Close X Cookies are necessary for the proper functioning of 24hGold.com. By continuing your navigation on our website, you are accepting the use of cookies.
To learn more about cookies ...
EnglishFrench
Gold & Silver Prices in

The "wealth effect" an Austrian view

IMG Auteur
From the Archives : Originally published December 01st, 2014
980 words - Reading time : 2 - 3 minutes
( 0 vote, 0/5 )
Print article
  Article Comments Comment this article Rating All Articles  
0
Send
0
comment
Our Newsletter...
Category : Fundamental

It is being said that if the fed could just get the ‘wealth effect’ into motion the US economy would fully recover from the recession. But the ‘wealth effect’ is a phantom, the sort of economic fallacy that only a Keynesian could conjure up.  Those who support this fiction argue that a stock market’s performance is driven by a net inflow of funds which in turn is driven by economic growth. They go further by saying that growth in turn is driven by investment, innovation and productivity, all of which influences corporate profits which in turn drive stock prices. Naturally, when these factors are positive GDP expands.

It follows from this line of reasoning that rising stock prices in this environment are a healthy sign of an expanding economy. This logic has been used to describe the state of the US and Australian economies throughout most of the 1990s and even up to the present. They also argue that increased employment has the effect of raising household incomes, part of which is invested in shares. This triggers an economic chain reaction that goes like this:

 The additional demand for shares boosts stock prices which then boosts household wealth. (The more you invest the richer you get). This increase in wealth encourages household borrowing which fuels consumption which then expands corporate earnings and the demand for labour which then boosts incomes which are in part invested in stock.

 If this sounds to you like the economic equivalent of perpetual motion, you are spot on. Logicians have a term for this kind of reasoning: They call it begging the question. Let’s get down to some economic basics. Savings fuel an economy while entrepreneurship drives it. Now what exactly are savings? Saving is a process by which present goods are converted into future goods. Genuine savings mean that resources are being directed from current consumption (present goods) and invested in capital goods (future goods). This process will increase the future flow of consumer goods. Therefore cash balances are not savings, even though they are deferred consumption.

Every economy has a capital structure that consists of complex stages of production. The effect of increasing savings is to lengthen the structure* by adding longer and more complex stages. These stages consist of heterogeneous capital goods embodying technology. This is the true nature of economic growth. It should also be clear that productivity is therefore the fruit and not the seed of economic growth.

In a progressive economy aggregate profits exceed aggregate losses. Hence, not only would a continual upward trend in the real value of stocks emerge but their returns would exceed the return on bonds, the difference being profit once risk had been accounted for. This brings us to productivity and profits. It’s shallow to argue that profits are a simple function of rising productivity generates profits. A firm’s physical and value productivity can still rise even as it goes broke. (There is no paradox here if one bears in mind that what matters here is demand for the product).

Profits are maladjustments between supply and demand, as are losses. This means that in a truly profitable firm or industry its factors are undervalued in relation to the value of their products. We can deduce from this that a sufficiently large switch in demand can bankrupt a firm whose productivity is rising and yet generate profits for another whose productivity is stagnant.

Of course, if an entrepreneur has sufficient forecasting skill he will invest in a way that lowers his costs of production, i.e., increases productivity, which in turn generates profits. But note, this is done by increasing the maladjustment between the supply of the product and the demand for the product, which will have the effect of attracting more competition which will squeeze the firm’s profits even as productivity continues to rise. This process will be accelerated by the tendency of a continuous increase in productivity to lower prices. The point is that productivity per se is not the key to profits — entrepreneurial forecasting, or decision-making ability, is.

Looked at in this light two things emerge: (a) households that invest for the long term will certainly increase their wealth; (b) in this situation speculative booms will not emerge. The cause of these booms is easily detected and the culprit is credit expansion. Central banks allow credit to expand which raises nominal incomes and investment**.

Eventually this credit begins to enter the stock market, laying the foundations of a speculative boom. Sure, as people think of themselves getting richer they borrow more to invest (or should I say gamble?) on the market. Thousands even engage in the risky practice of margin borrowing in the belief that economic gravity can be permanently defied. But where is all this credit coming from? The banking system is the answer.

