What is the “wealth effect”?
The wealth effect is the thought that as people become more wealthy, they spend more money. It makes some sense. After all, wealthy people buy fancier clothes, fancier food, and fancier toys that poor people. They can afford to. 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 wealthy, their assets or their income? Try a thought experiment: imagine you have a $5 million bond portfolio that pays you $150 thousand per year. A person can live fairly comfortably on such this income, although they can’t go crazy. Then interest rates fall and your portfolio is now worth. $8 million, but your income is still the same. Would you suddenly move to a luxury apartment in New York City? Would you spend a year’s income on a fancy car?
Photo: Alexandre Prévot, Source: Wikimedia
Not likely. The value of your assets would go up, 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. If interest rates fall dramatically, the assets would 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, Dartmouth College admitted that they accidentally released chemicals into a local watershed and contaminated a neighbor’s well. Real estate prices for the entire area fell in half. People who live there don’t get their water from the town water supply. Each house has its own well, and these wells could be vulnerable to contamination.
But the local economy didn’t collapse. Some individuals were impacted, but there wasn’t much change in how people live. The College provided drinking water and a filtration system for the family whose well they ruined, and life continued pretty normally for the rest of the rural community.
The wealth effect is theoretically 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 ripples and eddies are likely to be lost in the much larger ebb and flow of larger economic currents.
Photo: Faith Schuerch. Source: Pixabay.
There are lots of reasons why our economy is stronger today than five years ago: higher productivity, less regulation, more incentives to work. But bigger investment portfolios aren’t on the list.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”