Gerard Jackson
BrookesNews.Com
Monday 8 September 2003

John Edwards, chief economist at HSBC, said that he is not convinced of the "reality of the wealth effect" (Business Review Weekly 20/3/03). In support of his doubts he produced an impressive array of statistical evidence.

All well and good, until one realises that Edwards was wavering on the issue. He made this clear when he expressed the opinion that the wealth effect might make itself felt if the economy turned down.

Therefore, if this where to happen and incomes fell, people might decide to maintain their consumption levels by borrowing against the value of their homes. In this way, said Edwards, "the wealth effect turns out to be very helpful for Australia in a downturn."

The error here should be obvious. If incomes fall and individuals try to maintain their level of consumption by borrowing, then lenders must by definition reduce their own expenditure thereby leaving total spending unchanged. To argue, as Edwards does, is to commit the fallacy of composition.

His view overlooks the fact that borrowing and lending is a process of temporarily transferring purchasing power from one person to another. It does nothing to raise total spending. However, in the world of fractional banking borrowing does lead to increased spending, a fact of which most people are completely ignorant.

A highly simplified example should suffice to make my point. Assume that the reserve ratio is 20 per cent. This means that if $100 million dollars are deposited in the banking system total deposits will expand by $500 million and the money supply will grow by $400 million. Therefore the banks will be able to lend out $400 million dollars against the original $100 million in deposits..

It's important to understand that this $400 million increase in lending is pure credit expansion. This is where it gets interesting. Continuous credit expansion drives up house prices which in turn increases the paper wealth of house owners. Seen from this angle, we can easily observe that rather than rising asset values driving borrowing, it is credit expansion that is driving both.

It's easy to see that Mr Edwards' comment that the wealth effect could help Australia should the economy turn down is based on the dangerous Keynesian fallacy that consumer spending drives the economy. What needs to be driven home is that savings, not consumption, fuel an economy and entrepreneurship drives it.

Now what does it mean to save? Saving is a process by which present goods are converted into future goods. Genuine savings mean that resources are being directed from current consumption (present goods) and invested in capital goods (future goods). Savings that are diverted to consumption goods are dissavings.

The link between the rapid growth of asset values during the last few years and credit expansion is so little understood that it needs to be frequently exposed. Otherwise we will end up with more economic illiterates like Tim Blair joyously telling us what a marvellous thing inflation generated paper wealth is.

Gerard Jackson is Brookes' Economic Editor