To: Gene Epstein, Barron's
From: Jude Wanniski
Re: ‘The Wealth Defect'
Your interesting article on "The Wealth Defect" in the April 24 Barron's argues that "If stocks crumble, the economy may not be hit as hard as some theorize." The reason is in the headline, which turns the concept of a wealth "effect" into a "defect," pointing to research that shows little connection between consumer spending and the stock market, especially after 1988. As a supply-side political economist, I've never accepted the arguments that underpin the "wealth effect" idea -- which asks us to believe that anticipated wealth can cause an increase in "aggregate demand." This is the notion recently expressed by Fed Chairman Alan Greenspan as his reason for wanting the stock market to show less "exuberance." He fears that consumers who anticipate the economy will be more productive in the future because of the rise in the value of their equity holdings will decide to spend their anticipated wealth in the present. You are exactly right, Gene, in noting anomalies of the National Income Accounts, which attempt to put the decisions of myriad producers and consumers into neat little boxes. Those accounts, remember, were designed and created in a demand model, and I have been observing for 25 years that an individual cannot simultaneously put money in his pocket to save and take it out to spend. Even when you show a taxpayer selling part of his capital gains in order to buy a yacht, someone must provide the cash that buys the shares he sells.
In the supply model, it is much easier to see the way the world works. Instead of one consumer trying to save and spend, we have two producers trying to produce and exchange. If Jude Wanniski and Gene Epstein both have a surplus capacity to produce -- with you making bread and me making wine -- we can draw up a contract to make the exchange. The reason there must be a contract rather than a simple swap is that we are in a complex market economy, where an intermediary locates me and locates you before the deal is closed. You agree to give me more of your bread production, perhaps two loaves per day, and I agree to give you in exchange, one bottle per day. But because bread spoils after a day and it takes a year to produce a bottle of wine, the contract must permit me to deliver all the wine at the end of the year, even though I'm getting two extra loaves per day.
You see what has been happening in our economy is that underutilized resources have been coming into play, because of the lowering of tax rates both in the Reagan years and in the Clinton years. The 1997 tax act lowered the capital-gains tax to 20% from 28%, and the new Roth IRA enables producers to increase production and exchange without being taxed at the time or at retirement -- as long as they only invest after-tax income in the IRA to begin with. Because Keynesians and monetarists do not formally recognize producers as such, they devised the "wealth effect" as a way of describing the phenomenon. It really does not show any linkage prior to the late 1980s, though, because the statistics have been muddied by the monetary deflation. When the price of gold steadies or declines, real wages steady or increase in purchasing power. This means producers of bread and wine can exchange more at lower nominal prices, as the government only taxes at nominal prices and incomes. It is the reverse of "bracket creep," and explains why workers have been content to work harder and longer without an increase in pay. The nominal amounts they receive are worth more.
In any case, I think you should be complimented on tackling this issue and encourage you to look into it deeper. You will, I think find a greater appreciation of classical economics.