So forget about the “wealth effect” or “margin borrowing” fueling speculative frenzies: it’s a monetary illusion, a creation of credit expansion — nothing else.

* * *

*Strictly speaking, a lengthening of investment periods does not always require more stages of production. In some cases a lengthening involves the replacement of existing stages with more advanced but more time consuming stages. I stress the addition of more stages to emphasis the importance of the stages of production analysis. Failure to grasp this importance and the vital role of Austrian capital theory is why R. G. Hawtrey and Keynes were completely surprised by the arrival of the Great Depression. Unfortunately for posterity neither of these gentlemen learnt the lesson.

**Steve Kates argues that the classical economists believed that booms and busts were spontaneous events caused by capitalists erring. Completely false. The currency school developed a monetary theory of the trade cycle and it was this theory that dominated economic until the late 1840s. How anyone can argue otherwise while claiming to have studied the period certainly baffles me.

 

<< Previous article
Rate : Average note :0 (0 vote)
>> Next article
Gerard Jackson is the founder and economics editor of The New Australian (now Brookesnews.com), and offers offers timely articles focused on "events of the day" from a free-market perspective.
WebsiteSubscribe to his services
Comment this article
>Follow all commentairies
You must be logged in to comment an article8000 characters max.
Log in or Sign up
Latest comment posted for this article
Be the first to comment
Add your comment
Top articles
MOST READ
How To Buy Gold Or Silver - Trace Mayer - Run to Gold  (10)
March 27, 1980 : Silver Thursday, or the end of the The Hunt Brothers Story - History of Silver - Playboy  (4)
The Bank of England 1720-1844 - Nathan Lewis - New World Economics
The Gold Bug (Edgar Allan Poe) - Treasures and Gold Fever - Edgar Allan Poe  (13)
Most commented articles More... 
TOP RATED
The Gold Bug (Edgar Allan Poe) - Treasures and Gold Fever - Edgar Allan Poe  (13)
The US Constitution and Money - Michael S. Rozeff - Mike S. Rozeff  (6)
On corruption - Food for thought  (12)
How To Buy Gold Or Silver - Trace Mayer - Run to Gold  (10)
Most commented articles More... 
MOST COMMENTED
100 Items That Disappear First in a Disaster - Beans Bullets Bullion and Bible - 24hgold  (17)
Most commented articles More... 
Latest Comments
‘Real’ Performance Comparison
26 MarChristopherbalz
Question: In the method of figuring inflation referenced, what is the rationale for adding population growth to productivity growth? Sugge...
100 Items That Disappear First in a Disaster
23 Markevthorne
68, 69 probably not that safe - particularly if you're growing your own vegetables - keep a Maine Coon cat instead: does the job automatically.
Farage Interviews Le Pen: “Prison of the EU”
21 Marneville1
BRITANNIA RULES THE WAVES AND NOW BREXIT WAIVES THE RULES. GO FOR IT FRANCE AND RID YOURSELVES FROM THE CHAINS OF IDIOTS. NOT SIN...
How the Fed Operates — And Why It's a Problem
20 Marramasart
In a nutshell, the Fed facilitates the theft of the value of the dollar, as they can control the increase in supply which at the same time inverts ...
How the Fed Operates — And Why It's a Problem
20 Marneville1
With all due respects for outlining how the crooked american Fed works or should work. From all our research we find the following the Fed...
Sparta - Gold prohibition in a collapsing economy
18 Markevthorne
You've answered none of the authors points: your comment is flat rubbish.
America Too Broke to Fix Crumbling Infrastructure? “Bridges, Roads,...
16 MarCameron Waugh1
Just like the leaders of the Bolshevik revolution were not Russians, those formulating belligerent US foreign policy are not Americans, and they ha...
POTUS at SOTUS
16 MarDRGEORGE1
Try explaining that to my patients dying on public waiting lists or getting ripped off by exorbitant private specialist fees!
Most commented articlesFavoritesMore...
World PM Newsflow
ALL
GOLD
SILVER
PGM & DIAMONDS
OIL & GAS
OTHER METALS