The ‘Wealth Effect’ and Debt – Two Sides of the Same Coin – Part 1

1. What is the Wealth Effect? – Background and Overview  

The “wealth effect” is the notion that when households become richer as a result of a rise in asset values, such as corporate stock prices or home values, they spend more and stimulate the broader economy. The economic phenomenon of the wealth effect owes its power to consumer psychology and Central Banks’ have become customer psychologists, impacting customer perceptions for consumption and investing via rate expectations and quantitative easing/tightening and attempting to recalibrate interest rates in the economy relative to the real natural rate of interest, to bring the economy back in-line with potential output growth as measured by Real Gross Domestic Product (GDP) potential also known as the business cycle which tends to last about 8-10 years.  They may use macro-prudential policy and regulation to manage longer-term risks associated with the credit cycle/housing price trends tend to last over a 20-40 year period. We will attempt to extract the cycles from the trends for both the business and credit cycles so that we are better prepared for what may come at us next.

In a series of posts over the next couple of weeks we plan to cover:

The ‘Wealth Effect’ and Debt – Two Sides of the Same Coin – Part 1

  • Wealth Effect – Background and Overview
  • How Credit Contributes to Economic Growth
  • What are the Main Drivers of House Prices in Advanced Economies?

The ‘Wealth Effect’ and Debt – Two Sides of the Same Coin – Part 2

  • How does Debt impact the Wealth Effect?
  • Why is understanding Credit Cycles and Business Cycles are Important – A Review of the US – 1975 to 2021?
  • Why are Interest Rates and Debt-Service-Ratio Important to Watch for an Economy reliant on the Wealth Effect/Debt Growth?

We will cover the US market in this series of posts. In the next posts, we plan to review the select G20 countries’ wealth effects’ impacts specific to housing/stock ownership on their economies.

The increased value of housing and stock prices on paper makes consumers feel more confident in the economy’s prospects. Feeling more confident, they spend more and become more willing to buy goods and services by taking out more credit increasing their risk appetite.

Our financial system supports asset values by increasing credit creation over time. Each time a bank creates a loan, a corresponding deposit is created through the banking system, which adds to the money supply. Money is used to purchase goods and services and accumulate and save for a property. As the money supply grows, cash is devalued against assets (financial assets, real estate, commodities, art, etc.), causing nominal prices to rise.

As a result, households feel like they have more wealth and believe as they are richer they may be able to spend more on luxuries such as new computers, the latest technology gadgets, vacations, additional cars, and homes increasing private demand through consumption and investment. This is potentially why the Credit Impulse measure (new credit introduced to the economy through the banking system) tends to move contemporaneously with private demand (See Table 1). Another way to say this is that the balance sheet always shows the future income, so by following the balance sheet rather than solely focusing on the P&L, in this case, a flow metric such as GDP, you may be able to spot trends before the P&L is reported.    

Several factors affect consumer confidence, including house prices, unemployment rates, and inflation. Falling house prices compromise wealth accumulation and erode consumer confidence. Increased unemployment rates also negatively affect consumers’ confidence in the state of the economy. Inflation is an indicator of too much economic growth, and the rise in prices can reduce consumers’ purchasing power and confidence. It has always been difficult to estimate the magnitude of the wealth effect because changes in asset prices rarely occur without other macroeconomic changes.

Table 1 – Private Aggregate Demand vs. Credit Impulse – United States – 1976 to 2021

