Merryn's Blog

How the ‘wealth effect’ works in both directions

One of the main justifications for quantitative easing was that making the economy work better makes people feel richer. But it works in reverse, too, as a crisp-hoarding pensioner demonstrates.

One of the main justifications for quantitative easing (QE) in the first place was the wealth effect - the idea that you can make the real economy work better by making ordinary people feel richer.

Print money to push up asset prices and all of a sudden people will stop worrying about the future (saving) and get spending instead. And it works. You can see that from looking at a few charts (the personal savings rate is inversely correlated to the stock market). And I had a perfect example of it last week on the train.

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I hate to fly (the risk of me losing my temper at security is too high for comfort) so I take a lot of long train journeys. Last week I sat opposite a (very) elderly American couple on their way to London. They had recently come off a 31 day cruise from Fort Lauderdale (immediately after another 30 day cruise somewhere else). They'd done the Bahamas and much of Europe along the way, and now they were checking out the UK.

After an hour, the man asked me to check the US hockey scores for him. I did. Then he asked what I did. Then he asked about the market - and a bit more about the market. He asked about prices in Europe and prices in the US. He worried about bond prices.

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And after I told him how much they had all fallen (this was last Thursday) he asked for some more of the free crisps from the trolley that roams the East Coast trains and carefully put them in his bag for later.

He had gone from rich relaxed high spending cruiser to hoarding saver in a matter of hours (and that was without me offering him any detail on MoneyWeek's core macroeconomic views). This matters.

One of the (many) problems with the wealth effect is that it works both ways. Pumping up global markets and creating a fabulous illusion of wealth all-round made everyone feel better (my new friend was probably bathing in champagne as he and his wife headed for Bimini last month).

But their inevitable comedown with tapering or the mere talk of tapering, which has pushed the US stock market down over 6% from its May high, will do the opposite: there will be less spending and more saving; less wealth effect and more poverty effect; less GDP growth and more anxiety.

So there you go. Without real growth, rather than just an intangible illusion of riches, the wealth effect is hopelessly short term. And the risk to the global economy and to the egos of the world's central bankers can be personified in one globetrotting 80 something retired paediatric oncologist.

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