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Don’t Blame the Player, Blame the Game

By Keith Weiner

February 15, 2016

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This cannot be said too often—we don’t have a free market. We have monetary policy.

It has come to my attention that, perhaps, the great stock bull market is done. To most people, a bull market is good, and its end is bad. After all, a rising market signifies a healthy economy. Investors are making money. And it seems to prove that the free market is validated, able to deliver miracles despite Obamacare. Share prices are connected to business productivity, aren’t they?

In a free market they are, of course. However—and this cannot be said too often—we don’t have a free market. We have monetary policy. This is how our central planners try to stimulate the people into consuming more. They create a wealth effect.

Whenever you come across a metaphor like wealth effect, I encourage you to ask what is actually happening. Obviously, the government can’t create wealth by decree. Something else has to be happening. Let’s look at that.

Whenever you come across a metaphor like wealth effect, I encourage you to ask what is actually happening. Obviously, the government can’t create wealth by decree. Something else has to be happening. Let’s look at that.

The term wealth effect is interesting. There are many other effects, such as the placebo effect and the cheerleader effect. In each effect, something manipulates your judgement. The placebo effect convinces you that you feel better. The cheerleader effect convinces you that a girl is prettier. And the wealth effect convinces you that you’re richer. They’re all just illusions.

The medical journals talk about why placebos do that, and the psychology journals analyze the cheerleaders. Our concern is to understand the wealth effect—not by the magical thinking offered by many so called economists—but through monetary science.

Mechanically, the wealth effect is a simple process. One, the Fed drives up the price of bonds. Two, investors begin to find bonds too pricey, so they switch out of bonds. Three, they buy stocks and real estate, the main alternatives to bonds. Four, stock and real estate owners feel richer. After all, their net worth is rising much faster than the cost of living. The wealth effect exploits the common assumption that your real wealth is your net worth divided by the cost of living. Five, people spend. If your wealth went from $150,000 to $250,000, you can spend part of the $100,000 profit, the reward of having invested wisely. All asset owners are empowered to spend.

We’re painting a picture here, not of creating wealth, but spending it. The wealth effect is not about production, but consumption. To use my favorite farm analogy, the wealth-effected farmer is not operating his farm to grow crops. He’s just eating his seed corn.

It works, because your purchasing power is increasing. The price of corn isn’t going up (quite the opposite, it’s down 55 percent since 2012). But the assets you can swap for corn have risen significantly (stocks are up 28 percent over the same time period). The same house that could be traded for 2 years’ worth of corn, can now be swapped for maybe four. The same stock whose liquidation would pay for corn for a year, will pay for groceries for about three now. So people indulge themselves, and spend some of their gains.

The iron law of economics is that you must produce first, in order to consume.

Unfortunately, this is no real gain. The iron law of economics is that you must produce first, in order to consume. The Fed produces nothing when it drives up the price of your assets, and neither do you by simply holding them in the meantime.

The wealth effect, in reality, is a process of consuming precious capital, previously accumulated by hard working people who consumed less than they produced. Their savings now enable a whole class of people who consume more than they produce.

The Fed’s monetary policy induces this consumption, by altering the purchasing power of assets. In other words, the ratio of asset prices to consumer prices is distorted in favor of asset prices. The more this playing field tilts, the more everyone runs downhill to the endless party.

Well, it seems endless while it lasts. And now it may be coming to its inevitable end.

Please take no schadenfreude—pleasure from someone else’s pain. For the sake of our civilization, we had better stop consuming the capital base on which it’s built.

The end of the wealth effect is a good thing. The wealth effect has fueled a vicious game—a game in which some players have received unearned benefits.

But as always, the Left has taken advantage of the correct perception that there is a “game,” to promote their policy goals. The Left would like you to believe that it’s a class struggle. President Obama set it up as hedge fund managers (promoting them as society’s “bad guys”) versus kindergarten teachers (society’s “good guys”).

“The top 25 hedge fund managers made more than all the kindergarten teachers in the country,” declared President Obama in a discussion of poverty at Georgetown University. Calling them “society’s lottery winners,” he proposed to hike their taxes.

Predictably, battle lines have been formed between two polarized sides. One side—let’s call them the Gauche for convenience’s sake—is unhappy with the pay disparity. CBS News, in an almost neutral tone, asks, “Which group provides more value to America?” The reader is supposed to somehow answer that question, presumably in favor of teachers. Gawker goes much farther, calling hedge fund managers the biggest gangsters of all. It asserts, “It is, as the myth goes, capitalism at its most pure…” The other side—let’s call them the Adroit—defends hedge fund managers. PJ Media said, “That single comment [about winning the lottery] defines the president’s economic worldview. Success doesn’t come to those who act rationally in pursuit of their values. It doesn’t come from hard work performed intelligently.”

Hedge Funds vs Kindergarten: Who is worth more?

The reality is that all capital markets are massively distorted. Getting rich isn’t blind luck, but sometimes it’s not properly earned either.

Both sides get it partly correct and partly wrong. The Gauche correctly perceive something monstrously unfair: ever-larger financial profits accruing to an ever-shrinking group. However, their basic assumption is false. We do not have Capitalism today. And their remedy is the same old cliché: soak the rich. The Adroit are also correct about something. More taxes will not help anyone, and making money is not a lottery. However, in their desire to oppose the other team, they are missing the elephant in the room—rising assets, and falling yields. They too assume that we have Capitalism. The reality is that all capital markets are massively distorted. Getting rich isn’t blind luck, but sometimes it’s not properly earned either. Capitalism means free markets, the opposite of central planning. How could anyone look at our financial system and call it a free market? We have central planning of the most fundamental price in the economy: the rate of interest. Central banking is a key feature, not of Capitalism, but of Socialism. Indeed in The Communist Manifesto, Karl Marx advocates for a, “Centralization of credit in the hands of the State, by means of a national bank….” Every major country in the world has a central bank. All are caught up in the same megatrend—falling interest rates. A lower rate means rising bond prices. For more than three decades, we have had a relentless, ferocious bull market in bonds. Bond speculators have pulled down trillions. By a variety of mechanisms, the rising price of bonds bleeds into other markets and causes stocks and real estate prices to rise.

The freefall in yields harms wage earners. And it strangles pensioners, who can no longer live on the interest on their savings.

For example, when the Fed buys bonds, then the sellers usually buy other assets. The freefall in yields harms wage earners. How are you supposed to save for retirement with zero interest, and therefore no compounding? And it strangles pensioners, who can no longer live on the interest on their savings. It is a fact that we have central planning today. While this harms people who are working or retired, it seems to help those who own assets—and their fund managers. A falling interest rate converts everyone’s wealth into their income, which is an unsustainable process. Rather than arguing about whether hedge fund managers or teachers should make more, we should condemn this unfair system. We are against central banking and central planning, not those who make money. It’s impossible to tell what a fund manager should be paid, other than in a free market.

So don’t hate the player, hate the game.

And if the bull market in stocks really is coming to an end, it’s a good thing, because it means that finally the wealth effect illusion may be beginning to fade.

 

 

The bulk of this essay appeared across two articles from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog SNBCHF.com.

 

 

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