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CIAO DATE: 8/01
Hey, Mr. Greenspan: Wealth Creation Isn't a Problem
On The Issues
July 2000
The Federal Reserve Board should not raise interest rates to combat the supposed "wealth effect" caused by the booming stock market. A strong stock market will not stimulate consumption enough to drive up prices; in fact, under current conditions, a bull market may even boost supply more than demand.
Markets have soared in recent weeks, in part because of a sequence of good inflation reports. But the market may be rejoicing prematurely. Recent statements by Alan Greenspan suggest the Federal Reserve may increase rates in response.
If the Federal Reserve raises interest rates because of a booming stock market, it will be a terrible mistake.
The chairman's preoccupation with the market is certainly not new. Way back on December 5, 1996, he famously warned that share prices may be boosted by the "irrational exuberance" of shareholders. At the time, Robert Shiller of Yale University warned that the market's P/E (price to earnings) ratio, well above its long-run average, presaged disaster.
Subsequently, Mr. Greenspan dropped this line of reasoning. The long-run average P/E is not a sensible target if the equity risk premium is declining over time, as it has been in recent years. Even he now admits this, remarking recently that "because knowledge once gained is irreversible, so too are the lowered risk premiums."
But just as equity investors began to rest easy, Mr. Greenspan put forth a different argument for a rate hike in a rising stock market, the so-called "wealth effect." This is the extra stimulus to demand that occurs when consumers' wealth increases. The Fed's reasoning is that a booming stock market has made shareholders feel wealthier, increasing their demand for consumer products. Mr. Greenspan has worked out a formula: One dollar of extra stock-market wealth leads to an extra three to five cents of current consumption.
This nefarious wealth effect is said to be so powerful that it suspends the laws of economics. When the wealth effect strikes, demand runs "ahead of supply," leading to a rapid acceleration in inflation. This line of reasoning has been accepted by an unusual assortment of bears. Even liberal economist Robert Kuttner praised his newfound soul mate's "revolutionary" Keynesian insights in a recent Business Week article.
A Weak Relationship
But it just isn't plausible that a higher stock market is stimulating consumption enough to cause concern. It's true that aggregate fluctuations in consumption and the stock market are positively correlated, but there are many things that go up and down together over the business cycle. The challenge is to find connections that are truly causal. In this case, that link hasn't been made and probably never will be.
Here is why: Most stock is owned by fairly wealthy individuals—the top 1 percent of equity owners hold about 50 percent of all corporate stock. The top 5 percent own about 80 percent of all stock. Since these individuals have a relatively small share of aggregate consumption—perhaps as low as 12 percent—it is almost mathematically impossible for them to drive an increase in aggregate consumption big enough to cause large-scale imbalances.
For aggregate consumption to increase as much as Mr. Greenspan's formula suggests, these rich people would have to be responding enormously to stock-market fluctuations. Consumption by the very rich would have to be about 30 percent higher today because of recent stock-market gains in order to generate an effect as large as Mr. Greenspan proposes. And how many fewer hamburgers has Bill Gates consumed because of his declining wealth? Those who believe in the wealth effect would have to say "quite a few."
This point is so powerful that many wealth-effect proponents have given up claims of a direct effect and now theorize that it is more a twisted channel through which the stock market drives consumption. My favorite stretch is the argument that a booming market changes consumer sentiment, causing a big increase in demand by low-income workers who don't own stocks. This might be plausible if there were a strong statistical link between sentiment and consumption, but there isn't.
There is no question that an increase in wealth will ultimately lead to higher consumption. For some goods such as BMWs (said to be selling above their sticker prices), the link can even be quite strong. But the evidence doesn't support the view that the consumption response will be coordinated enough and sudden enough to threaten the aggregate economic balance.
Given the weakness of the relationship on a priori grounds, it is perhaps not surprising that the empirical evidence supporting this channel is weak. For example, an exhaustive study for the New York Federal Reserve by Sydney Ludvigson and Charles Steindel recently concluded that "forecasts of consumption growth one or more quarters ahead are not typically improved by accounting for changes in existing wealth."
Good News
And even if there were a strong consumption effect, there is another important factor working to offset it: the investment effect. In a recent article, my AEI colleague R. Glenn Hubbard and I concluded that a broad literature agreed that a booming stock market should increase business capital investment significantly. Higher equity prices make it easier for firms to finance the purchase of capital goods. Since 1995, for example, the Standard & Poor's 500 index has risen about 200 percent, while investment in equipment has increased about 78 percent. This massive increase in supply is the chief reason inflation has remained relatively subdued.
The evidence also suggests that the increase in supply can be quite timely. Census data on capital-good delivery lags suggest that the average capital good is delivered to the factory floor about 1.5 months after it is ordered. Given the length of time between Fed meetings, it is possible that capacity reinforcements arrive on shop floors before the committee has had a chance to discuss the inflationary impact of the latest wealth effect.
So a sudden increase in the stock market provides a reliably large stimulus to investment but has an uncertain, and probably small, effect on consumption. The net effect on inflation might even be negative.
There is one final issue to put to rest. Some economists note that maybe it isn't consumption demand that drives up prices, but investment demand. Maybe prices of capital goods will soar when the stock market booms, and that will cause a more general inflation.
But here too the literature supports a different conclusion. In a different paper, Mr. Hubbard and I concluded that local conditions in the United States have no discernible effect on capital-goods prices because these prices are set on the world stage. Capital-goods prices have dropped steadily during the latest investment boom, even posting a decline in the first quarter of this year.
Equipment investment, meanwhile, surged at the remarkable annual rate of 26.6 percent. Economics can be a frustrating and inexact science; reliable answers are hard to find. But this case is different. The literature clearly implies that a soaring stock market won't produce inflationary pressures, all else being equal. Mr. Greenspan and his colleagues at the Fed must reconcile themselves to the fact that it is good news when the stock market goes up.
Kevin A. Hassett is a resident scholar at AEI. A previous version of this article appeared in the Wall Street Journal on June 26, 2000.
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