The Wealth Effect

Economists have devoted much study to the phenomenon of the wealth effect and its influence on consumer behavior as a component of the business cycle. Like all idealistic youth, the protesters currently occupying Wall Street have little understanding of the very thing they are protesting. Wealth is a complex condition composed of many factors that come together to produce the sensation that one is secure in their material possessions. 

The general idea of Utopia is a place where no strife exists and people have all they need without having to worry. The Bible speaks of a time after the Armageddon when Christians will live a Utopian existence in Christ. Communism describes Utopia as workers owning the means of production and everyone sharing equally in the output of production. The idea of an earthly Utopia is a powerful concept with great appeal to the idealistic, who look upon our present society and see only problems without attempting to visualize solutions.

In the description of Utopia, it is generally agreed that money would be unnecessary as everything would be available to everyone as needed. Basically, everything would be free. Communist and socialist systems have demonstrated the fatal flaw in this theory by exposing the fact that humans, being what they are, will game the system to their advantage by working as little as possible while taking as much as they can. The problem then becomes one of developing the mechanisms by which people are conditioned, encouraged, or forced to live within the system’s rules.

When thinking of Utopian systems, it is assumed by the designers of such systems that they will serve as a replacement for capitalism, which is seen as a corrupt system of greed that exploits its participants at every level. However, capitalism creates a system by which the mechanisms of its compliance become largely voluntary without coercion from the state. In its purest form, capitalism is a self-regulating system in which transgressors are punished by banishment from the system as their misdeeds become known. In the real world though, we have laws to regulate economic activity to prevent the more egregious forms of abuse and expose them far faster to minimize their effects upon the participants.

Communism sees wealth as the fruits of exploitation deserving of banishment while capitalism sees wealth as the fruits of hard work to be enjoyed by the accumulator. Under communism, everything is free, but leads to disappointment as there is no pride of accomplishment or ownership. Under capitalism, everything has a price and entrepreneurship leads to fulfillment as one’s labor is traded for the things produced by that labor with money as the medium of exchange.

As incomes rise and people accumulate wealth, the percentage of their income devoted to necessities shrinks with the result that they become less expensive in relation to the overall disposable income of the individual. For example, $10 spent on gas out of a $100 income equates to 10% of that income, while $10 out of a $1,000 income equates to 1% of that income. The result is that as income grows, the percentage spent on necessities shrinks and leads to more disposable income, thus making one feel wealthier. Viewed another way, the smaller the percentage of your wealth that something costs, the more free that item appears. $10 to a man making $100 is a lot of money, but not so much to the man making $1,000 and even less to a billionaire. As income rises, that $10 goes from a major portion of net wealth to an insignificant sum barely noticed.

One factor that influences the feeling of wealth is certainly a rising income by which necessities are more easily satisfied leaving more disposable income for leisurely pursuits. Another factor is a feeling that the future holds a degree of certainty that things will proceed as expected with no sudden shocks on the horizon. The conditions that create uncertainty in the market and cause businesses to adopt a cautious outlook also cause individuals to adopt a cautious outlook. Purchases are delayed if there is increased uncertainty about one’s employment condition. Delayed purchases on a large enough scale affect the economy through decreased demand that causes an oversupply and forces a slowdown in production. This production slowdown increases unemployment as unneeded workers are shed, leading to ever more decreasing demand and increasing oversupply.

The point is that bad things occur in the economy when the wealth effect is trifled with. While government provides a needed oversight role in the market to prevent egregious forms of abuse, this oversight role can be easily abused by those seeking to advance their own misguided agenda of marketplace fairness and lead to the uncertainty that fuels the downward spiral of economic depression. This is the situation we find ourselves in today as businesses idle their capital waiting for market certainty. Wealth redistribution and increased regulation in the name of fairness make for great sound bites to those seduced by the notion that they will get something for nothing and no consequences will arise, but they make lousy policy precisely because there are consequences.

For the economy to turn around, the opposite of the policies which have led to the current disaster must be put in place to generate market certainty among businesses. Expensive mandates to businesses such as universal health care, ineffective environmental regulations, and poorly conceived financial regulations must be eliminated to provide business with a degree of certainty that they can obtain an adequate return on their risked capital. The financial practices that led to enactment of Sarbanes-Oxley and Dodd-Frank were already illegal, but these acts increased financial reporting requirements in an effort to provide oversight authorities with an oversimplified view of company finances and hide their lackluster performance in allowing these frauds to perpetuate. The overseers got too comfortable, allowed frauds to be perpetrated, and called for new laws when the news broke to cover up their failure to properly perform their oversight functions in the first place. Instead of properly punishing the government agencies who failed to do their jobs, Congress punished business with increased regulation to cover up their mistakes. Business has responded by idling its capital and refusing to play. This too is part of the wealth effect.

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