of the money supply which artificially lowers and distorts the structure of interest rates.[9] To minimize the length and severity of a recession, economic actors should save more which will reduce the gap between artificial and natural rates of interest.

Regrettably, this is not merely an academic discussion. Due to their mistaken economic beliefs, the Federal Reserve has quadrupled the money supply while bringing interest rates to historic lows. The results will inevitably arise: significant price inflation, volatile financial markets, and severe economic downturns. In many respects, Sir Francis Bacon’s aphorism that “knowledge is power” is true. Unfortunately, in the economic realm, the Austrian economist F.A. Hayek was closer to the truth: those in power possess the pretense of knowledge.

 

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Wed, 03/12/2014 - 12:50 | 4539277 Emergency Ward
Emergency Ward's picture

In a world of carnival fun-house mirrors the bizarre looks normal....

Wed, 03/12/2014 - 12:50 | 4539288 ihedgemyhedges
ihedgemyhedges's picture

The wealth effect sure worked for Porsche and Hermes.....

Wed, 03/12/2014 - 13:53 | 4539517 FlipFlop
FlipFlop's picture

I never understood wealth effect? Higher valuations induce consumpition = GDP goes up. But. Money comes from somewhere, ie earnings, savings or borrowing ( more leverage). In stock flow model real consumption needs to be financed somehow, it is not some abstract statistical relationship.

Anyone agreeing?

Wed, 03/12/2014 - 16:41 | 4540268 N2OJoe
N2OJoe's picture

Does anyone really believe that they believe in keynesianism?

It is a useful means to their ends of printing currency and gifting their political allies, that is all.

It gives them cover for unpopular but politically convinient actions.

 

We still need to refute and ridicule their "ideas" but let's not pretend that they actually believe in unicorns and santa clause.

Wed, 03/12/2014 - 17:07 | 4540380 PT
PT's picture

When will they figure out that "debt" is not the same thing as "affordable"?

An economy's true wealth comes from production.  If you don't produce it then no-one can buy it, no matter how rich they are or how hard they work.

Who is going to buy a house if they can't afford the repayments?
Who is going to build a house and rent it out if the rent does not even cover the price of the land on which the house is built?
Who is going to build a factory if the price of the nick-nacks built by the factory doesn't even pay the mortgage on the factory?
Who is going to invest in a company if the dividends do not justify the share price?

Oh, sorry.  All that shit is actually happening and has been happening for the last 15 years.  I must be an idiot.  Capital gains and Ponzi finance for everyone!  Hurrah! 

See, what you need is a poor country where you can build stuff real cheap.  Then you need a rich country, where you sell stuff real expensive.  Rule number 1:  Let someone else supply the rich customers. 

If there are no rich customers then you just have a country full of idiots and you lend them lots of money.  When they miss repayments, get the govt to bail out your banks and just keep on lending money to idiots.  Remind the people and govt how that no-one could buy anything if no-one borrowed any money.

Someone else can add in the bit about derivatives.  I have to go. 

Wed, 03/12/2014 - 12:48 | 4539278 PlusTic
PlusTic's picture

Trillions of dollars alll based on this alchemy...we outa have our heads examined allowing these charlatans to run things.  Either they are the dumbest people on the planet, or thier goal is to intentionally destroy the place.  My bet is the latter.

Wed, 03/12/2014 - 14:20 | 4539615 asteroids
asteroids's picture

57 years ago Milton Freeman put down the idea. Well, it's been tried a few times, and it obviously doesn't work. The FED should put a fork in it and never mention it again.

Wed, 03/12/2014 - 14:54 | 4539800 FreeMktFisherMN
FreeMktFisherMN's picture

Friedman was all for the Fed.

Wed, 03/12/2014 - 12:49 | 4539280 Divided States ...
Divided States of America's picture

It dont work when only the Jews get all of it and they aint willing to share any of it with you, unless youre a Jew of course.

Wed, 03/12/2014 - 13:00 | 4539318 NotApplicable
NotApplicable's picture

Careful, yer gonna get disappeared.

Wed, 03/12/2014 - 14:15 | 4539592 Divided States ...
Divided States of America's picture

Yo bro,

I know I am treading on thin ice here but the truth is the truth and if we go on ZH to read articles about how everybody (China, NAR, Carl fuckin Icahn, etc) else is a sham, and then I get banned for speaking the truth, then the Tylers will be the biggest hypocrites out there. So far, they have done a good job in balancing all of the noise, racial or otherwise and I commend them for it.

