Is the wealth effect real?
Photo: hcmholms. Source: 500px
It makes some sense. After all, wealthy people spend more than poor people. And they buy fancier clothes, fancier food, and fancier toys. So if the Fed wants to boost the economy – which is 70% consumer spending – why wouldn’t they try to lift asset prices and juice people’s wealth?
But just what makes someone wealth? Is it their assets? Or their income?
Let’s try a thought experiment. Imagine you have a $5 million bond portfolio that pays you $150 thousand per year. A single person can live fairly comfortably, although not extravagantly, on such an income. Then interest rates fall and your portfolio is now worth. $8 million, although your income hasn’t changed. Would you suddenly move to a penthouse apartment on Central Park West in New York City? Would you spend a year’s income on a luxury car like a Lamborghini or Masarati?
Photo: David Shankbone. Source: Wikimedia
Not likely. The value of your assets would change, but your income would stay the same. The same thing happens in an entire economy. If an economy has an aggregate asset value of, say $1 trillion and produces $30 billion of income per year, that would support consumer spending of about $20 billion. Should interest rates fall in half, the assets would now be worth $2 trillion. The value of any asset is the discounted value of future cash flows, and cutting the discount rate in half will double the value of the assets. But would people suddenly spend more? Are they twice as wealthy?
The same thing works in reverse, too. Recently it was revealed that Dartmouth College had released chemicals into a local watershed, contaminating a neighbor’s well. Real estate prices for the entire area fell. These folks don’t get their water from a municipal water supply. Each house has its own well, and these wells could be vulnerable. Real estate values fell, and purchase and sales activity was nonexistent.
Estimated chemical plume from Rennie Farm. Source: Dartmouth College, State of NH
But the local economy didn’t collapse. Some individuals were impacted, but there wasn’t much change in folks’ lifestyles. The College provided drinking water and a filtration system for the neighbor whose well they had ruined, and life continued for the rest of rural Hanover.
The wealth effect is intuitively appealing, but questionable in practice. The latest studies estimate that its impact is about 4 cents on the dollar – that for every dollar of additional wealth, people increase their spending by about 4 percent. Such small financial eddies are likely to be lost in the much larger ebb and flow of stronger economic currents.
I can come up with lots of reasons why our economy is stronger today: higher productivity, less regulation, more incentives to work. But bigger investment portfolios aren’t one of them.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”