Why most investment banks on Wall Street have it so wrong on the US economy after they got it so wrong on the Households balance sheets.

We start looking at a very basic chart which is the total debt in the economy to real GDP ratio. This very simple chart means that for every unit increase in total debt , we got less and less increase in real economic activity.
We understand thus that the marginal utility of debt on economic activity has become almost 0. Debt does not create economic activity, unless it is used to increase the level of capital in the economy, which in turn would raise productivity and the potential growth rate of the economy.

The second chart looks at the correlation between consumer credit and household consumption spending. It is a very weak correlation. In fact, swings in consumer credit are way more violent than changes in real consumption expenditures.

The third chart looks at the correlation between households total financial assets and real consumption spending. This is what is known in economics jargon by the wealth effect. Here again, large swings in the financial wealth of households do not lead to major changes in real consumption expenditures. It is well known by most macroeconomists that the wealth effect in the USA is no more than 3%. So let us say paper wealth drops 30% year on year, the effect on consumption spending will be a mere drop of 1%. The more wealth is concentrated in the top percentiles, the less changes in wealth have an effect on consumption spending.

Finally, we present you the chart that relates personal disposal income to consumption spending. Well here we have a perfect positive correlation. Disposable income is the most important determinant of real consumption spending.

We conclude from these below charts that paper wealth destruction DOES NOT lead to severe recessions. Credit contraction DOES NOT not lead to severe recessions. The Federal Reserve and other central banks in the world are not in the business of bailing out paper wealth, the mirror image of debt.

The Federal Reserve is in the business of finding the right balance between employment and inflation. If inflation is too high relative to the Fed target, the only way to slowdown an economy that is overheating, is by engineering a contraction in personal income. This can be achieved only via a significant increase in unemployment, since 80% of disposal income is derived from labor income. We are still very far from reaching that equilibrium. To reach the 2% inflation target, unemployment rate should rise to at least 6% and wages growth should drop to a level that is below the inflation target. If the cost of reaching the inflation target is a massive destruction in paper wealth, the Federal Reserve, based on its internal econometric models, is already aware that it wont pose a big problem to the overall economy. The rich will be less rich. That’s all. Why most investment banks on Wall Street have it so wrong on the US economy after they got it so wrong on the Households balance sheets.

We start looking at a very basic chart which is the total debt in the economy to real GDP ratio. This very simple chart means that for every unit increase in total debt , we got less and less increase in real economic activity.
We understand thus that the marginal utility of debt on economic activity has become almost 0. Debt does not create economic activity, unless it is used to increase the level of capital in the economy, which in turn would raise productivity and the potential growth rate of the economy.

The second chart looks at the correlation between consumer credit and household consumption spending. It is a very weak correlation. In fact, swings in consumer credit are way more violent than changes in real consumption expenditures.

The third chart looks at the correlation between households total financial assets and real consumption spending. This is what is known in economics jargon by the wealth effect. Here again, large swings in the financial wealth of households do not lead to major changes in real consumption expenditures. It is well known by most macroeconomists that the wealth effect in the USA is no more than 3%. So let us say paper wealth drops 30% year on year, the effect on consumption spending will be a mere drop of 1%. The more wealth is concentrated in the top percentiles, the less changes in wealth have an effect on consumption spending.

Finally, we present you the chart that relates personal disposal income to consumption spending. Well here we have a perfect positive correlation. Disposable income is the most important determinant of real consumption spending.

We conclude from these below charts that paper wealth destruction DOES NOT lead to severe recessions. Credit contraction DOES NOT not lead to severe recessions. The Federal Reserve and other central banks in the world are not in the business of bailing out paper wealth, the mirror image of debt.

The Federal Reserve is in the business of finding the right balance between employment and inflation. If inflation is too high relative to the Fed target, the only way to slowdown an economy that is overheating, is by engineering a contraction in personal income. This can be achieved only via a significant increase in unemployment, since 80% of disposal income is derived from labor income. We are still very far from reaching that equilibrium. To reach the 2% inflation target, unemployment rate should rise to at least 6% and wages growth should drop to a level that is below the inflation target. If the cost of reaching the inflation target is a massive destruction in paper wealth, the Federal Reserve, based on its internal econometric models, is already aware that it wont pose a big problem to the overall economy. The rich will be less rich. That’s all.