Wed, 03/12/2014 - 12:50 | 4539286 buzzsaw99
buzzsaw99's picture

the wealth effect is a ruse. make people feel better because their 401K balance is high so they spend more but then pull the rug out from under them before they can cash out. full frontal naked kleptomania in high places is all it is.

 

And you don't want us, exposing ourselves. [/Peter Venkman]

Wed, 03/12/2014 - 13:03 | 4539332 Dr. Richard Head
Dr. Richard Head's picture

The Wealth Effect is just a repacked Trickle Down economic theory based on unicorns shitting skittles.

Janine: Do You want some coffee, Mr Tulley?

Louis: Do I?

Dr. Spengler: Yes, have some.

Louis: Yes, have some.

 

Wed, 03/12/2014 - 14:09 | 4539577 GooseShtepping Moron
GooseShtepping Moron's picture

That's true. The difference between Keynesians and Supply-Siders amounts to nothing more than an argument over whether fiat ought to be released through the Federal Reserve or the Tax Code. They are two sides of the same (inflationary) coin.

Wed, 03/12/2014 - 12:54 | 4539300 skwid vacuous
skwid vacuous's picture

good ole ben shalom, havin' the folks interest at heart and all... what a mensch!

Wed, 03/12/2014 - 12:54 | 4539301 Dewey Cheatum Howe
Dewey Cheatum Howe's picture

It worked spectacularly. You didn't ask the right question which is for whom.

Wed, 03/12/2014 - 13:04 | 4539338 Dr. Richard Head
Dr. Richard Head's picture

Exactly!  It depends on whom defines Ben's use of the word consumer.

Wed, 03/12/2014 - 13:10 | 4539361 Dewey Cheatum Howe
Dewey Cheatum Howe's picture

Cui Bono bitchez. It tends to be the most important question that needs to be answered when someone is selling anything.

Wed, 03/12/2014 - 13:46 | 4539404 Solon the Destroyer
Solon the Destroyer's picture

 

 

Savings is Power, Consumption is slavery.

All mainstream economists from Keynes onwards are apologists for Statism and the State's need for finance.

Friedman is one of the High Priests for this apologist philosophy and worked damn hard to provide justification for all sorts of things which benefit Big Government and Big Banking above all... not the least of which was his push for floating exchange rates.

There is no way Friedman and other Statist economysts would want the power of the economy in the hands of the people in terms of savings, but rather have them at the beck and call of the elites by inciting the people to consume.  If they're consuming with leverage, well that's an even better stranglehold.

Gold coin was once the representation of an individual's power in the economy. Since that power has been stripped away, savings is serving the same function (albeit less efficiently).  No way do TPTB want this power to become powerful.

Besides, if savings are that important, it means the Fed's efforts to "finetune" the economy are essentially futile. Part of the apology is giving the Fed a reason to exist.

Wed, 03/12/2014 - 12:57 | 4539305 yogibear
yogibear's picture

"assumption that increased consumer spending stimulates economic growth."

Since a great deal of products are outsourced or manufactured overseas it stimulates their economy. The money is borrowed and eventually must be paid back.

Wed, 03/12/2014 - 12:57 | 4539308 mpodval
mpodval's picture

When no oe is borrowing and banks are not lending, the savings are not spent

Wed, 03/12/2014 - 13:01 | 4539321 JayKitsap
JayKitsap's picture

The Wealth effect works fine when it is people running successful growing businesses, it is the rising sea lifts all boats.  When Main street boomed we had lots of wealth.

It doesn't work when the government gives our wealth out to big banks to earn interest on and pump the stock market.  If Apple rises by $50 today, does anyone net cash out.  If they do it drops.  There is a huge amout of OPM wealth out there, but is it real - NOT really.

 

Wed, 03/12/2014 - 13:06 | 4539346 adr
adr's picture

Pretty hard to extract $3 billion in "wealth" from a private company that loses $600 million a year. Actually it's pretty hard to even have a private company exist that loses $600 million a year.

That is exactly why Wall Street exists. To make money off what can't ever make money.

