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The Wealth Effect

Updated: May 2, 2018

This article was published in the Australian Broker magazine on 28 October 2016.

Over the last few years central banks and governments’ monetary and fiscal policies have been directed at stimulating economic growth. But despite policies of low or negative interest rates and fiscal stimulus, global economic growth has remained subdued. Consumers have not responded in the manner that policy makers predicted.

Asset rich, cash poor

Consumers only spend when they feel wealthy – a psychological phenomenon that is known as the ‘wealth effect’. But policy makers should not assume this phenomenon is the driving force behind investment. Consumers are not necessarily buying property because they feel wealthy. Rather, financially able consumers see property as a safe haven. Everyone wants to get onto the property ladder, especially before they are locked out altogether as a result of even higher house prices, and for some that means borrowing from their parents.

But a consequence of consumers taking on more debt is that they reduce their disposable income, thereby limiting their expenditure while they adjust their lifestyles to allow for more debt.

Those consumers that do not have the financial means, such as retirees and pre-retirement workers who have lost their jobs, are dipping into their capital to maintain their living standards. This cohort tends to be asset rich, but cash flow poor. Students are loaded with debt on entering the workforce, so their ability to spend on non-essentials is already limited and many are supported by their parents in some way or another.

Businesses are adopting a “wait and see” approach to significant capital investment. They are reducing production and distribution costs through offshoring, outsourcing and self-service over the internet. These business actions are undermining consumer confidence, as employees wonder whether they will be the next to lose their job or find their hours reduced. Their response is therefore to defer spending.

Currency Policy – No win strategy

For over seven years now governments and central banks of the major economies – the US, UK, EU and Japan - have been attempting to devalue their currencies through Quantitative Easing (QE). Those economies that have not followed the QE route have been lowering interest rates to counter the actions of those that have adopted this strategy. Australia is one of those nations. Unfortunately, it is a nil sum game when all participants are adopting the same strategy, as Australia has found out. Historically, a reduction in the Cash Rate and an increase in the US Fed Funds Rate should have led to a reasonable fall in the value of the Australian dollar against the US dollar, and yet the Australian dollar has continued to rise in value.

Fiscal Policy - Failure

With the exception of the US, budget deficits are increasing as governments are either unable, or refuse to reduce real levels of government spending. The focus appears to be on raising more revenue (tax receipts) rather than recognising we are living beyond our means. Increasing taxes will be a disincentive to spend and it will reduce savings. It is another form of wealth transfer and will it also have a negative impact on the wealth effect, which is a necessary behavioural component required for economic growth.

Governments pay for budget deficits by issuing bonds; however with each issuance the deficit increases. As we are all aware interest payments on all types of debt will also increase once interest rates rise. The possible impact of this is a sleeping giant!

Savers footing the bill

The world is seeing the largest transfer of wealth from savers to borrowers in modern history, as a consequence of these policies. Savers are being asked to foot the bill for previous government economic policy failures. So how did we end up here?

1. Low or negative interest rates reduce the disposable income of consumers that rely on investment income and their savings. This reduces their propensity to spend as they feel poorer.

2. The tax system rewards borrowers and penalises savers.

3. Borrowers are getting access to greater levels of debt than they would in a “normalised” interest rate environment and in a tax effective manner.

4. Governments force bondholders to take haircuts on sovereign debt, e.g. Greek debt, and investors carry the loss for borrowers.

5. Central banks engage in Quantitative Easing (QE) where they buy debt back and they are looking at cancelling it. If so, the borrower is able to walk away and the cost is ultimately borne by the taxpayer.

6. Governments fund budget deficits through low or negative real returns on Government debt. Investors are being asked to pay for budget repair with only a guarantee of a return of their capital on the back of the government credit rating.

A new policy direction

These monetary and fiscal policy strategies by Governments and central banks around the world are unsustainable and have failed. They don’t take into account human behaviour, they undermine confidence and fuel speculators, and savers are paying the price for traditionally prudent behaviour. Collectively, these policies have set the world up for years of economic malaise and unsustainable budget deficits.

New action is needed. As monetary policy is ineffective, the solution is for all governments to tackle their structural budget deficits by reducing real expenditure and introduce measures aimed at rewarding savers and investors. The deliberate policy settings that are causing the greatest wealth transfer in history must be reversed.

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