The Death of Money (10 page)

The wealth effect’s power has been debated for decades, but recent research has cast
considerable doubt on its impact. Few economists doubt that the wealth effect exists
to an extent. The issues are, how strong is it, how long does it last, and is it worth
the negative impacts and distortions needed to achieve it?

The wealth effect is typically expressed as a percentage increase in consumer spending
for each dollar increase in wealth. For example, a $100 billion increase in stock
market and housing prices that had a 2 percent wealth effect would produce a $2 billion
increase in consumer spending. The Congressional Budget Office shows that various
studies put
the wealth effect from housing prices in a range from 1.7 percent to 21 percent. Such
a wide range of estimated effects is risible, casts doubt on similar studies, and
highlights the methodological difficulties in this field.

A leading study of the wealth effect from stock prices, published by the Federal Reserve
Bank of New York, contained findings that substantially undermine the Fed’s own belief
in the wealth effect. The study says:

We find . . . a positive connection between aggregate wealth changes and aggregate
spending . . . but the effect is found to be rather unstable and hard to pin down.
The . . . response of consumption growth to an unexpected change in wealth is uncertain
and the response appears very short-lived. . . . We find that . . . the wealth effect . . .
was rather small in recent years. . . . When we force
consumption to respond with a one-period lag, a . . . shock to the growth of wealth
has virtually no impact on consumption growth.

Another study shows that the wealth effect, to the extent it exists, is
heavily concentrated among the rich and has no impact on the spending of everyday
Americans. David K. Backus, chairman of the economics department at New York University,
echoed this view:

The idea of a wealth effect doesn’t stand up to economic data. The stock market boom
in the late 1990s helped increase the wealth of Americans, but it didn’t produce a
significant change in consumption, according to David Backus. . . . Before the stock
market reversed itself, “you didn’t see a big increase in consumption,” says Backus.
“And when it did reverse itself, you didn’t see a big decrease.”

Even more disturbing than doubts about the wealth effect’s size and timing is the
fact that economists are not even sure about the
direction
of the effect. While conventional wisdom holds that rising stock prices increase consumption,
economists have suggested that it may be the other way around; that
rising consumption may increase stock prices. The prominent monetary economist Lacy
H. Hunt summarizes the state of research on the wealth effect as follows:

The issue here is not whether the Fed’s policies cause aggregate wealth to rise or
fall. The question is whether changes in wealth alter consumer spending to any significant
degree. The best evidence says that wealth fluctuations have little or no effect on
consumer spending. Thus, when the stock market rises in response to massive Fed liquidity,
the broader economy is unaffected.

Now consider that several of the leading studies on the wealth effect were published
either in 1999 or in 2007, at the height of the two most recent stock bubbles. It’s
hardly surprising that academic research on the wealth effect might be of particular
interest during stock bubbles when the wealth effect was supposed to be at its strongest,
but this research indicates that the wealth effect is actually weak and uncertain.

Taken together, all this suggests that while the Federal Reserve is printing trillions
of dollars in pursuit of the wealth effect, it may actually be in service to a mere
mirage.

■
Asset Bubbles

America is today witnessing its third stock bubble, and its second housing bubble,
in the past fifteen years. These bubbles do not help the real economy but merely enrich
brokers and bankers. When these bubbles burst, the economy will confront a worse panic
than occurred in 2008, and the bankers’ cries for bailouts will not be far behind.
The hubris of central bankers who do not trust markets, but seek to manipulate them,
will be partly to blame.

Asset bubble creation is one of the most visible malignancies caused by Federal Reserve
money printing, but there are many others. One obvious effect is the export of inflation
from the United States to its trading partners through the exchange-rate mechanism.
A persistent conundrum of Fed monetary policy since 2008 has been the absence of inflation
in U.S. consumer prices. From 2008 through 2012, the year-over-year increase in the
consumer price index averaged just 1.8 percent per year, the lowest for any five-year
period since 1965. Fed critics have expected for years that inflation would rise sharply
in the United States in response to money printing, albeit with a lag, but the inflation
has not yet appeared; indeed persistent deflationary signs began emerging in 2013.

