Mises Daily

Why the Wealth Effect Doesn’t Work

Higher equity prices will boost consumer wealth and help increase confidence, which can spur spending. — Ben Bernanke, 2010.1

Across all financial media, between both political parties, and among most mainstream economists, the “wealth effect” is noted, promoted, and touted. The refrain is constant and the message seemingly simple: by increasing people wealth through rising stock and housing prices, the populace will increase their consumer spending which will spur economic growth. Its acceptance is as widespread as its justification is important, for it provides the rationale for the Federal Reserve’s unprecedented monetary expansion since 2008. While critics may dispute the wealth effect’s magnitude, few have challenged its conceptual soundness.2 Such is the purpose of this article. The wealth effect is but a mantra without merit.

The overarching pervasiveness of wealth effect acceptance is not wholly surprising, for it is a perfect blend of the Monetarist and Keynesian Schools.3 While its exact parentage and origin appears uncertain, its godfather is surely Milton Friedman who published his permanent income theory of consumption in 1957.4 In bifurcating disposable income into “transitory” and “permanent” income, Friedman argued the latter dictates our spending and consists of our expected income in perpetuity. If consumer spending is generated by expected income, then surely it must also be supported by current wealth?

But this may or may not be true. It will vary across time, place, and among various economic actors whose decisions about consumer spending are dictated by their time preferences. And time preferences — the degree to which an individual favors a good or service today (consumption) relative to future enjoyment — take into account far more variables than the current, unrealized wealth reported in brokerage statements and housing appraisals.

Regardless as to whether or not increased wealth will actually spur increased consumer spending, the most important component of the wealth effect is the assumption that increased consumer spending stimulates economic growth.5 It is this Keynesian concept which is critical to the wealth effect’s validity. If increased consumer spending fails to stimulate the economy, the theory of the wealth effect fails. Wealth effect turns into wealth defect.

Will increased consumer spending improve the economy? On one side of the argument, we have the aggregate individual conclusions of hundreds of millions of economic actors, each acting in their own best interest. These individuals and businesses are attempting to reduce consumer spending and increase savings.

Dissenting from their views are the seven members of the Board of Governors of the Federal Reserve. Each member believes in the paradox of thrift — the belief that increased savings, while beneficial for any particular economic actor, have deleterious effects for the economy as a whole. The paradox of thrift can essentially be described as such: decreased consumer spending lowers aggregate demand which reduces employment levels which negatively affects consumption which in turn lowers aggregate demand. The paradox predicts an economic death spiral from diminished demand. And mainstream economists believe we were (and potentially are) mired in such a spiral. As noted econo-sadist Paul Krugman noted in 2009: “we won’t always face the paradox of thrift. But right now it’s very, very real.”6

The inverse of this “reality” predicts flourishing economic prosperity when a society increases its consumer spending. But history suggests the opposite: it is higher savings rates which lead to economic prosperity. Examine any economic success story such as modern China, nineteenth century America, or post-World War II Japan and South Korea: did their economic rise derive from unbridled consumption, or strict frugality? The answer is self-evident: it is the savings from the curtailment of consumption, combined with minimal government involvement in economic affairs, which generates economic growth.

So why do so many “preeminent” economists falsely believe in the paradox of thrift, and thus the wealth effect? It is because of their mistaken understanding of the nature of savings. The Austrian economist Mark Skousen addressed this in writing:

Savings do not disappear from the economy; they are merely channeled into a different avenue. Savings are spent on investment capital now and then spent on consumer goods later.7

Savings are spent. Not directly by consumers on electronics and espressos, but indirectly by businesses via banks on more efficient machinery and capital expansions. Increased savings may (initially) negatively affect retail shops, but it benefits producers who create the goods demanded from the increased pool of savings. On the whole, the economy is more efficient and prosperous.

