The Devastating Impact Of The Reverse Wealth Effect

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Most people find that the pain of losing wealth exceeds the joy they get from gaining. While consumers may feel more financially secure and confident that they can spend more freely, the reverse can also be true. Get ready for the "reverse wealth effect" to kick in.

The wealth effect is a behavioral economic theory based on people spending more as the value of their assets rise. Even decades after its economic bubble popped, Japan stands as a monument to the devastation the reverse wealth effect can unleash.

The complacency that has developed from years of markets moving ever higher has insulated huge numbers of investors from the reality that bad times may be in the cards. In addition to complacency, the market is being supported by the idea that the Fed will pivot the moment any bad thing happens. In such a situation, the expectation is that the Fed put will kick in. This translates into the idea that it might be better to tough out a drop because it may not be possible to get back in when the market bottoms out of the drop. 

Higher for longer is a force that has yet to play out. The bond markets scream caution. The mixed signals flowing from the debt market have left open the possibility that the bond markets could become a wrecking ball. This would result in the Fed being forced to intervene and the potential for a debt death spiral. 

We must not forget that for over a decade, super low or negative interest rates forced people to invest in stock markets in search of yield. As this money is pulled out of stocks and returns to safer alternatives, stocks may decline, stripping people of their paper gains.

Circling back to the crux of this, much of the rationale behind QE has been that it creates what the Fed calls a “Wealth Effect.” For years, this has been a key driver of central bank policy. This view is firmly embedded in the macro-econometric models used by the Fed. 

The notion, widely adopted by central bankers, is that by inflating asset prices to make the wealthy (the asset holders) even wealthier, these people will spend more of what they see as free money from asset price inflation. The premise is that this additional spending will create additional demand for goods and services, thus providing jobs for the masses. 

Sadly, several times over the years, the wealth effect formula has slid off the tracks, and it most likely will again. Consumption does not create wealth. It creates debt.

The example that stands out in the minds of most people is from back in 2008. By loaning money against homes with little scrutiny as to the borrower's ability to repay them, the Fed created a financial bubble with broad implications. It could be argued that since 2008, Fed policy has never really addressed that mess but attempted to paper over it by printing money and expanding debt through quantitative easing.

In a world where optimism and hope have dominated the investment landscape for over a decade, we should be prepared for reality to raise its ugly head. This time is not any different, and debt does matter. As pointed out by many economists over the years, low-interest rates and easy money do not always result in a strong, vibrant economy. Japan's failure to recover from its bubble bursting decades ago remains proof of this.

The problem is that the policy track we have been on may have driven consumer buying, but it also created a lot of debt and waste. This has been great for certain sectors of the economy, such as the financial sector, but it has failed to generate the kind of growth that makes an economy strong.

Looking back throughout history, we may see that the policies that breed the wealth effect can slide off track or lose their effectiveness while creating risk. At some point, the combination of easy-to-borrow money at low-interest rates tends to morph into a high-risk environment of increased speculation and leverage. In short, savers and investors seeking a return on their savings are forced out of traditional accounts because such investments get ravaged by inflation.

We must not forget the 2008 financial crisis resulted in the worst economic disaster since the Great Depression of 1930. It should be noted the Fed's response to the great financial crisis has gotten a great deal of well-deserved bad press for driving inequality and fracturing society. Since 2008, it has become apparent the Fed has created an unfair system that is broken, unfair, and corrupt. This has affected different generations in rather specific ways.

The amount of debt generated since 2008 screams that wealth effect policies are not working. Not only have they failed to create a healthy economy, but they feed into a self-feeding loop of more debt.

Following the great financial crisis, the Federal Reserve and the Bush administration spent hundreds of billions of dollars to add liquidity to the financial markets. They worked hard to avoid a complete collapse. They almost didn't succeed. Today, we are spending not billions, but trillions of dollars to keep the same policy moving forward.

Investors should treat the wealth effect with caution because it is susceptible to harsh reversals. Since the great financial crisis, attempt after attempt has been put forth to change the tide, but still, we have watched the middle class shrink.

The elephant in the room when it comes to growing the economy is how "the broken window theory" is spun and interpreted. The gist of this theory is that if a window is broken, the subsequent repair expenditure will have no net benefits for the economy. Still, it is not uncommon to see destruction touted as a good thing because it promotes spending. 

In truth, this idea discounts several facts. One has to do with where the money is coming from, but, whether it is from an insurance company or someplace else, it still means the money is diverted from being used on another purchase. Repairing a broken window is maintenance spending, which doesn’t improve growth because it doesn’t improve productivity. This expenditure would have occurred anyway.

The only thing a broken window does is cause maintenance spending to occur earlier and lower the useful life of the window. Maintenance spending may keep the economy going, but it doesn’t provide a boost. Instead, it is better to invest the money in something which creates wealth by increasing productivity.

Many people and even economists have real misconceptions as to how the economy works. Where money flows and who it enriches is a key component of economics. This is a blind spot many people have. Years of being told that everything revolves around spending has diminished the important role savings play in the scheme of a balanced economy.

Fans of Keynesian economics that encourage government spending to stabilize the economy during a downturn tend to discount the importance of where and how money is spent.

In the end, this all comes back to the fact that current policies are presenting us with diminishing returns while increasing risk.

Bubbling up to the surface is the recognition the Fed has to shoulder a huge responsibility in pushing inequality higher. Powell has even gone so far as to claim there was little demand for loans below $1 million. Sadly, the same policies that dump huge money into larger businesses because it is an easier and faster way to bolster the economy give these concerns a huge advantage that devastates its smaller competitors.

The long-term ramifications of destroying smaller businesses hurts America in the long run. It eliminates competition, reduces opportunity, and fuels inflation over time. It has sent jobs abroad and increased our consumption of imported goods, resulting in massive trade deficits. Good economic policy encourages personal responsibility and is rooted in saving, not spending. Consumption does not create wealth, it creates debt.


More By This Author:

Japan's Future Remains An Issue Of Debate
Stocks Soar On Slowing Fundamentals, An Overreaction
Lulled Into Complacency Again? Yes, It Happens

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