Markets, Wealth, NY Fed
David Kotok
February 27, 2013
Our written comments on wealth effects were discussed on Bloomberg TV and Bloomberg Radio. For copies see this or Twitter. That discussion and the commentaries about markets and wealth effects triggered a blizzard, which expanded after friends at Big Picture and Business Insider posted them. Thank you to all bloggers, readers, economist writers and others for expressing views on this subject.
Below are a few follow-up notes. But first I must add something to the discussion of Gretchen Morgenson’s NY Times column and my support of her view. Yesterday, Judge Lewis Kaplan issued an interim order in the litigation. I will quote two sentences. He said “Thus, the FRBNY appears to be engaged in an attempt to circumvent and defeat the forum selection clause to which it is bound by its agreement with AIG. On the face of it, the actions of the FRBNY and its instrumentality, Maiden Lane II, are perhaps unattractive and, indeed, wrongful.”
I stand with Gretchen and her reporting of the actions of the Federal Reserve Bank of New York. Truth, transparency and US Constitutional protection of the press and of free speech are all that stand between our citizens and the financial tyranny of the last five years. If we lose that Constitutional protection, tyranny will win and we are doomed.
Now let’s get to wealth effects.
Long-time personal friend and TV star economist Bob Brusca weighed in on Liz Webbink’s comment. Readers, if you are bored with discussion of wealth and savings and income, stop here. Others who are serious students of economics and/or financial markets may enjoy the next few minutes.
Bob Brusca said, “Not true! Not necessarily true – oh those economists!” He explained why we got such disagreement on a simple statement about income and savings and wealth. Bob wrote:
There are two calculations of the savings rate. One is from the flow of funds and that is the one for which I believe Liz’s statement is correct. The flow of funds report is from the Fed. It builds up its data from stock data stocks [‘stocks’ as in stockpiles] of assets and of liabilities. The other savings calculation is monthly, from the personal income and spending report (PCE). That is a FLOW calculation. In the PCE framework there is your income (a monthly flow) and your spending (also a monthly flow). The difference between is ‘not-spending’ or savings. That’s all there is to it. If you have a mortgage or pay it off, it does not matter here except to the extent that it you have one, you are making mortgage payments and that will increase spending and reduce savings.
Another Bob, my colleague Bob Eisenbeis, suggested we simplify the notion of elasticity. He put it like this: “You may want, for the lay audience, to convert the elasticities; i.e., a dollar increase in stock market wealth leads to 1.5 cents in additional spending.” That is what the Credit Suisse calculations showed when they examined the pre-crisis period. The 1.5 cents of spending per dollar increase dropped to 1.1 when the crisis period was included.
What about housing?
Well, we have some good revised estimates from nationally renowned experts, including a third Bob, as in Bob Shiller.
You can find them In “Wealth Effects Revisited: 1975-2012,” by Karl E. Case, John M. Quigley, and Robert J. Shiller, NBER Working Paper No. 18667, January 2013. I will paraphrase their summary abstract. The authors re-examine the links between changes in housing wealth, financial wealth, and consumer spending. They extend a panel of US states observed quarterly during the 17-year period 1982 through 1999 to the 37-year period 1975 through 2012Q2. Using techniques reported previously, they impute the aggregate value of owner-occupied housing, the value of financial assets, and measures of aggregate consumption for each of the geographic units over time. They find a rather large and statistically significant effect of housing wealth upon household consumption. This effect is consistently larger than the effect of stock market wealth upon consumption.
In their earlier version of this paper they found that households increase their spending when house prices rise, but they found no significant decrease in consumption when house prices fall. The results presented with the extended data now show that declines in house prices stimulate large and significant decreases in household spending. The elasticities implied by this work are large. An increase in real housing wealth comparable to the rise between 2001 and 2005 would, over the four years, push up household spending by a total of about 4.3%. A decrease in real housing wealth comparable to the crash which took place between 2005 and 2009 would lead to a drop of about 3.5%.
Let’s sum this up. To get rising aggregate demand and translate it into more robust economic growth, the best method is to raise income. Nearly every dollar of additional income is spent. If you want more personal income in the United States, tax work less. If you want to repress income growth, tax work more. Our politicians still do not get this concept, which is why they tax work more and then try to transfer those tax receipts to those who do not work. It is okay to support those who need it, in my view, but doing so in a way that diminishes work exacerbates the negative outcome.
It is important to acknowledge that wealth matters. As a nation we want more of it. We want it for our savings, which means investments, and we want it for our housing and our other non-liquid assets. We would prefer that this increased wealth be real, not the product of inflation, where the nominal price is higher but the actual value is not. That is why we fear inflation. The Federal Reserve is trying to engineer the former (rising prices of assets) while controlling the latter (inflation).
That is why the interest rates have been and will be so low for so long. The Fed wants to encourage rising asset prices and it wants to encourage us to convert some of that additional wealth into spending. We, meanwhile, are recovering from a major financial shock. We do not trust financial markets, for good reason. And we do not have conviction about national policy, for good reason. So we hold back. And we fret. That makes the Fed’s job harder.
At the end of this period we will get to some new form of equilibrium. It is likely to include some more inflation and higher asset prices and higher interest rates. How long that takes and what path will lead us there is the major issue facing all investors and all citizens. None of the experts knows the answer. We are all guessing, and we need to be prepared to change our views. The NBER paper cited above is an example of a change in view. It is superb work. What is implied is that we know very little about what our future will bring. More importantly, we have great difficulty forecasting it.
At Cumberland, we think there will still be a prolonged period of low interest rates. We think that period and those low rates give assets prices an upward bias. That means those of us who are fortunate enough to have accumulated wealth can benefit from thoughtful allocation of that wealth.
We also see our national government applying a rising cost to work. That counters positive wealth effects. There is the basic tension now present in our society. None of us knows how this will be resolved. The economist in me says that taxing work and making earned income more costly to obtain is a bad thing for our country. In the end we all lose when that happens. For now, wealth gets the benefit of the policy, thanks to the Fed. We remain biased toward fully invested positions.
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David R. Kotok, Chairman and Chief Investment Officer
