The ‘wealth effect’ fiction

US Fed chief Ben Bernanke has gone out of the way to explain how monetary policy works once the traditional policy tool, the overnight inter-bank rate, hits zero. When the Fed buys long-term Treasuries, it depresses yields and forces investors to buy assets that carry more credit risk, such as stocks and corporate bonds.

Lower yields make housing more affordable. Higher stock prices work through the wealth effect to increase consumer spending leading to higher corporate profits and personal incomes in what he called a ‘virtuous circle’(extract from a Bloomberg article, ‘The Question the Fed Should be asking’.)

‘Phew’ might well be the reaction of a non-economist, not to speak of the layman. What a roundabout way. And what’s the certainty that it will lead to results? None.

Not that Bernanke hasn’t achieved anything — in fact, he’s achieved a lot: pulled the US economy back from the brink, house prices and turnover in the housing sector are up and, as we all know, the Dow and S&P 500 have set new records.

Accretion evident

Wealth accretion is very much in evidence — those owning stocks and property are richer.

And US companies have billions of dollars in cash, which is great for their financial health. But there’s no sign of Bernanke’s ‘wealth effect’, which is supposed to buoy the economy.

Not that Bernanke doesn’t know: he’s too clever not to. The negative effects of ‘sequestration’ — the automatic spending cuts in the absence of a budget deal between lawmakers — have been among Bernanke’s explicit and oft-mentioned worries.

Economic policy can only be a subset of the process of acquiring political power to further one’s group interests or ideology. Despite losing the election to Obama, the Republicans have enough votes in Congress to stall the President’s economy-boosting measures.

First is their fear that a major Government-spending programme will succeed in lifting growth to a much higher plateau, discrediting the Republican stance of minimal government. Never mind that the risks are negligible in a situation where there’s significant idle capacity in industry and labour. Also, never mind that it can avoid a lot of unnecessary human suffering. The political stakes are too high.

So it’s left to Bernanke to bravely soldier on, with monetary policy becoming the beast of burden.

The economic philosophy embodied in the first paragraph is beautifully and succinctly described in the phrase, ‘trickle down economics’. And the catalyst is supposed to be rising prices of the assets of the wealthy.

This shows how far we have departed in thinking from the traditional sources of growth-investment, technology and increasing supply of labour.

Current mantra

Now the mantras are low taxes and little (and if possible no) regulation (‘the market will take care’, said Milton Friedman in his several writings — lucky for him he died well before the 2007-08 crash), and ‘a thousand flowers will bloom’.

It’s more like a thousand flowers withering.

One looks forward to a historic, incisive, firm no-nonsense speech from Bernanke setting out the limits (and potential problems) of easy money.

That will be the day.

(The author is a Chennai-based financial consultant.)

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