Source: US Federal Reserve, BeowulfsTreasury.com
  • In countries that rely primarily on consumption to drive economic growth, the wealth effect is pretty significant to continue to drive economic growth forward. Debt plays heavily into the wealth effect as we shall see. Based on various Central Bank research, each dollar increase in asset values (risk assets such as real estate and corporate equities) is estimated to increase consumer spending between 3-5%. For advanced economies, consumption is anywhere between 50-70% of GDP (see Table 3 by country).   
  • Although theories that highlight the role of wealth in determining patterns of consumption do not usually imply different effects for different types of wealth, there are many reasons to believe that the marginal propensity to consume (MPC) 1 from housing wealth and stock market wealth could be different. It is thought to be stronger for housing wealth, partially due to a higher proportion of the population holding their net wealth in housing. Also, the distribution of wealth within a country may impact the marginal propensity to consume, as less wealthy citizens may spend more of their income on consumption relative to more wealthy citizens may have the propensity to save more of their income rather than consume it.     
  • Capital gains on wealth resulting from owner-occupied housing may lead to a higher MPC since these gains have a tax advantage over stock market gains in some countries.
  • The distribution of wealth or wealth inequality within the economy may impact the ‘wealth effect’ if a large share of wealth is held by the top 1%, given there are limits to consumption of this group relative to the rest of the population and hold less of their wealth in real estate, which may have large implications from a perspective of financial stability and interest rates. More on this later….   
  • Consumption by households is generally higher in the US at almost 70% of GDP given high disposable income as well as usage of consumer credit. As a result of high consumption, the US runs a large trade deficit with the rest of the world through imports of durable consumer goods (washing machines, automobiles, and furniture), as well as nondurables such as gasoline, groceries, and clothing. Consumption includes spending on domestic services like real estate and health, cable, and internet services which account for about 2/3rds of consumption. Retail Sales are a great barometer for consumption, as well as consumer confidence. If people are confident (grey-line) as their home values (blue-line) is increasing in value, they are more likely to spend now (orange-line) (Table 2).
  • As home values rise, homeowners find it easier to borrow using their home value as security for either home renovations or consumption spending. If this ‘wealth effect’ is strong, it could leave the economy more vulnerable to adverse events, such as a large decline in house prices. We can see in the run-up to the 2007-2008 recession in Table 2 home equity extraction was potentially being used by households to finance spending, and the combination of the pullback in house prices as well as job loss reduced consumption significantly in 2007-2008. We see in 2020-2021 a similar trend of housing/consumption moving together – well above trend. Historically, large price increases well above trend have resulted, in large declines, including a reduction in household spending. Hence too much reliance on residential real estate and the wealth effect/consumption could have issues for some countries’ financial sustainability going forward. We plan to cover this in a future post.

Table 2 – Personal Consumption Expenditures (PCE), Confidence Surveys, and Real Estate

Source: US Federal Reserve, BeowulfsTreasury.com

Table 3 – Consumer Spending, Allocation of Wealth between Housing and Stock Market

Source: OECD, BeowulfsTreasury.com

1. Income inequality scale = Gini coefficient, 0 = complete equality and 1= complete inequality.2. Closer to 1 = Greater Wealth Equality, further away from 1 = Less Wealth Equality. 3. Indicators include housing expenditures as % of total expenditures, Dwellings with basic facilities, Rooms per person.

In Table 3, we lay out a few summary metrics for a selection of OECD countries – Europe (France/Germany) and Anglo-Saxon (US, UK, Australia, and Canada). We note the following:

  • Housing is the principal source of household wealth in most countries and homeownership reduces wealth inequality. High homeownership countries tend to exhibit lower wealth inequality. 
  • Mortgages represent the largest part of household debt. House prices have increased faster than income in most countries as housing supply has not kept pace with demand and structural elements such as tax policy and regulation tend to favor capital investment/risk-taking relative to labor income. Historically capital investment has driven higher productivity leading to greater economic growth. Having such a disproportionately large residential investment sector relative to the size of the economy can create problems as though it may provide short-term growth when the house is built or when the house is sold, it is considered non-productive investment, as it does not provide future growth to the economy continuously.
  • Real Estate (if financed by debt) diverts money to be spent on debt service which could have been invested in a business. This business may support the community and provide additional jobs. Government involvement through the secondary mortgage market may increase the supply of credit (i.e. implicit guarantee in the US by government-sponsored entities) and have led to misallocation of too much capital into real estate historically – see Table 4 for other government involvement in mortgage markets.  During the Great Financial Crisis, 40% or so of loans went to people with a poor ability to service them – sub-prime and low documentation of income borrowers. And many were non-recourse loans – so borrowers could just hand over the keys to the house if its value fell. This was encouraged by a public policy aimed at boosting home ownership and ending discrimination in lending. You will note that in Table 4, only the US has non-recourse loans.