Wed, 03/12/2014 - 13:03 | 4539331 adr
adr's picture

I saw a lawyer driving a Tesla, didn't makee feel richer.

Neither did his license plate, Legal4U.

In other words, legal fees extracted from you equals Tesla for him. Same with Goldman.

Wed, 03/12/2014 - 13:04 | 4539336 Caviar Emptor
Caviar Emptor's picture

Translation: "Give 'em something for nuthin': paper profits that they think they have through stawks. Then watch em spend their real money like drunken sailors! Like takin candy from a baby :) bwahaha "

Wed, 03/12/2014 - 13:04 | 4539337 withglee
withglee's picture

The answer is self-evident: it is the savings from the curtailment of consumption, combined with minimal government involvement in economic affairs, which generates economic growth.

Half right ... half wrong.

Savings go up with uncertainty. It's not so much about consumption. It's about inventory control. When you have trouble predicting demand, transportation, and supply (i.e. income ... are you insecure in your employment?), you need more safety stock (i.e. savings ... how you going to meet necessities if your income is cut off?).

The half that's right is "yes ... government involvement creates uncertainty which inhibits economic growth"

Wed, 03/12/2014 - 13:15 | 4539372 Solon the Destroyer
Solon the Destroyer's picture

And did you manufacture this safety buffer of savings out of nothing?  or did you curtail consumption, since the money you are now saving is no longer being spent?

Wed, 03/12/2014 - 14:46 | 4539590 withglee
withglee's picture

You curtailed consumption to allocate to savings. You moved investments to more secure, less volitile positions. But those actions don't result in "more economic growth". Rather, they result in economic contraction.

Wed, 03/12/2014 - 14:59 | 4539830 FreeMktFisherMN
FreeMktFisherMN's picture

Savings is foregone consumption, which liberates real resources for an entrepreneur to eventually use to invest in something that will lead to greater production. The Fed is trying to replace legitimate savings with fiat and it distorts decision making as low rates are only warranted when savings is abundant.

If you are trying to promulgate the 'paradox of thrift' BS then please leave

Wed, 03/12/2014 - 16:14 | 4540189 withglee
withglee's picture

My preceding comment applies.

Wed, 03/12/2014 - 15:26 | 4539944 Solon the Destroyer
Solon the Destroyer's picture

And what happened with that money you took from consumption and invested?  What did you securely invest in?  Government bonds... spurs government "capital spending". Corporates... spurs corporate capital spending. Equities... spurs corporate capital spending. Bank accounts... spurs bank lending for capital spending.  If this capital spending is allocated properly it creates growth.  Unless you are burying it in your backyard or hoarding it physical, this money you invested is still in the economy being used, and if used correctly, spurs growth.

Wed, 03/12/2014 - 16:10 | 4540167 withglee
withglee's picture

I don't subscribe to the capitalist notion that capital must exist before trade can take place. Further, I don't subscribe to the notion that our economy is a capitalist economy. And the more leverage there is in our economy, the less capitalistic it becomes. The idea that someone must save before someone can make use of that savings to invest in trade and growth is just ridiculous. But that's the model we've had stuffed in our heads, so that's what people think.

An economy is about trading. Traders will only enter into a trade when they believe they can successfully deliver on their trading promises. Compromise their ability to succeed and you compromise trade. Uncertainty, taxation, tariffs, legal restrictions, so-called societal good ... these all compromise the trading function. Not all (actually few) result in common good. Most, if not all, can be revealed to purposely move a trading advantage to one trader or constituency over another ... not to advance a common good.

Look at the current Tesla situation in New Jersey. They can't sell their cars directly. Why? Because dealers there (and actually almost everywhere) have gotten laws passed to protect their trading position. And these restrictions are for the protection of the public? It's just ridiculous ... but pervasive.

Wed, 03/12/2014 - 13:05 | 4539342 max2205
max2205's picture

I LOL when all those dems screamed about trikle down econ.   Now they are so on board

 

Fuck you Democrats

Wed, 03/12/2014 - 13:18 | 4539387 Ariadne
Ariadne's picture

Bernanke and friends picked this fight

Wed, 03/12/2014 - 13:25 | 4539406 TrumpXVI
TrumpXVI's picture

"Paradox of Thrift"?

How about the paradox of no fucking money?

Wed, 03/12/2014 - 13:37 | 4539444 Your Creator
Your Creator's picture

yeah trickle down theory.  Getting a paycheck from the government.  That's the real trickle down theory.

