The Wealth Effect

And 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, trying to quantify it, to determine 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.

And yes, after making about 10% of the population a lot richer and producing immense concentration of wealth at the top 1%, there are some minor trickle-down effects on the rest of the economy.

Meanwhile, the already immense wealth disparity in the US between the top 10% and the bottom 50% – or worse still, the top 1% and the bottom 50% – blows out.

Turns out, the lower 50% of Americans holds practically no stocks, no bonds, and very little real estate, according to the wealth distribution data from the Federal Reserve. And these folks cannot benefit at all from the wealth effect. For them, life (such as housing) just gets more expensive as a result of the wealth effect.

From the Federal Reserve’s data, as of Q1 2021:

  • The average household in the richest 10% owns $2.6 million in stocks and $1.2 million in real estate.
  • The average household in the richest 1% holds $16 million in stocks and $4 million in real estate.
  • The average household in the bottom 50% holds essentially no stocks, no bonds, and only small amounts of real estate.

The wealthiest 1% is where the real concentration of wealth takes place.

The wealthiest 15 US individuals have a combined wealth of $2 trillion, according to the Bloomberg Billionaires Index (June 2021). They benefit more than anyone from the wealth effect.

The Wealth Effect purposefully increases asset prices. But only the top 10% of households have significant amounts in assets.

The bottom 50% hold nearly no stocks because they don’t make enough money to put anything aside. Many of these people live from paycheck to paycheck.

But the Wealth Effect also makes housing more expensive – both buying and renting – and thereby the bottom 50% disproportionately pay for the Wealth Effect. For the bottom 50%, the Wealth Effect is a negative. This chart is from my Wealth Effect Monitor.