The Mythical “Wealth Effect”

Seeking Alpha has a nice article debunking the tired “wealth effect” concept. We see this phony phrase trotted out endlessly, but it’s helpful to understand it as combining both Keynesian and Monetarist elements:

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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?

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