Wed, 03/12/2014 - 18:53 | 4540739 are we there yet
are we there yet's picture

Maby you mean Obama's 'tinkle down' economic theory.

Wed, 03/12/2014 - 13:37 | 4539452 Notsobadwlad
Notsobadwlad's picture

My guess is that it does not work because it has never worked and has never been intended to work. It is only the lie they tell the ignorant as a cover story for theft.

Wed, 03/12/2014 - 13:47 | 4539486 dumbStruck
dumbStruck's picture

"The answer is self-evident: it is the savings from the curtailment of consumption, combined with minimal government involvement in economic affairs, which generates economic growth."

I disagree. The answer is not self evident. Please provide the details/reasoning as to why this statement is correct. Self evident truth is very rare and always of no value ie A=A is self evident but of no value because it tells us nothing we don't know. I doubt saving by itself causes growth anymore than spending does by itself. I doubt either saving or comsuming contributes to growth. I think maybe both spending alot or saving alot could be like running on a treadmill, lots of action but no progress being made.

Wed, 03/12/2014 - 14:24 | 4539632 GooseShtepping Moron
GooseShtepping Moron's picture

I think the implied premise is that savings result in rational capital allocations, spending in irrational consumption.

A predisposition for saving will grow the economy over time as capital slowly crystallizes into useful forms (i.e. businesses, infrastructure). But when monetary policy creates artificial incentives to spend, the economy consumes itself, burning through capital base and misallocating resources in an orgy of consumption.

It's like the difference between planting a farm and raiding one. You can till the earth and increase your wealth year after year; or you can raid a farm a get all the wealth at once, but then there's nothing left over for the future.

Wed, 03/12/2014 - 15:38 | 4540008 dumbStruck
dumbStruck's picture

I see healthy spending/saving as signs of a healthy economy rather than as contributing to a heathy economy. I think saying that either makes an economy rather than speaks to the condition of same is putting the horse before the cart. What the author seems to be saying is that savings become loans which increase productivity, but as can be seen in China infrastructure built with loans doesn't necessarily equal a better economy. An unhealthy economy caused by the sickness of central banking causes the symtoms of misallocated funds, so called "money" becomes increasing worthless, saving becomes a mistake if it is in the form of a national currency which is being infladed away/misallocated in stupid loans to losing propositions. Safety rather than savings becomes the siren call for us all. Safety in real assets or maybe in select stocks neither of which is going to help the economy much. Their needs to be a healthy economy first of all, in a distorted economy from central bank meddling savings aren't needed for loans to occur and anyone who is saving maybe getting 3rd degree burns from inflation. Without a hard currency system in place globally, competitive devaluation rules the world.

Wed, 03/12/2014 - 14:00 | 4539547 WyMi
WyMi's picture

It works in the models though! Ceteris Paribus - so long as the wealthy are getting wealthier more than the unwashed get poorer. we are better off, right? And it will work until the poor have nothing, at which point the propaganda will have proven to have also been a very effective supporting mechanism indeed. Now can we get the Ukraine to drink the coolaid - I bet we can. Whose next? Not the Arabs, they'll never fall for it, but farther east and, maybe the Chinese. The 'market economy' is simply grand!!.

Wed, 03/12/2014 - 14:37 | 4539696 Hohum
Hohum's picture

The author states what was true.  I said "was."  Growth was easy in the $20/barrel of oil world.  Not so much now.

If growth is defined as net of debt, forget about it.  Growth is over.

Wed, 03/12/2014 - 14:40 | 4539705 karzai_luver
karzai_luver's picture

one day you run out of slaves and soon after that "saved" wealth is gone.

Anyone that cites China or war ravaged countries as miracle savers is lost.

You raid the "others" to get their wealth - that has been and is the dominat model , all the rest is justification by delusion.

 

 

Wed, 03/12/2014 - 14:51 | 4539779 sschu
sschu's picture

There are places and times when the actions like those of our leaders would have resulted in riots, mayhem and violence.  

Why not now?  Why do we put pictures of the perps on magazine covers and pay them millions to explain away their (intentional or not) theft?

This is the real question and one that keeps Bennie etal surrounded by armed guards and always alert.  