A principal reason for the absence of inflation in the United States is that inflation
was exported abroad through the exchange-rate mechanism. Trading partners of the United
States, such as China and Brazil, wanted to promote their exports by preventing their
currencies from appreciating relative to the U.S. dollar. As the Fed prints dollars,
these trading partners must expand their own money supplies to soak up the dollar
flood coming into their economies in the form of trade surpluses or investment. These
local money-printing policies cause inflation in the trading partner economies. U.S.
inflation is muted because Americans import cheap goods from our trading partners.

From the start of the new millennium, the world in general and the United States in
particular have had a natural deflationary bias. Initially the United States imported
this deflation from China in the form of cheap goods produced by abundant labor there,
aided by an undervalued currency that caused U.S. dollar prices for Chinese goods
to be lower than economic fundamentals dictated. This deflationary bias became pronounced
in 2001, when annual U.S. inflation dipped to 1.6 percent, perilously close to outright
deflation.

It was this deflation scare that prompted then Fed chairman Alan Greenspan to sharply
lower interest rates. In 2002 the average Federal Funds effective rate was 1.67 percent,
then the lowest in forty-four years. In 2003 the average Federal Funds rate was even
lower, 1.13 percent, and it remained low through 2004, averaging 1.35 percent for
the year. The extraordinarily low interest-rate policy during this three-year period
was designed to fend off deflation, and it worked. After the usual lag, the consumer
price index rose 2.7 percent in 2004 and 3.4 percent in 2005. Greenspan was like the
pilot of a crashing plane who pulls the aircraft out of a nosedive just before it
hits the ground, stabilizes the aerodynamics, then regains altitude. By 2007, inflation
was back over 4 percent, and the Fed Funds rate was over 5 percent.

Greenspan had fended off the deflation dragon, but in so doing he had created a worse
conundrum. His low-rate policy led directly to an asset bubble in housing, which crashed
with devastating impact in late 2007, marking the start of a new depression. Within
a year, declining asset values, evaporating liquidity, and lost confidence produced
the Panic of 2008, in which tens of trillions of dollars in paper wealth disappeared
seemingly overnight.

The Federal Reserve chairmanship passed from Alan Greenspan to Ben Bernanke in February
2006, just as the housing calamity was starting to unfold. Bernanke inherited Greenspan’s
deflation problem, which had never really gone away but had been masked by the 2002–4
easy-money policies. The consumer price index reached an interim peak in July 2008,
then fell sharply for the remainder of that year. Annual inflation year over year
from 2008 to 2009 actually dropped for the first time since 1955; inflation was turning
to deflation again.

This time the cause was not the Chinese but deleveraging. The housing
market collapse in 2007 destroyed the collateral value behind $1 trillion in subprime
and other low-quality mortgages, and trillions of dollars more in derivatives based
on those mortgages also collapsed in value. The Panic of 2008 forced financial firms
and leveraged investors to sell assets in a disorderly fire sale to pay down debt.
Other assets came on the market due to insolvencies such as Bear Stearns, Lehman Brothers,
and AIG. The financial panic spread to the real economy as housing starts ground to
a halt and construction jobs disappeared. Unemployment spiked, which was another boost
to deflation. Inflation dropped to 1.6 percent in 2010, identical to the 1.6 percent
rate that had spooked Greenspan in 2001. Bernanke’s response to the looming threat
from deflation was even more aggressive than Greenspan’s response to the same threat
almost a decade earlier. Bernanke lowered the effective Fed Funds rate to close to
zero in 2008, where it has remained ever since.

The world is witnessing a climactic battle between deflation and inflation. The deflation
is endogenous, derived from emerging markets’ productivity, demographic shifts, and
balance sheet deleveraging. The inflation is exogenous, coming from central bank interest-rate
policy and money printing. Price index time series are not mere data points; they
are more like a seismograph that measures tectonic plates pushing against each other
on a fault line. Often the fault line is quiet, almost still. At other times it is
active, as pressure builds and one plate pushes under another. Inflation was relatively
active in 2011 as the year-over-year increase reached 3.2 percent. Deflation got the
upper hand in late 2012; a four-month stretch from September to December 2012 produced
a steady decline in the consumer price index. The economy is neither in an inflationary
nor a deflationary mode; it is experiencing both at the same time from different causes;
price indexes reveal how these offsetting forces are playing out.

