Wealth effect: Not such a good excuse for further interest r

Wealth effect: Not such a good excuse for further interest rate hikes

On February 23, the US Federal Reserve chairman Alan Greenspan testified before the US Senate's Committee on Banking, Housing, and Urban Affairs. He had made the same testimony a week earlier before a counterpart committee in the House.


The gist of his remarks is that the American economy is no longer capable of enjoying the happy combination of robust growth and low inflation that has been continuing for the last nine years, unless reined in by further hikes in interest rates. As grounds for his somber diagnosis, Greenspan offered the "wealth effect" as the principal culprit for the worsening situation.


It is true that the same effect, rising gross domestic products as people feel like spending more with higher valuation of their assets in the long bull market, has fueled the economy for the past years.


World according to the Fed


According to the Fed's calculations, 3 to 4 cents out of every extra dollar of stock-market wealth eventually go into increased consumer purchases. The booming market has, it is estimated, added about a percentage point a year to gross domestic purchases for the last five years. The same is occurring in corporate investment spending where costs declined substantially through higher stock values.


What, then, has gone wrong with the wealth effect to create a threat to economic stability? The reason, chairman Greenspan said, is that an additional spurt in demand generated by stock-market wealth is not well matched by a corresponding increase in supply. It is exactly this mismatch that triggers inflation, according to the classical economic theory.


Until now, that excess demand over and above what the economy can adequately supply has been filled up by imports and the domestic pool of the unemployed. But these two "safety valves" are increasingly showing strains. With the unemployment rate currently at around 4 percent, as Greenspan sees it, the economy is running out of available workers. And with the trade deficit of the US at a record high now, it can no longer avoid trouble by importing goods.


It is thus necessary to raise interest rates to stave off a coming halt to the historic expansion of the 1990s and beyond, he argued in the testimony. Predictably, business economists scoffed at the Fed chairman's stance, dismissing the "wealth-effect theory" of Greenspan as a rickety pretext to push his case for more interest rate hikes.


Flimsy case


We think that there is some truth in their criticism. Over the years, the Fed is gradually losing the leverage with which it can control the pace of economic activities mainly because many businesses, especially those enjoying stellar-high stock prices while performing poorly on the balance sheets, are no longer dependent on banks for their financing needs. There are now so many different ways for them to procure money. For example, companies can go directly to the equity market and finance their capital at much lower cost than indirectly through the banks.


For this reason, interest rates are not an omnipotent tool to herd businesses out of harm's way any more. It, however, still has a powerful effect on the other side of the equation, that is, how consumers behave when interest rates change. It is easy to imagine higher interest rates in the US will affect consumer spending not coming from the wealth effect but from people's earned income, which will eat away those gains in gross domestic purchases made by feeling richer due to their rising stock values.


That effect would send adverse repercussions to the Korean economy still reeling from the past crisis. It is useful here to recall that US interest rate movements are closely tied with other countries, of course including Korea. The nation's economy, still based on industries sensitive even to small upward changes in interest costs, will lose precious momentum toward regrouping itself and may plunge into recession not knowing when to bounce back.


As for the "Greenspan theory," it has some flaws as well, though fascinating by itself. For one thing, the chairman presumes that the two safety valves, imports and pool of those unemployed, that help alleviate the growing mismatch between demand and supply, will soon reach their limits. However, the US economy can buy things from overseas indefinitely as long as it has the means to pay the bills. Certainly it can pay the import bills with, at least in part, the ever growing value of stocks held by Americans.


By the same reasoning, the labor market can be expanded easily by outsourcing jobs to foreign contractors who would happily take the job for a fraction of wages that US companies pay at home. Information technology has cut the cost of long-distance communications down to nil, which rendered foreign outsourcing a viable alternative to adding in-house workers.


The New Economy still has plenty of room to accommodate further expansion without igniting inflation. Too much caution too early may backfire, leading to a premature demise of the current economic boom. It is important to remember that a policy misstep in one influential economy may spill over into other small economies, creating havoc on those fragile turfs.