Table 4 – Key Country-level programs to support mortgage borrowers

Source: OECD, BeowulfsTreasury.com
  • Generally speaking, modernizing the economy through enhanced productivity, and reducing wealth and income inequality by boosting homeownership and housing values (i.e. wealth effect) has led to the higher marginal utility of underlying citizens as measured by OECD Better Living Index (Canada and Australia).
  • Property taxes collected by the government also rely on housing retaining value over time and represent about 3% of GDP on average. However, taxes on personal income are roughly 3-4 times property taxes.
  • Wealth inequality arises from the way capital is accumulated. Labor and capital are both inputs into the production process, but the income received by workers and capital-owners likely accrues to different economic classes of people
  • Higher-income/wealthy citizens tend to own their homes outright (i.e. no mortgage) relative to lower-income citizens and tend to have a higher proportion of financial assets (stocks) – owners of capital (see Table 5) either through savings or acquired through compensation plans.
  • Since returns on capital (dividends, interest, and capital gains) based on corporate profits, are a major source of income for the wealthy citizens, and capital tends to grow faster than wages, the rich become richer, as they save more than they consume. This theme is consistently observed across the globe and across time. Generally, returns on capital or profits are associated with a combination of innovation, risk-taking, and ownership of capital and intangible assets (machines, servers, etc).
  • You will note that returns on capital have risen, as returns on labor (wages) have fallen over time. Low-wealth citizens tend to rely on wage income, have very little savings and rely on higher levels of consumer debt relative to income to fund consumption. In the case of the US, the share of GDP of capital relative to labor has dramatically changed over time and accelerated in the unanchored credit-based system, particularly after 2000 (See Table 6) with the flood of labor supply with China and other former communist countries joining global trade, as well as technology change/automation. In the case of the US, over the past 30 years, corporate equities of the Top 1% of the wealth distribution have increased significantly to 48% of assets as compared to 18% in 1989 (see Table 7). Similar trends have been observed across other western countries as tax policies have generally favored capital investment over labor and unions which protected the labor share previously have been in decline since the 1970s.

Table 5 – OECD Average Wealth Distribution by Type

Source: OECD, BeowulfsTreasury.com
 

Table 6 – Labor (LHS) and Capital (RHS) as % of GDP – United States

Source: US Federal Reserve, BeowulfsTreasury.com

Table 7 – Balance Sheet by Wealth Distribution – United States

Source: US Federal Reserve, BeowulfsTreasury.com
  • Low-wealth households have much higher debt, of which property debt is the main form but consumer debt (e.g. credit card debt and installment loans) represents almost 30% of total household debt by the bottom 40% on the wealth distribution. While consumer debt can help support economic growth for consumption, it could also be a sign of stretched living standards which leaves those households exposed to future financial shocks. We noted a similar pattern in the US as shown in Table 7.
  • While higher-income households tend to have higher debt loads, debt payments as a proportion of household disposable income are larger for lower-income households. We tend to watch changes in debt-service ratios and changes in interest rates rather than output gaps (Real GDP vs Potential Real GDP or unemployment gaps) alone as a determining factor of the changes between business cycle – growth and recession, given the level of debt within the economy held by a large proportion of the population in most countries. More on this later..  
  • We have noticed a recurring pattern reviewing runs to 2000, 2008, and 2020 recessions in the US. When real rates rise above long-term equilibrium real rates, private debt-service (households and corporates) levels tend to increase above trend reducing the growth rate of the economy (debt too high relative to cash flows), and in a high debt economy, interest rates need to be lowered or fiscal stimulus provided directly to indebted customers as we saw during COVID-19 in 2020. More on this in section 6.        
  • Despite having the highest net wealth per household which has grown substantially over the past 40 years, in the US wealth and income inequality are substantially higher than all the countries above at least 2x in every category from both a wealth and income inequality perspective.
  • In Table 8, we show how wealth is distributed across the select economies and note that most are generally distributed similarly, with the US as the outlier. We note that the top 10% have increased their share of total wealth to 70% from 61% in 1989 (Table 7) in the US. A high concentration of wealth can have major social, economic, and political impacts.
    • The concentration of wealth/incomes also creates disproportionate political power for wealthy members of society who are able to influence the policy process
    • Stagnant labor income (which we have seen over the last 30 years) is harmful in times of weak aggregate demand, since income gains that are concentrated at the top of the wealth/income distribution, are less likely to fuel consumption and aggregate demand.
    • Over the last 10 years, we have started to see the outcome of this inequality through greater political polarization and populism play out.
Source: OECD Wealth Distribution Database
  • Long-duration risk assets (such as stocks and real estate) have benefited households from the reduction in the real interest rates over the past 40 years (real 30-Year Treasury yield (orange-line) in Table 9 which is thought to be due to lower working-age population, higher saving rates, as well as actions taken by the Central Banks related to lowering short-term rates and Quantitative Easing.
  • This has increased the select countries’ average household’s net wealth relative to disposable income by 1.5x from 1995 (Table 9) but has also increased wealth inequality, particularly benefiting the top 10% of wealth who hold financial assets such as stocks in the US (green-line). It has also increased debt as well.  
  • Quantitative Easing (QE) is a policy tool that has allowed Central Banks to more directly influence those longer-term interest rates that consumers and businesses pay. Under QE, a central bank buys government bonds. By buying government bonds raises their price and lowers their return-the bond’s yield. QE sends a signal that Central Banks intend to keep the policy interest rate low for a long time—as long as inflation stays under control. By giving more certainty that the Central Bank policy interest rate will remain low, QE can help reduce longer-term borrowing costs for businesses and households.  
  • Many businesses have taken advantage of the lower cost of borrowing and repurchased their own shares in the open marketplace with lower-cost debt. Over the last decade, buybacks have tripled often to obtain the desired leverage target or debt as a percentage of assets. Firms desired leverage can be excessive if companies do not consider all financial distress costs through the cycle and therefore these costs may shift to creditors or the public through potential bailouts. These actions may have also provided additional returns on capital to households higher up in the wealth distribution as well. Excessive leverage may be a financial stability concern as well.