This dynamic has profound implications for policy. It means the Fed cannot stop its
easing policy so long as the fundamental deflationary forces are in place. If the
Fed relented in its money printing, deflation would quickly dominate the economy,
with disastrous consequences for the national debt, government revenue, and the banking
system. But deflation’s root causes are not going away either. At least a billion
more workers will enter the labor force in Asia, Africa, and Latin America in
coming decades, which will keep downward pressure on costs and prices. Meanwhile a
demographic debacle in developed countries will put downward pressure on aggregate
demand in these advanced economies. Finally, technological breakthroughs are accelerating
and promise higher productivity with cheaper goods and services. The energy revolution
in natural gas, shale oil, and fracking is another deflationary force.

In short, the world wants to deflate while governments want to inflate. Neither force
will relent, so the pressure between them will continue to build. It is just a matter
of time before the economy experiences more than just bubbles, but an earthquake in
the form of either a deeper depression or higher inflation, as one force rapidly and
unexpectedly overwhelms the other.

■
Tremors

Expected earthquakes of great magnitude near large population centers are colloquially
referred to as “the big one.” But before those big quakes appear, they may be preceded
by small tremors that wreak havoc in localities along the fault line far from the
big cities. The same can be said for the Fed’s market interventions. In its desperate
effort to fight deflation, the Fed is causing minor meltdowns in markets far removed
from the main arena of U.S. government bond interest rates. The unintended and unforeseen
consequences of the Fed’s easy-money policies are becoming more visible, costly, and
problematic in many ways. An overview of these malignancies reveals how the Fed’s
quixotic pursuit of the deflation dragon is doomed to fail.

While inflation was quite low from 2008 to 2013, it was not zero, yet growth in personal
income and household income was close to zero. This meant that real incomes
declined
even in a low-inflation environment. If the Fed had instead allowed deflation, real
incomes would have risen even without nominal gains, because consumer goods prices
would have been lower. In this way, deflation is the workingman’s bonus because it
allows an increase in the living standard even when wages are stagnant. Instead,
real incomes declined. Economist Lacy Hunt captured this effect succinctly when he
wrote,

Since wages remained soft, real income of the vast majority of American households
fell. If the Fed had not taken such extraordinary steps, interest rates and inflation
would be lower currently than they are, and we could have avoided the unknowable risks
embodied in the Fed’s swelling balance sheet. In essence, the Fed has impeded the
healing process, delayed a return to normal economic growth, and worsened the income/wealth
divide while creating a new problem—how to “exit” its failed policies.

Another unintended consequence of Fed policy involves the impact on savers. The Federal
Reserve’s zero-interest-rate policy causes a $400 billion-per-year wealth transfer
from everyday Americans to large banks. This is because a normalized interest-rate
environment of 2 percent would pay $400 billion to savers who leave money in the bank.
Instead, those savers get nothing, and the benefit goes to banks that can relend the
free money on a leveraged basis and make significant profits. Part of the Fed’s design
is to penalize savers and discourage them from leaving money in the bank, and to encourage
them to invest in risky assets, such as stocks and real estate, to prop up collateral
values in those markets.

But many savers are inherently conservative and with good reason. An eighty-two-year-old
retiree does not want to invest in stocks because she could easily lose 30 percent
of her retirement savings when the next bubble bursts. A twenty-two-year-old professional
saving for a down payment on his first condo may avoid stocks for the same reason.
Both savers hope to get a reasonable return on their bank accounts, but the Fed uses
rate policy to ensure that they receive nothing. As a result, many citizens are saving
even
more
from retirement checks and paychecks to make up for the lack of a market interest
rate. So a Fed manipulation designed to discourage savings actually
increases
savings, on a precautionary basis, to make up for lost interest. This is a behavioral
response not taught in textbooks or included in models used by the Fed.