The conceptual framework for a man's search for meaning

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Wealth Consumption Effect

December 8th, 2013 by dimpledbrain

We first talked about Quantity Theory of Money some time back (click here for the post) focusing rather on the macro picture. For example how do money printing and manipulation of money supply become government’s propaganda tool.

Today we’ll take a look from a micro effect perspective, namely wealth effect and how does it affect us.

(1) Quantity theory of money revisited

  • How does it feel like when everything turns out well? Sunny, wealth effect increases and more unfinished cigarette on the ground.
  • Translated into mathematical equation, it would mean GDP increases. (Of course this is just looking at Consumption in the equation of GDP = C + I + G +X). Click here for the post.
  • Now if I spend RM2 each trip (for total 5 times) to the bakery to buy 10 croissants at RM1 each, I will spend RM10 to buy RM10 worth of goods.
  • Mathematically it means Money Supply (RM2)* Velocity (5 trips) = Price level (RM1 per croissant) * GDP (10 croissants)

(2) Get ’em spend more

  • Now if I were the government and that means I can print as much money as I want, I effectively control the money supply.
  • However the problem is even if I print say MYR 10 and it somehow goes to Citizen Miser, the entire MYR 10 may be hidden under his pillow and will not find its way to the economy. Mathematically the velocity becomes 0. One could recall albeit vaguely this is exactly the problem when government prints money trying to revive the economy but banks simply shove them away.
  • So the government resorts to wealth effect techniques, aimed at increasing Velocity (V) or turnover of money.
  • 2 most popular techniques are propping up capital market prices and real estate prices.

(3) How does it affect us

  • Sir John Templeton explains it best – think for a moment what fuels a bubble. It’s not just the increase in the underlying price of the instrument that marks the end of a bubble – it’s the consumption of that wealth effect that keeps fuelling it until it busts. In other words, if I buy say Speculative Share A or Speculative Real Estate X and both prices increase by 100%, the problem starts when I begin spending the wealth away. And spending begets wilder price and wilder price begets more crowds until it finally busts away.
  •  The peculiar thing is that this behaviour is so pervasive – moving to better neighbourhoods, buying bigger cars, buying bigger houses, spending away annual bonuses etc…
  • It’s my speculation but I think this sort of entrapment affects the low to middle class more than the rich – it’s just like spending away your money after striking a lottery.
  • I’ll admit it upfront that it’s very difficult to go against the crowd. To paraphrase a prominent banker, “when the music is still on, you have to keep dancing.”

How about trying to one down? If I just have MYR 10,000 I’ll just spend MYR500 instead of MYR 20,000. How about moving to a smaller neighbourhood? One smaller car? Ordinarily it means befriending and imitating those misers around us. Focus on absolute performance vs relative performance. If everyone moves to a better neighbourhood, gets to a better school, buys a bigger car, the relative advantage diminishes. A woman may wear high heels to look more attractive but if every woman wears them, the relative advantage disappears.

In a concert where everyone remains seated initially, the first person to stand up will afford a better view. Suddenly, the entire crowd goes hysteria and experts advise, “Stand up to get a better view.” So everyone starts standing up and soon some even move up to the fences. To a neutral observer the scene may just look like as if a fire broke out or something and everyone is clamouring upward for safety. And the climb higher than your neighbours soon takes on a life of its own, even though the concert has ended 7 hours earlier. At the 11th hour, people begin to realize this absurdity but it’s too late – the concert has ended. What’s the climbing for? The next batch of concert viewers experience the same scenario. The loop never ends.



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