Table 9 – Net Wealth to Disposable Income

Source: OECD, US Federal Reserve, BeowulfsTreasury.com

The other side of the higher wealth coin is higher debt. This is a very important concept and will be discussed in the next series of posts. It is also important to recognize where the debt sits in the overall wealth distribution of a country and who owns the debt/is financing it within this distribution.  In Table 10, we note that total debt (grey-line) within the economy at both private (households and corporate) and public (sovereign) debt has grown by 1.4x similar to wealth (blue-line) of 1.5x. You can see from the rolling compound annual growth rates for net worth, private credit and money supply, these three elements are very much intertwined and related to the wealth effect concept. We will cover this concept throughout the next series of posts.  Remember, each time a bank creates a loan, a corresponding deposit is created through the banking system, which adds to the money supply.  There are limits to how much money a banks can create which are imposed by various regulations and also depend on demand for loans at the existing interest rates. We have also seen governments create money via the Treasury by directly transferring funds to household bank accounts during COVID-19 situation (and running significant fiscal deficits, which are large monetized by the central bank through buying up the issued bonds) which is included in the money supply. This is very high-powered money and allows an economy to recovery very quickly from a shock and does not have the lagged effect of lower interest rates. These actions are consistent with views proposed by some economists that call for fiscal authorities to rely on greater fiscal spending/borrowing such as Modern Monetary Theory or Universal Basic Income, which may be used to partially redistribute spending back to lower wealth/income households. The flip side of increasing fiscal spending is that associated above target inflation that many countries have seen in response to COVID-19 fiscal stimulus, coupled with supply chain shocks.

Table 10 – Private Credit (LHS), Money Supply (LHS) and Net worth (RHS) – United States

Source: US Federal Reserve, BeowulfsTreasury.com
  • However, the growth in overall wealth and increase in inequality may have driven down the cost of capital as more money is available in a credit-based system to invest in capital (debt or equity), this may have increased risk-taking due to lower expected returns across all assets and the incentives for outsized wealth have driven substantial investments in technology and innovation supported by capital markets (see Table 11).  More on this later….     

Table 11 – Increases in Technology and Innovation (% of World Patents)

Source: OECD, BeowulfsTreasury.com

2. How Credit Contributes to Economic Growth

Before we jump into the drivers of asset prices over various debt cycles, let’s take a look at what drives economic growth. Generally, there are three ways to increase an economy’s GDP over time using the Cobb Douglas production function:

Labour + Capital + Total Factor Productivity = GDP growth

  • Labor = number of person-hours worked to produce a good or service
  • Capital = invest in a capital good – machinery, equipment, buildings
  • Total Factor Productivity = More output per inputs of labor and capital

Households may work more hours to obtain greater disposable income to be spent or saved. Capital may be invested in a business to generate a profit. Earlier we have discussed how the labor share of production has been declining over time. Increased productivity may come from automation to produce more output.

In Tables 12-13, we have shown the growth in the working-age population over time and how the growth in labor and increases in productivity have historically driven economic growth in the US. As growth in labor is expected to decline from 0.4% to 0.2%, if higher productivity is not achieved, then real GDP growth will be lower than what we say today which is roughly 2.0%.  

To offset the decline in labor growth, the ‘wealth effect’ looks to optimize the above equation and brings forward future consumption and investment as credit provides additional purchasing power in today’s economy for the future promise of repayment along with interest payments along the way.

