WEALTH EFFECT MYTH

The American Spectator - July 2001
http://www.gilder.com/amspec/gilderarchives/July01/Wesbury3.htm
The Wealth Effect Is a Myth
Stocks react to the ecomomy, not the other way around
By Brian Wesbury

One of the most enduring, but misleading, myths about the U.S. economy is that a rising stock market boosts economic activity. The so-called "wealth effect" is blamed for overheating the economy in the late 1990s, while the "negative wealth effect" is blamed for creating a slowdown in 2001.

The theory is that rising stock prices and increased wealth cause consumers to spend more of what they earn. Spending thus rises faster than production, putting stress on the economy and ultimately creating inflation.

The theory is deeply flawed. There is no historical evidence of any long-term relationship between stock prices and spending or inflation.

And it is misleading because instead of crediting the 20-year boom to innovation, creativity, and productivity-and the incentives that drive them-demand-side economists use the wealth effect to pass off the boom as a mirage caused by rising stock prices. Similarly, rather than blame the recession this year on bad policy, many blame it on weak stocks and the bursting of the so-called bubble.

The danger is that, as with all demand-side theory since Keynes, the wealth effect is used to excuse government efforts to fine-tune the economy, the most recent devastating example being Alan Greenspan's determination to bring down the Nasdaq by 40%.

BAD THEORY

A bad theory can often be spotted when it becomes circular, like arguing that a gasoline engine provides power because the pistons push the crankshaft and, in turn, the crankshaft moves the pistons.

Similarly, the "wealth effect" says that rising stock prices boost consumption. This excess spending, in turn, boosts corporate profits, employment, and then inflation. Higher profits send stock prices up and rising incomes increase the demand for stocks. Then rising stock prices increase consumption and the circle begins all over again in some theoretical perpetual motion machine.

A much better theory suggests that stock prices react to the economy, rather than the other way around. In this view of the world, entrepreneurial effort creates new and more productive technologies. Higher productivity boosts incomes, expected profits, and investment. This increases employment and economic growth and, at the same time, stock prices.

The spark plugs for this development are low taxes, stable money, respect for property rights, and free trade. Wherever these conditions exist, wealth is created at an amazing rate and the stock market performs well. It is no mystery.

THE SAVINGS PARADOX

Those who believe in the wealth effect often point to the diminished savings rate as a sign that consumers, feeling flush as their portfolios swell, are spending above their means. After all, savings rates have fallen from 8.7% of disposable personal income in 1992 to a negative 1.0% in 2001.

A closer look shows that consumer overspending can't be driving this decline in savings. During the past five years, personal income rose a total of 33%, while personal consumption expenditures increased 36%. This small difference could not possibly have driven the savings rate into negative territory. What actually caused the collapse in savings rates was a surge in tax payments-up 64 percent in the past five years. Because savings rates are calculated using after-tax income, the surge in taxes is the real culprit behind negative savings, not excess consumption.

NO HISTORICAL EVIDENCE

If the wealth effect worked we would expect to see a correlation between rising stock prices and rising consumer spending. But as the chart shows, there has been virtually no correlation. Between 1965 and 1982, the S&P rose an average of just 1.4% per year, while consumption jumped from a 7.5% annual growth rate to over 12%. Since 1981 stock prices have increased roughly 1200 percent, while the pace of increase in spending has actually slowed. If the wealth effect exists at all, it stayed hidden for almost 40 years before showing itself in 1999.

The theory has even less evidence when it comes to inflation. In 1965, the personal consumption deflator excluding food and energy (Greenspan's favorite measure of inflation) was rising at a measly 1.3% annualized rate. By the early 1980s, despite a stagnant stock market, it was climbing 10% annually.

Since the boom began in the early 1980s, inflation has done nothing but fall, and through April of this year, the "core" PCE deflator had risen just 1.7% from year-ago levels.

SEE NO EVIL

All of this evidence does not sway Alan Greenspan or other members of the Fed. Greenspan told the U.S. Congress in February that "changes in stock market wealth have become a more important determinant of shifts in consumer spending relative to changes in current household income than was the case just five to seven years ago."

However, this is just a convenient way to avoid any blame for the problems that the economy is having this year. If the "bubble theory" and the "wealth effect" are real, then the Fed has simply been prudently reacting to potential dangers.

Thus in a speech in late May Greenspan said the Fed's only "realistic alternative is to lean against the economic pressures that may accompany a rise in asset prices, bubble or not."

This is a recipe for disaster. In the 1970s, because of high taxes and burdensome regulation, the economy and stock market were stagnant. The Fed "leaned" against these dismal forces, attempting to use loose monetary policy to solve problems created by fiscal policy. This created an ugly episode of inflation. In the 1980s and 1990s, with tax rates much lower and the force of technology boosting the economy, the Fed has attempted to lean the other way with over-tight money, inviting deflation and ultimately contributing to the massive deflation of financial assets that started in the spring of last year.