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It is
being said that if the fed could just get the ‘wealth effect’ into motion the
US economy would fully recover from the recession. But the ‘wealth effect’ is
a phantom, the sort of economic fallacy that only a Keynesian could conjure
up. Those who support this fiction argue that a stock market’s
performance is driven by a net inflow of funds which in turn is driven by
economic growth. They go further by saying that growth in turn is driven by
investment, innovation and productivity, all of which influences corporate
profits which in turn drive stock prices. Naturally, when these factors are
positive GDP expands.
It
follows from this line of reasoning that rising stock prices in this
environment are a healthy sign of an expanding economy. This logic has been
used to describe the state of the US and Australian economies throughout most
of the 1990s and even up to the present. They also argue that increased employment
has the effect of raising household incomes, part of which is invested in
shares. This triggers 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
spot on. Logicians have a term for this kind of reasoning: They call it
begging the question. Let’s get down to some economic basics. Savings 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.
Every
economy has a capital structure that consists of complex stages of
production. The effect of increasing savings is to lengthen the structure* by
adding longer and more complex stages. These stages consist of heterogeneous
capital goods embodying technology. This is the true nature of economic
growth. It should also 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 profits are a simple function of rising
productivity generates profits. A firm’s physical and value productivity can
still rise even as it goes broke. (There is no paradox here if one bears in
mind that what matters here is demand for the product).
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 is
rising and yet generate profits for another whose productivity is stagnant.
Of
course, if an entrepreneur has sufficient forecasting skill he will invest in
a way that lowers his costs of production, i.e., 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
squeeze the firm’s profits even as productivity continues to rise. This
process will be accelerated by the tendency of a continuous increase in
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 credit to expand which
raises 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.
So
forget about the “wealth effect” or “margin borrowing” fueling speculative
frenzies: it’s a monetary illusion, a creation of credit expansion — nothing
else.
* * *
*Strictly
speaking, a lengthening of investment periods does not always require more
stages of production. In some cases a lengthening involves the replacement of
existing stages with more advanced but more time consuming stages. I stress
the addition of more stages to emphasis the importance of the stages of
production analysis. Failure to grasp this importance and the vital role of
Austrian capital theory is why R. G. Hawtrey and Keynes were completely
surprised by the arrival of the Great Depression. Unfortunately for posterity
neither of these gentlemen learnt the lesson.
**Steve
Kates argues that the classical economists believed that booms and busts
were spontaneous events caused by capitalists erring. Completely false. The
currency school developed a monetary theory of the trade cycle and it was
this theory that dominated economic until the late 1840s. How anyone can
argue otherwise while claiming to have studied the period certainly baffles
me.
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