Forget The Wealth Effect

It’s Time to Focus on The Income Effect to Understand the Sluggish Economy

article | October 01, 2013

    Peter W. Atwater

The “wealth effect” concept is remarkably simple: spending increases (decreases) as perceived wealth increases (decreases). When people perceive themselves to be richer, they spend more.

With the prices of stocks and bonds near all-time highs and home prices on the rebound, consumer spending should be on a tear. But it’s not -- much to the consternation of many economists, particularly those at the Federal Reserve. As a result, many believe the wealth effect is somehow broken.

What these economists and pundits seem to be missing is that when it comes to the economic implications of wealth, perception truly is reality. Believing that one is wealthier is far different from being the owner of assets whose prices are merely higher.

Changes in our level of confidence alter what we believe to be true, and in turn our decisions and actions. Based on my research, for the wealth effect to work as economists suggest confidence must rise along with asset prices. With higher confidence we believe that higher asset values have increased permanence, and it is this perception of permanent wealth that results in higher spending levels. It is our confidence level that drives what we do.

Higher confidence also boosts our perception of permanence with respect to our incomes, too. Confident individuals believe that they will be employed longer – and at higher salaries – than people who lack confidence.

For consumers with weak confidence, it is the income effect not the wealth effect that matters. People with low confidence focus on the here and now. Uncertainty with respect to hourly wages and weekly incomes counts far more than what happens to asset prices. And today, high un- and underemployment accompanied by rising food, energy and healthcare costs are weighing heavily on the average consumer’s confidence. To borrow from Sendhil Mullainathan and Eldar Shafir, low and even middle class Americans are experiencing a scarcity effect; they are “struggling to manage with less than they need.” So too are most savers, as thanks to the prolonged effects of the Federal Reserve’s zero interest rate policies savers’ incomes are far lower than they were five years ago. For those with limited means, increased confidence has not accompanied the boom in asset prices because their confidence in the permanence of incomes is not there.

While policymakers have struggled to generate a virtuous wealth effect, they have succeeded in generating a vicious income effect. It has been five years since the collapse of Lehman Brothers and, not surprisingly, American economic confidence (Gallup) has yet to turn positive.

To be fair to policymakers, there is one group of Americans experiencing a very robust wealth effect today: the financial elite. Having owned significant wealth at the bottom of the banking crisis, their portfolios have benefitted enormously from the unprecedented coincidental long term rally in both fixed income and equity. For the financial elite, the perceptions of wealth today are not only well above the average American, but are now bordering on irrational exuberance. From art to cars to luxury condominiums, the wealthy are spending today like there is no tomorrow. Given the extreme narrowness of this group and their particular mix of purchases, however, the impact on the real economy is minimal and makes the income and wealth effects even more negative for the rest of society.

Today, Americans are experiencing historic extremes in confidence where a very small group is now basking in the classic wealth effect – where higher asset prices have translated to higher perceived wealth – while the rest of America struggles with a worrisome income effect – where weak wages coupled with higher food, energy and important quality-of-life services (healthcare, education, childcare) costs are strong headwinds to rising confidence.

Most economists still believe that confidence is an outcome of policymaking. For policymaking to be effective, however, economists must begin to understand how confidence is an input into how we make decisions and affects what we believe to be true. Perception is reality; and today all but a very few Americans perceive a negative income effect.

If Washington wants to help build confidence and create a sustainable recovery, it is time policymakers stopped worrying about the wealth effect and started to focus on the income effect.

A member of the New America Foundation World Economic Roundtable, Peter W. Atwater is the president of Financial Insyghts and the author of “Moods and Markets." He spoke on confidence-driven decision making at TEDx Wilmington in August.

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    Peter W. Atwater