Does this economic maxim hold even when the economy is in a recession?8 Even more so. As all Austrian economists know, business cycles derive from government manipulation of the money supply which artificially lowers and distorts the structure of interest rates.9 To minimize the length and severity of a recession, economic actors should save more which will reduce the gap between artificial and natural rates of interest.

Regrettably, this is not merely an academic discussion. Due to their mistaken economic beliefs, the Federal Reserve has quadrupled the money supply while bringing interest rates to historic lows.10 The results will inevitably arise: significant price inflation, volatile financial markets, and severe economic downturns. In many respects, Sir Francis Bacon’s aphorism that “knowledge is power” is true. Unfortunately, in the economic realm, the Austrian economist F.A. Hayek was closer to the truth: those in power possess the pretense of knowledge.11



  • 1Ben S. Bernanke, “Op-Ed Columnist — What the Fed Did and Why: Supporting the Recovery and Sustaining Price Stability.The Washington Post. 4 November 2010.
  • 2To date, most criticism focuses on the relatively minor increase in real GDP (11.2 percent from April 1, 2009 through October 1, 2013) relative to the substantial increases in the money supply and the stock market which have risen, respectively, 330.0 percent (Adjusted Monetary Base from August 1, 2008 through January 1, 2013) and 160.9 percent (S&P 500 from March 1, 2008 through February 19, 2014). The dates have been selected to measure the increase since the respective lows reached subsequent to August 1, 2008 to the most recent data.
  • 3The characterization of monetarism as an economic school can be disputed. By definition, a school of thought must be systemic, which means positions and theorems must be connected by underlying assumptions. The so-called Monetarist School consists of various unrelated hypotheses which are empirically “tested.” While the preponderance of the “school’s” positions may favor free markets (although often not for the most critical markets — e.g., money), they display inconsistency in application. This underscores the lack of an academic edifice built from fundamental axioms.
  • 4Milton Friedman, Theory of the Consumption Function. Princeton, N.J.: Princeton University Press; Homewood, Ill.: Business One Irwin. 1957.
  • 5The commonly cited support for this assertion, that personal consumption accounts for approximately 70 percent of Gross Domestic Product is, strictly speaking, correct. However, it is correct only because GDP overstates personal consumption as a by-product of a misguided attempt to avoid “double counting.” If non-durable capital goods and intermediate products (e.g., steel) were included in GDP (as they should be if one is attempting to measure economic activity), personal consumption would fall to approximately 40 percent of economic activity based upon the latest GDP component and Gross Output statistics. Mark Skousen, “Beyond GDP: Get Ready For A New Way To Measure The Economy.” Forbes. 29 November 2013. <http://www.forbes.com/sites/realspin/2013/11/29/beyond-gdp-get-ready-for-a-new-way-to-measure-the-economy/#!>
  • 6Paul Krugman, “The Paradox of Thrift — for Real.The Conscience of a Liberal. The New York Times. Web. 7 July 2009.
  • 7Mark Skousen, Economics on Trial. Homewood, Ill.: Business One Irwin, 1991. p. 54.
  • 8It would be odd indeed if one argued that savings increases economic growth during normal times, but exiting a recession requires greater levels of consumption. As Ayn Rand wrote: “Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong.” (Atlas Shrugged, New York: Random House, 1957). If economic growth during a recession requires increased consumption, then this business cycle theory does not comport with general economic theory — which is prima facie evidence that it is wrong.
  • 9It should be noted that an increase in consumer spending due to increased levels of real or perceived wealth in no way invalidates or contradicts Austrian business cycle theory (“ABCT”). While some economists have alleged increased consumption during the boom phase of a business cycle is in conflict with ABCT, Austrian economist Joseph Salerno has effectively squashed such criticisms as a misinterpretation. (Joseph Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics. 15, No.1. [2012]).
  • 10See footnote 2.
  • 11“To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.” F.A. Hayek, “The Pretense of Knowledge.” Lecture to the Memory of Alfred Nobel. Stockholm Concert Hall. Stockholm, Sweden. 11 December 1974.
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