Table 12– Growth in the Working-age Population

Source: J.P. Morgan Asset Management

Table 13– Drivers of GDP Growth – United States

Source: J.P. Morgan Asset Management

Debt lets households smooth over income shocks (i.e. illness, short-term unemployment) and invest in high-return assets such as housing or education, raising average consumption over their lifetime.  Credit demand may increase as households may be optimistic about income prospects or low costs (i.e. interest rates are low). As mentioned earlier, the largest debt on consumer balance sheets (Table 14) are mortgages representing about 65% of total liabilities by U.S. consumers used to fund the largest asset on most households’ balance sheets – Real Estate –which we will cover in the next section. However, to understand the ‘wealth effect’ in greater detail and who benefits from it, in Part 2, we intend to dig deeper and construct balance sheets by wealth distribution to understand how wealth is created in America and where the debt that is used to create this wealth resides.  

Structural factors such as demographic changes or population growth/immigration are expected to drive credit demand, also contribute to an increase/decrease labor in the production function.  

Table 14 – Aggregate Consumer Balance Sheet – United States

Source: J.P. Morgan Asset Management
 

3. Given that for most countries’ citizens’ residential real estate are the largest source of net wealth and is the largest source of the ‘wealth effect’, what are the main drivers of house prices in Advanced Economies?

House prices in many advanced economies have risen substantially in recent decades. But experience indicates that housing prices can diverge from their long-run equilibrium or sustainable levels, resulting in a financial crisis like we would have seen in the Great Financial Crisis given that a significant amount of leverage is used in financing residential housing. This is why it is very important to understand the credit cycle in our credit-based financial system… more on this later. So monitoring house prices and understanding the fundamental drivers of home prices, along with macro-prudential regulation related to banking/mortgages has become more important as total debt in the economy has increased.

Let’s take a look at the fundamental drivers of residential housing pricing over time.

In Table 15, you can see there is a correlation between the growth in disposable income, home prices, and the number of housing units/population growth.  

Table 15 – Real House Price Growth vs. Growth of dwelling stock vs. Growth of real disposable income vs. Population Growth since 1990 (per annum (%))

Size of bubble based on Real House Price Growth since 1990
Source: OECD, BeowulfsTreasury.com

In a recent working paper, the International Monetary Fund (IMF) has broken down demand and supply factors which gives us a good framework to work from:

Demand:

  • Household disposable income plays a key role in shaping house price trends – either from capital or labor share.
  • Household net financial wealth also appears to be a determining factor of house prices
  • Housing demand has also been fueled by declining interest rates
  • Demographic trends reinforced the high demand for owner-occupied housing (population growth and net migration to certain countries)

Supply:

  • Undersupply conditions of housing can also contribute to housing price gains outpacing incomes
  • Tax incentives for mortgage financing and homeownership, which reduce the user cost of housing, can contribute to high and rising house prices. This favorable tax treatment on housing investment may crowd out capital from more productive use than housing and encourage excessive leverage.
  • Tax on Property is a significant source of revenue for governments. Most of the revenues from recurrent taxes on immovable property are assigned to local governments. Even in countries in which there are three levels of government, local governments tend to get the largest share.

In addition to the items highlighted by IMF, other supply issues for housing independent of credit may include land-use governance such as green space around cities, which reduce the responsiveness of supply changes to demand changes for housing. Government involvement through the secondary mortgage market may increase thesupply of credit (i.e. implicit guarantee in the US by government-sponsored entities). 

Credit supply and credit cycle (interaction between borrowers and lenders and changing risk perceptions) are also very important to housing prices which we will look to cover next.

Also, given the financial liberalization over the past 40 years, foreign buyers may drive local real estate demand and some may view housing assets as a safe haven (like an inflation-adjusted bond). An increasing number of national and local authorities in countries such as Canada, New Zealand, Australia, and Hong Kong have imposed restrictions on foreign buyers, basing their policy action on anecdotal reports of substantial purchases by foreign Chinese buyers.

Stay Tune for Part 2 of The ‘Wealth Effect’ and Debt in which we will cover:  

  • How does Debt impact the Wealth Effect?
  • Why is understanding Credit Cycles and Business Cycles are Important – A Review of the US – 1975 to 2021?
  • Why are Interest Rates and Debt-Service-Ratio Important to Watch for an Economy reliant on the Wealth Effect/Debt Growth?

Appreciate any questions or feedback you have or other research topics you may suggest.

Please contact us at beowulftreasury@gmail.com.

BT

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