Getting it Right on Recessions and the 'Wealth Effect'
I have received a number of emails concerning my article Stock prices and the phony 'wealth effect'. these readers wanted to learn more about how such an "obvious fallacy" became the received wisdom. It's a good question and one that I shall try to answer. Let's us begin with an article by Tim Colebatch, economics editor of The Age. Writing from Holland about that country's recession, he asserted that "the biggest factor was the collapse of 'the wealth effect': the same factor that has underpinned Australia's success story, by giving consumers the confidence that they could go heavily into debt, spend heavily, and still come out richer as a result" (Should going Dutch be the Australian way?, 23 March 2004).
Focusing on Colebatch's article throws into sharp relief this economic nonsense that, Unfortunately, every economics commentator in the country seems to have swallowed without so much as a burp. Just in case any readers have forgotten, the "wealth effect" fallacy has it that rising employment increases household incomes. Part of these incomes are then used to buy shares. This in turn triggers an economic chain reaction that raises the demand for shares which in then lifts stock prices which then boosts household wealth.
Now that households feel wealthier they also feel more comfortable about increasing their debt levels. Their increased borrowing fuels consumption which then expands corporate earnings and the demand for labour which then boosts incomes which are in part invested in stock. . . . If the above sounds circular, then you are absolutely right. Despite what the Reserve Bank of Australia, the Australian Treasury and our economic commentariat think, it is savings that fuels an economy -- not consumption, and certainly not any mythical "wealth effect" -- while entrepreneurship drives it.
Genuine savings take place when resources are directed from current consumption (present goods) and invested in capital goods (future goods). It can be easily deduced that this process is one of capital accumulation that will eventually bring about a greater flow of consumer goods. This brings us to another fallacy: one that defines savings as deferred consumption. This is truly sloppy thinking. It amounts to saying that because men are human being it must follow that all human beings are men. The error here is the inexcusable one -- at least for economists -- of confusing the demand to hold money (an increase in cash balances) with the demand for savings.
W. H. Hutt demolished the idea that cash balances were some how 'idle' and therefore did not provide a service. (The Yield from Money Held in On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises, Princeton: Van Nostrand, 1956, p. 197 and p. 216). He also pointed out that cash balances simply showed that "persons may prefer to hold more or less of their assets in the form of money". [His italics]. (The Keynesian Episode: A Reassessment, LibertyPress, 1979, p. 322). Therefore cash balances are not savings, even though they are deferred consumption, while savings that are loaned for the purpose of consumption are not savings at all. He summed up with the observation that economic growth
[A]rises not through a decline of consumption leaving an accumulation of unconsumed assets but (a) through the diversion of the services of some versatile resources from producing short-life (consumer) goods to producing long-life (capital) goods, or (b) through additional services, due to an increasing real income, being directed to long-life goods rather than short-life goods...
In plain English, saving is a process of directing expenditure from consumer goods to producer goods. It follows from this that money borrowed to increase consumption cannot increase the supply of future goods. On this important matter Hutt clearly stated that :
"Consumption" does not express demand but exterminates it [his italics]... consumption cannot be regarded as in any sense the source of any demand... (Ibid. 304).
It is vital to understand what Hutt is saying if we are to make sense of what passes for economic commentary down here. So where did the so-called wealth effect spring from? Keynesianism is the answer. Those who are free of this curse recognise a simple fact. If buckets of money are being borrowed and spent on shares and houses they must be coming from somewhere. But according to Professor J. A. Vilbrief Netherlands (as quoted by Colebatch), acting director of the Netherlands Ministry of Economic Affairs, "wealth effects have driven the cycle up through overspending, and now they're driving the cycle down, in conjunction with confidence effects". As expected, Colebatch concurs with the professor's view.
It seems that Holland's central bank neither calculates M1 nor even publishes demand deposit figures. Nevertheless, adding currency to overnight deposits provides a rough substitute for M1. What we find here is particularly interesting. In 1990 M1 stood at 61,188: by January 2004 it had risen to 173,638. This is a 183.8 per cent increase . During the same period M3 jumped from 186,400 to 483844 -- a 160 per cent increase. The situation is even worse for Australia where during the same period currency increased by 154 per cent, bank deposits by 385 per cent and M1 by 312 per cent.
Wealth effect my foot. What Holland experienced was a rapid monetary expansion that fuelled a boom which could have only one ending. And the same obviously goes for Australia. Unable to see further than his laptop Colebatch used the Dutch experience to try and explain Australia's housing boom. In his words:
Our tax system subsidises landlords whereas theirs subsidises owner-occupiers, by allowing them to write off their mortgage bills against tax. But it has had the same effect of driving up prices, making it difficult for young people to buy into the market, and driving up debt, making the economy top-heavy.
Balderdash! Sheer economic balderdash. For Colebatch's argument to hold up he would have to show that favourable tax treatment always preceded housing booms. He would also have to explain how this tax treatment causes credit to expand. In addition, he would have to show that countries that did not give favourable tax treatment to house-buyers never suffered housing booms.
I should make it clear that Colebatch is not the only Australian economics commentator who ignores the role of monetary policy in fuelling asset booms. I honestly cannot think of a single Australian conservative commentator who recognizes the fundamental role money supply plays in the so-called boom-and-bust cycle.
I regret to say that the above is the kind of monetary approach that is likely to get one marked out as a "right-wing Austrian fanatic" by some of Australia's neo-classical economists.