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Is the “Wealth Effect” Real?

By Chris Lowe, Editor-at-Large on November 3, 2014

The Dow has been extremely volatile over the past four weeks. Hundred-point swings have become commonplace. And the big losses at the start of the month have been followed by a sharp “snap back” rally.


Source: StockCharts.com
This is a big problem. Because it prevents QE from working as planned.

You see, central banks have a theory. It’s called the “wealth effect.” And it’s through the “wealth effect” that QE is meant to heal the economy.

QE involves creating money – whether it be yen, dollars or euros. This gives central banks the power to lift financial markets. But so far, QE has been unable to shift economies.

Central bankers believe that when people see their stock market portfolios rise in value they’ll go out and spend that money as though it were extra income.

The problem is that people don’t behave as the theory explains.

That’s because when people look at their broker statements, and they see a big bump in the value of their portfolios, they ask themselves a very sensible question: Is this permanent or temporary?

If they see it as temporary – because it’s being pushed up by central banks and because stocks have been hugely volatile – people won’t see rising prices as new income. Instead, they’ll see it as “easy come, easy go” money. And they won’t go out and spend that new wealth.

Volatility – which measures how much stock prices swing up and down – also causes investors to be more cautious with their investments. That’s because, the more prices bounce around, the greater the chance that traders get stopped out of their positions.

QE contains the seed of its own destruction, in other words. Some QE helps lift markets and dampens volatility. But as QE goes into hyper-drive, as has happened in Japan, it brings with it higher volatility.

And the higher volatility goes, the less effect QE has on spending… and the less investors are willing to take risks in financial markets.

The move by the Bank of Japan misses this point entirely. More QE won’t mean higher consumer spending, as long as it means more portfolio volatility.

Pushing up stock prices is not a means to an end, as planned, but an end in itself.

P.S. Large-scale central planning leads to disaster. This is the central message of Bill’s new book, Hormegeddon. But Hormegeddon isn’t just about economics. It’s relevant to all aspects of life. In fact, as Agora CEO Myles Norin explains, it contains a secret that helped more than 50 Agora employees become millionaires. Follow this link for full details.

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