'Wealth effect' no cure for economy

By Christopher Lingle

HONG KONG (JP): Considerable exuberance is evident on stock markets around East Asia with several recently hitting new highs. Measured in U.S. dollars, the main stock index in Jakarta rose over 100 percent in the second quarter of 1999. South Korea's index is up nearly 75 percent over the past six months while stock prices in Hong Kong gained over 40 percent during the same period.

Some analysts and government officials believe that these rises can generate a "wealth effect" whereby increased personal worth from rising local stock markets will inspire higher spending and boost growth in the region's economies. Even China's leaders are hoping that gains in valuations on its bourses in Shanghai and Shenzhen will reverse its economy's slower growth.

Behind this wishful thinking is a misreading of the nature of the economic boom in the United States. This is compounded by a misdiagnosis of what ails East Asia's economies.

In order to clarify these issues, it is first necessary to examine what lies behind America's experience with relatively high economic growth. Most important to high and steady growth of the U.S. economy is the increased efficiency in its capital markets. These gains in efficiency have initiated a virtuous cycle of low unemployment and stable prices joined by the seemingly irrepressible rise in stock prices. Increased capital market efficiency allows growth despite a sharp decline in personal savings because funds are attracted from countries with less efficient markets and/or higher risk.

It is misleading and misinformed to suggest that the United States is experiencing a consumer-led boom that is being driven by a "wealth effect". If consumer-led growth were possible, business cycles would not exist since recessions could be remedied quickly through expansion of government deficits or loose monetary policy. Whatever the impact of a wealth effect on America's economy, it was observed once the growth phase was well underway. It was not the mainspring for a recovery. Instead, it seems to have been one factor providing momentum for robust growth.

Rising consumer spending or increased government expenditures financed by larger deficits cannot drive long-term economic growth. Market economies rely upon entrepreneurs as the engines of economic growth having ready access to capital to finance their ventures. This seems to be prompted by gains in productivity driven by a revolution in information technology.

Falling risk premiums combined with an increase in economies of scale in the collection and processing of information have lowered capital costs. In the end, this means that global financial resources are utilized more efficiently.

The role of the so-called wealth effect in the U.S. economy is somewhat ambiguous since there is not clear line of cause and effect. Willingness to spend today is a complex combination of factors that include changes in one's future position. This is certainly influenced by changes in the stock of wealth, but it also depends upon the anticipated flow of future income. Consumer confidence is shaped by expectations relating to job security and prospective pay packages.

While all these factors are positive in the United States, the same cannot be said for most of East Asia. Many questions remain over whether current improvements in the region's economies herald a viable recovery.

In all events, it is unlikely that rises in Asian stock markets can generate wealth effects to boost their overall economies. There are various reasons for this.

In the first instance, the total capital values of traded shares are relatively low. Market capitalization for the U.S. markets is about 150 percent of Gross Domestic Product while in Asia the ration is considerably lower.

Also, the proportion of Asia's population with large holdings on local bourses is much smaller and wealth is more highly concentrated in the hands of a few. If there were to be a wealth effect, it will only influence the spending patterns of the wealthy. For example, even if the Hang Seng index in Hong Kong continues rising, it will not offset the negative impact of rising unemployment upon retail sales.

In the case of China hopes for inspiring a wealth effect, government exhortations to buy shares have replaced underlying fundamentals and prompted increases in the stock indexes. Talking up asset values on the basis of political aims without support of growth in profits and rising profitability is a recipe for stock market instability.

In looking at Japan, a word of caution is in order when considering the unexpected rises in spending observed during the first quarter of 1999. There is no surprise when purchases are made to replace worn out consumer durables after five successive quarters of declining real GDP. This is likely to reflect a temporary decrease in saving rather than a sustainable rise in spending.

In the unlikely event that Asian economies were to benefit from the impacts of a widespread wealth effect, it would only offer a short-term remedy. Most of the economies in the region suffer from problems arising from inefficiency and lack of competition in their domestic economies. While many countries have multinationals that are truly global competitors, protectionist barriers have caused many domestic banks and enterprises to lag behind. Domestic businesses weakened by a lack of competition cause more jobs losses than do closures arising from domestic consumers' preference for imports instead of goods and services produced locally.

In the end, governments should not look for elusive remedies like wealth effects to offset lagging economic growth. Instead, they should look to long-term remedies by improving the competitiveness and vibrancy of the domestic sector of their economies. This will only happen if these countries continue to strengthen their financial sectors while allowing for greater inflows of goods and services.

The writer is an independent corporate consultant and adjunct scholar of the Centre for Independent Studies in Sydney who authored The Rise and Decline of the Asian Century (Hong Kong: Asia 2000, 1998). His E-mail address is: CRL@po.cwru.edu.