A Wealth Effect That Did Not Trickle Down

Many pundits who dismiss trickle down economics also support the Fed’s multiple QE’s and its stated goal to create a “wealth effect”. This I find ironic since the Fed’s manufactured wealth effect was meant to boost the economy by trickling down.

In The Washington Post , Ben Bernanke wrote on November 4, 2010: “the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability.”

If you thought the Fed had only two mandates, think again. Since 1987, the Federal Reserve Bank has unilaterally added “managing asset prices” to its responsibilities of managing inflation and unemployment levels. Bernanke also explains why this is important:

“higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending”.

It is fair to say that this scenario did not work out as he had planned. Asset prices did go up and rich people with assets may feel better – much better – today. However, spending continues to be subdued because asset inflation does not translate into income. Household incomes today stand 6.4% below they were at the beginning of the recession, even 4.7% below where they were at the end of the recession when asset prices started to climb*.

Let’s think this through. Suppose we give a number of people tulips (not everyone in America owns assets). Then, we push tulip prices up. Tulip owners feel good. Some will sell their tulips, cash the money and buy a nice car. But now the guy who sold feels bad because tulip prices keep going up and he is missing out. He buys tulips again. Others, who have been on the sidelines now want to join the party. Tulip prices go higher as a result, and so forth. The big money goes to speculation, not to consumption. We all know the story and how it ends.

Here is why such analogy is not as far fetched as you may think. Paper wealth due to asset inflation is ephemeral. Real wealth is created by generating return on investment. Tulips are bad investments because they don’t yield any income. The return on an investment in tulip is zero. That is also the problem with Bernanke’s complete neglect of return on investment. His orchestrated universal asset inflation did not eliminate returns on investment all together, but it greatly diminished them.

An economy with low returns cannot grow healthily. Investments seek returns. When adequate returns are not available, companies don’t invest. Has anybody noticed the amazing contradiction in companies hoarding record amounts of cash while generating profit margins 70% above their historic average? With that kind of profit margin and return on sales, shouldn’t companies put their low-returning cash to work? Yet, they cannot find new investments yielding sufficient returns. Obviously, asset inflation has not created investment opportunities yielding proper income.

Furthermore, consumers spend their income. Feeling rich may induce someone to indulge for a short while, but it is the recurrent income generated by good investments that makes the consumer spend money.

Return on Investment is the obvious missing link in the wealth effect’s implementation. Actually, the Fed’s policy has been an unprecedented exercise in the destruction of returns on investments. Pensioners, a growing percentage of the population, has seen their returns on bonds melt to ridiculous levels. Cash in bank accounts no longer yield even a small return. Housing reflation has greatly diminished returns** and stocks’ earnings yield keep coming down as PE ratios (the reverse of earnings yield) go up and up.*** Hence, in taking away the markets’ pricing mechanism, the Fed has greatly distorted the economy’s return on investments. Maybe it should consider a fourth mandate.

Trickle down economics worked in the last two decades of the twentieth century because it was based on organic growth and high returns on investments, which resulted in higher asset values. This, in turn, created a virtuous circle and the benefits did trickle down, admittedly unevenly. Bernanke’s QE experiment tried to put the cart in front of the horse and it did not work.

Asset inflation actually reduces returns on investment.

* Politics & Ideas, The Wall Street Journal of February 12, 2014

** S&P Case-Shiller 20-City Composite Home Price Index peaked at 206 in August 2006, bottomed at 134 in February 2012, was at 166 in November 2013 and is expected to be up another 5% or so in 2014 (which would bring it at 174, 15.5% below the all time/spike). The Vanguard REIT Index ETF now yields 4.14%.

*** Companies’ profits margins, which are at historic highs, are calculated on sales. Yet earnings yields for an investor today are above historic averages, hence the high PEs. If one “normalizes” earnings by assuming more average profit margins, the PE ratios look very overpriced.

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