It is widely believed that borrowing against the rising value of their homes has allowed American households to maintain high levels of consumption.
This argument is a warmed-over version of the misleading notion of the "wealth effect" that kept analysts enthralled during the dotcom mania of the late 1990s.
It turns out that most of the rapid growth of asset values over the past few years is the result of credit expansion and inflation of the money supply that has generated paper wealth.
Investors burned by the tech bubble should well remember the illusory nature of paper wealth that can quickly turn to real financial losses.
In its current version, the so-called wealth effect that supposedly drives consumption and growth does not hold up to a simple logic check.
Consider what must happen if individuals keep up consumption by borrowing as their incomes fall. This would mean that lenders would have to reduce their own expenditure.
Total spending would remain unchanged because borrowing and lending involve the temporary transfer of purchasing power from one person to another. This redistribution cannot, as a matter of logic, increase actual total spending.
However, a fractional banking system will allow borrowing to increase spending by making more credit available through a virtual process that approximates printing more slips of green paper.
When central bank policy accommodates continuous credit expansion, housing prices will be pushed up and create (illusory) increases in the paper wealth of homeowners.
But the increasing asset values do not drive borrowing. Both are being increased by credit expansion arising from inflationary monetary policy.
It turns out that the US Federal Reserve (Fed) has been guilty of pursuing a reckless monetary expansion, beginning in 1998 when it flooded markets with liquidity.
Rapid monetary growth in the US, mostly in the form of credit expansion, fuelled an unprecedented debt explosion that raised the ratio of total private-sector debt to GDP to a record level.
Throughout this period, a high rate of growth of the money supply through promiscuous credit expansion appears to be the hero but is actually the villain.
Monetary growth provided the means for the increase in demand for imports that pushed the current account deficit to 4 per cent of GDP. A boom in retail sales resulted from a growing gap between private savings and investment that is also about 4 per cent of GDP.
At the same time, rising credit availability induced margin borrowing to rise precipitously until it reached about $ 280 billion on the New York Stock Exchange at the high point of the dotcom bubble. At that time, advocates of the wealth effect presumed that stock prices would sustain economic growth.
Instead, the hard lesson was learned that only economic growth can generate a sustained net inflow of funds to boost stock market performance.
As economic growth motivates investment, innovation and productivity, these propel corporate profits that act as the driving force behind stock prices.
The fable continues by depicting employment growth causing household incomes to increase whereby some of the funds are used to purchase shares of stock and initiates an economic chain reaction.
Growing demand for shares causes stock prices to rise and household wealth to increase. With this perception of new-found wealth, there is more household borrowing and consumption expands so that corporate earnings and the demand for labour raises household incomes.
This may seem correct, but the fallacy is revealed through an examination of the nature of profits and the relationship between saving and investment. As suggested, "wealth effects" are neither necessary nor sufficient conditions for growth.
High monetary growth has provided an environment and means for consumers to acquire excessive debt that will have to be liquidated sooner or later.
A collapse in the housing and property bubble or another stock market correction or a recession would force households to cut spending in order to cover their debts. Declining share prices would force liquidations as investors try to repay their margin debts.
Depicting a consumer-led boom driven by a "wealth effect" is misguided. If consumer-led growth were possible, business cycles would not exist since recessions could be remedied quickly through expansion of government deficits or loose monetary policy. History proves this to be blatantly untrue.
The underlying logic behind a wealth effect depends upon the specious notion that consumer spending drives an economy.
But increased savings provide the fuel for economic growth that is driven by the risk-taking and innovative activities of entrepreneurs.
When central banks expand credit too rapidly, nominal incomes and investment rise so that some new credit that enters the stock market can help fuel a speculative boom. In the end, the so-called wealth effect in the US economy is the result of excessive credit expansion.
And the bad news is that it has set the stage for another bust in the not-so-distant future when the Fed is forced to push up interest rates to quell rapid price increases.
The writer is professor of economics at Universidad Francisco Marroquín in Guatemala and global strategist for eConoLytics.com.
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