The Wealth Effect

How the “Wealth Effect” creates Wealth Disparity.

By Wolf Richter for WOLF STREET.

The doctrine of the “Wealth Effect” has long formed the official foundation for the monetary policy of the Federal Reserve. The Wealth Effect has been described in numerous Fed papers, including by San Francisco Fed president Janet Yellen in 2005. She wrote, “As part of its analysis of demand in the economy, central bank models have long incorporated the wealth effect of house prices and other assets on spending.”

In November 2010, after inflating asset prices for two years through zero-percent interest rates and QE, Fed Chair Ben Bernanke explained the concept of the Wealth Effect to the American people via a Washington Post editorial.

The Fed’s “strong and creative measures” would inflate stock prices, which would lead those holding stocks to feel wealthier and more confident, and then they’d spend a little more, and some droplets of this might trickle down to the people that are working in the real economy.

The National Bureau of Economic Research (NBER) did a study on the Wealth Effect, to quantify how much richer the rich have to become to have x% impact on the overall economy, and how long this boost lasts before it fades.

“The ‘wealth effect’ is the notion that when households become richer as a result of a rise in asset values, such as corporate stock prices or home values, they spend more and stimulate the broader economy,” the NBER said.

It makes 10% of the population a lot richer, producing immense concentration of wealth at the top 1%, and mind-boggling concentrations of wealth among the truly rich and at the billionaire level. After which there may be some muted trickle-down effects on the economy.

As a result, the already immense wealth disparity in the US between the top 1% and the bottom 50% blows out. Then there’s the billionaire class. They benefit more than anyone from the wealth effect.

The bottom 50% of Americans holds practically no stocks, no bonds, and very little real estate, according to the wealth distribution data from the Federal Reserve. Many live from paycheck to paycheck. They don’t make enough money to put anything aside. These folks cannot benefit from the wealth effect. For them, life (including housing costs, buying and renting) just gets more expensive as a result of the wealth effect.

Even the households between the top 10% and the bottom 50% have little compared to the 1%. But the truly rich (the 0.01%) and the billionaire class have such immense wealth that by comparison, even the 1% have nearly nothing. This immense concentration of wealth at the very top and this huge disparity in wealth to everyone else are in part a result of the Fed’s monetary policies that rely on the “wealth effect.”