I would like to think that the time is near, but unlikely.  Not sure that these guys will ever he held to account ... on this earth at least.

sschu

Wed, 03/12/2014 - 16:34 | 4540248 dumbStruck
dumbStruck's picture

A possible partial answer to the lack of protest in the streets.....
Captured news media?

"Hitler's dictatorship...made the complete use of all technical means for domination of its own country. Through technical devices like the radio and loudspeaker, 80 million people were deprived of independent thought."

Sorry for bringing Hitler into it but the nazis were the trail blazers.

Wed, 03/12/2014 - 19:43 | 4540730 are we there yet
are we there yet's picture

There is a reason congress has its own private subway system, travel in their own government planes, have armored cars and trained with guards license to kill. As well as distant isolated controlled teleprompted tv presentations in secure defended locations, often at unknown times for prerecording. The evil mafia is more accessable, is more up front, and has a lower body count than our leaders now. 

Wed, 03/12/2014 - 16:43 | 4540280 moneybots
moneybots's picture

"Higher equity prices will boost consumer wealth and help increase confidence, which can spur spending" - Ben Bernanke, 2010

 

Ben Bernanke, 1988- QE doesn't work.

 

Making the rich richer, doesn't make consumers, whose income have dropped, spend more money.

Wed, 03/12/2014 - 17:00 | 4540350 mumbo_jumbo
mumbo_jumbo's picture

and all this time i thought that higher incomes was the best way to get people to spend more money!!!

we live in opposite world!!!

Wed, 03/12/2014 - 17:07 | 4540378 Budd aka Sidewinder
Budd aka Sidewinder's picture

Most average residents in the U.S. can’t afford the average price of a new car or truck – and that includes Dallas.

A survey by financial web site Interest.com looked at median household income in the top 25 metro areas in the U.S. and compared that with the average new-car price of $32,086.

Only residents of Washington,D.C., were theoretically able to afford the cost of an average new vehicle with a 20 percent down-payment and four-year financing – a $633 monthly payment, Interest.com said.

To be affordable, that amount could not exceed 10 percent of an average household’s gross monthly income.

Dallas ranked 13th in the survey, with the average resident able to comfortably afford only a $20,731 transaction price and maximum payments of $405 a month.

However, the Dallas area was slightly above Los Angeles (14), Houston (16) and Atlanta (18).

In 16 of the cities in the survey, median incomes fell at least $10,000 short of what it would take to buy the typical new vehicle, according to TheDetroitBureau.com.

 “Too many families are spending way too much on new cars and trucks,” said Mike Sante, managing editor of Interest.com. “Just because you can manage the monthly payment doesn’t mean you should let a $30,000 or $40,000 ride gobble up such a huge share of your paycheck.”

While consumers in Washington,D.C., were most able to afford average new-car prices, those in Tampa were least able, according to the survey.

In Tampa, ranked 25th in the survey, the typical median-income household could afford only a maximum price of $14,209 and monthly payment of just $280.

Consumers, of course, have found ways to deal with rapidly rising car and truck prices, using five- and  six-year – or even longer-term — loans to reduce monthly prices.

Few expect the upward trend to ease, said TheDetroitBureau.com.

 Automakers are trying to cut their reliance on lavish incentives from years past and are starting to pass on more of the costs of new mileage, emissions and safety regulations, TheDetroitBureau.com noted.

http://bizbeatblog.dallasnews.com/2014/03/most-average-consumers-cant-af...

Wed, 03/12/2014 - 17:25 | 4540443 mumbo_jumbo
mumbo_jumbo's picture

"but it benefits producers who create the goods demanded from the increased pool of savings"

 

so if we in the USA save, China will benifit?

Wed, 03/12/2014 - 17:54 | 4540528 kellycriterion
kellycriterion's picture

Could "wealth effect" have been a self serving rationalization? Western governments hover around 50% plus of the economies. Talking about the Cantillion Effect or trickle down becomes meaningless in an environment where confiscate up, hiding and shifting costs are the order of the day.

The loot from the Imperialism 2.0 component goes to the top but there is some, let's call it rebate effect for the masses. And let's be fair, the Gulf states haven't done badly.

Wed, 03/12/2014 - 17:57 | 4540541 kellycriterion
kellycriterion's picture

Correction Gulf state monarchies.

Do NOT follow this link or you will be banned from the site!