Market Watch

The Wealth Effect

One of the better articles I have read recently. Thanks to Charles Smith of Two Minds….


Central bankers have been counting on “the wealth effect” to lift their economies out of the post-2009 global meltdown slump. The wealth effect concept is simple: flooding the economy with credit and zero-interest money boosts the value of assets such as housing, stocks and bonds. Those owning the assets feel wealthier, and thus more inclined to borrow and spend more money. This new spending creates more demand which then leads employers to hire more employees.

Unfortunately for the bottom 90% who don’t own enough stocks to feel any wealth effect, the central bankers got it wrong: wages don’t rise as a result of the wealth effect, they rise from an increased production of goods and services. Despite unprecedented money-printing, zero interest rates and vast credit expansion, real wages have declined.

The unintended consequence of inflating asset bubbles to drive an illusory wealth effect is that speculative bubbles inevitably pop, creating a pervasive poverty effect. The asset bubble creates phantom collateral that households borrow against. When the bubble pops, they’re left with the debt and debt payments (“the poverty effect”) while the ephemeral “wealth” has vanished.

I tend to think of “inflation” as the effect on the purchasing power of wages from the differential rate of change of money supply (and by extension bank lending and GDP) to wages (relied upon virtually exclusively by 90% of households, including those receiving transfers from taxes on wages) with regard to production.In other words, if wages are rising along with production and prices, price inflation is largely a reflection of population, value-added output and consumption, and commensurate returns to labor from growth of money and production, i.e. an optimal growth condition.

However, if growth of money (M2) and bank lending (and GDP, which rises as a result of gov’t deficit spending), exceeds growth of wages and production, money inflation tends to result in price inflation that erodes the purchasing power of wages and private production. This reflects economic conditions that are sub-optimal or recessionary.

To the extent that there is a so-called “wealth effect,” the flow effect is likely in the opposite direction as is commonly assumed; that is, rising production and wages to money supply affect an increase in asset prices; therefore, it should be referred to as the “wage effect” on growth of economic activity and asset prices, rather than the converse.

Thus, the S&P 500 dropping back to the level of the mid-’90s (when the bubble commenced) would reflect the “wage effect” and actual sub-par economic conditions rather than the dubious “wealth effect” assumed from rising asset prices.
Of course, in the hyper-financialized US economy and global imperial trade regime, this is heresy.

Full article can be read HERE