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, 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 rest of the economy.

Meanwhile, the already immense wealth disparity in the US between the top 1% and the bottom 50% blows out as a result of trying to create the Wealth Effect.

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. 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.

Then there’s the billionaire class. The wealthiest 15 US individuals have a combined wealth of $2 trillion with a T, according to the Bloomberg Billionaires Index (June 2021). They benefit more than anyone from the wealth effect.

The bottom 50% (green in the chart below) hold nearly no assets because they don’t make enough money to put anything aside. Many live from paycheck to paycheck. Higher asset prices for the wealthy increase housing expenses for the bottom 50%. For them, the Wealth Effect is a negative. Even the top 10% to 50% (purple) have little compared to the 1% (red). And not shown separately in this chart are the truly rich (the 0.01%) and the billionaire class.