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Stock prices and the 'wealth effect' myth

By Gerard Jackson
web posted December 24, 2001

Even though the American recession has been declared official the myth of the so-called wealth effect lives on. That it can do so with apparent impunity should alert one to the dreadful amount of sloppy thinking in papers that is being passed off as economic analysis. One of my favourites is what I call the stock-prices-growth fallacy. This said that the stock market's performance was driven by a net inflow of funds which in turn was driven by economic growth. It went further by saying growth in turn is driven by investment, innovation and productivity; all of which influences corporate profits which drives stock prices. Naturally, when these factors are positive GDP is growing. It follows from this line of reasoning that rising stock prices in this environment are a healthy sign of an expanding economy. By definition, therefore, a positive GDP is incompatible with recession. A lot of people have now learned otherwise.

Now the above has been used to largely describe the state of the US and Australian economies throughout most of the '90s. It's still argued that employment growth raised household incomes, part of which were invested in shares. This triggered an economic chain reaction that goes like this: The additional demand for shares boosts stock prices which then boosts household wealth. (The more you invest the richer you get). This increase in wealth encourages household borrowing which fuels consumption which then expands corporate earnings and the demand for labour which then boosts incomes which are in part invested in stock. . . . If this sounds to you like the economic equivalent of perpetual motion, you are dead right. Logicians have a term for this kind of reasoning: They call it begging the question.

Let's get down to some economic basics. Savings (which equals investment) fuel an economy while entrepreneurship drives it. Now what exactly are savings? Saving is a process by which present goods are converted into future goods. Genuine savings mean that resources are being directed from current consumption (present goods) and invested in capital goods (future goods). This process will increase the future flow of consumer goods. Therefore cash balances are not savings, even though they are deferred consumption, while 'savings' that are loaned for the purpose of consumption are really dissavings.

Every economy has a capital structure that consists of complex stages of production. The effect of increasing savings is to lengthen this structure by adding longer and more complex stages to it. These stages consist of heterogeneous capital goods embodying technology. This is the true nature of economic growth. It should be clear that productivity is therefore the fruit and not the seed of economic growth.

In a progressive economy aggregate profits exceed aggregate losses. Hence, not only would a continual upward trend in the real value of stocks emerge but their returns would exceed the return on bonds, the difference being profit once risk had been accounted for. This brings us to productivity and profits. It's shallow to argue that rising productivity generates profits. A firm's physical and value productivity can still rise even as it goes broke.

Profits are maladjustments between supply and demand, as are losses. This means that in a truly profitable firm or industry its factors are undervalued in relation to the value of their products. We can deduce from this that a sufficiently large switch in demand can bankrupt a firm whose productivity was rising and yet generate profits for another whose productivity was stagnant.

Of course, if an entrepreneur has sufficient forecasting skill he will invest in a way that lowers his costs of production, ie., increases productivity, which in turn generates profits. But note, this is done by increasing the maladjustment between the supply of the product and the demand for the product, which will have the effect of attracting more competition which will then squeeze the firm's profits even as productivity continues to rise. A process that will be accelerated by the tendency of increasing productivity to lower prices. The point is that productivity per se is not the key to profits — entrepreneurial forecasting, or decision-making ability, is.

Looked at in this light two things emerge: (a) households that invest for the long term will certainly increase their wealth; (b) in this situation speculative booms will not emerge. The cause of these booms is easily detected and the culprit is credit expansion. Central banks allow the banking system to expand credit which raises then nominal incomes and investment. Eventually this credit begins to enter the stock market, laying the foundations of a speculative boom. Sure, as people think of themselves getting richer they borrow more to invest (or should I say gamble?) on the market. Thousands even engage in the risky practice of margin borrowing in the belief that economic gravity can be permanently defied. But where is all this credit coming from? The banking system is the answer. And Alan Greenspan knew it even as he opened the monetary taps further.

So forget tales that say the alleged 'wealth effect' fuels speculative frenzies: it's really a monetary illusion, a creation of credit expansion.

Gerard Jackson is the editor of the peerless The New Australian. Reprinted with the TNA's kind permission.

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