The Poverty Effect

10 December 2010

Friday


At investopedia.com we find the following definition of the so-called “wealth effect”:

The premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more. For example, economists in 1968 were baffled when a 10% tax hike failed to slow down consumer spending. Later this continued spending was attributed to the wealth effect. While disposable income fell as a result of increased taxes, wealth was rising sharply as the stock market moved up. Undaunted, consumers continued their spending spree.

This is a definition specific to investment income (at least, the first sentence is specific to investment income), but we can easily generalize the idea of the wealth effect down to hourly wage earners and those living paycheck-to-paycheck. I wrote “so-called” above because any thesis as sweeping as that of the wealth effect is going to be controversial. There is an article on Slate by Christopher Flavelle called Debunking the “Wealth Effect.” This is to be expected. An industrialized economy comprising the ordinary business of life for three hundred million people is bound to be extraordinarily complex, and different conclusions can be drawn from different sets of evidence.

The obvious mirror image of the wealth effect is the poverty effect: if people feel poor, if they see the value of their assets decrease (whatever those assets may be, from stock portfolios to houses to art to collector cars), or even if they hear continuously on the news how poor they ought to feel, they are likely to act as though they are poor, and in practical terms this means that they are likely to spend less money.

Keynes already anticipated this in the General Theory. His first well known quote about the role of “animal spirits” in the economy goes as follows”

“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (Chapter 12, section 7)

On the next page of the General Theory Keynes went on to say this:

“…if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; — though fears of loss may have a basis no more reasonable than hopes of profit had before.”

It could be argued that Keynes’ grasp of market psychology was superior to his grasp of the theoretical foundations of market mechanics. Obviously, Keynes knew whereof he spoke, since he made two fortunes in the stock market (the first he lost).

In the longue durée of markets, it is to be expected that during some periods of time markets will predominantly be driven by psychological factors, and that during other periods of time markets will be driven predominantly by fundamental mechanisms like supply and demand. During periods of psychological dominance, noise traders will be the most successful, while during periods of market mechanism dominance, value traders will be the most successful. (A “noise” trader buys and sells on news and rumors; a “value” trader buys and sells on the basis of knowledge and research.) Neither strategy will always return optimal results; market strategies must be tailored to the state of the market at the time, and if I knew what this was, I wouldn’t be working for a living.

This treatment, again, is primarily an investor’s point of view, like the definition I quoted above about the wealth effect. Individuals do not live in the longue durée; their perspective is likely to be local, parochial, and personal. An individual can, by considerable effort, adopt the point of view of the longue durée, but there is little benefit for doing so, and perhaps even a penalty. When Plato recounts the sojourn of the soul from the cavern of shadows to the light of the Good, he acknowledges that the man how has once beheld the dazzling light of the Good, when he returns to the cave, will be unable to see, and will seem slow and disoriented to those who have never left the cave.

This brings us to another all-too-familiar Keynes quote, and one which I have previously cited in this forum:

“The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.”

The rationale for Keynes’ advocacy of short term thinking is to be found, if anywhere, eloquently expressed by the pre-Socratic philosopher Epicharmus:

“A mortal man must think mortal and not immortal thoughts.”

When we take the Keynes’ quote in the context of the present discussion, we can make something of it more than the usual admonition to short term thinking, already the favored strategy among politicians and the only strategy that can be communicated in a soundbite on the evening news.

The misleading character of the long term is only misleading when the long term is conceived in tactical rather than strategic perspective. Strategic thinking is for the long term, and while our strategy guides our tactics, we cannot dictate tactics according to strategy, or we will likely lose. When the short term is conceived in strategic rather than tactical terms, it is equally misleading. Tactical thinking is for the short term, and while our tactics will be focused on attaining the objective identified by strategy, the tactician must not be limited by the strategist. And all of this holds, mutatis mutandis, when translated into political terms.

But understanding the world according to the longue durée (or, if you’re a Spinozist rather than a Braudelian, I could say sub specie aeternitatis) does not come naturally to the human condition. Consequently, long term strategic thinking is an accomplishment; it is reserved for the few who make the effort to achieve this perspective. In this, it is like T. S. Eliot’s position on tradition in his famous essay “Tradition and the Individual Talent”:

“…if the only form of tradition, of handing down, consisted in following the ways of the immediate generation before us in a blind or timid adherence to its successes, ‘tradition’ should positively be discouraged. We have seen many such simple currents soon lost in the sand; and novelty is better than repetition. Tradition is a matter of much wider significance. It cannot be inherited, and if you want it you must obtain it by great labour. It involves, in the first place, the historical sense, which we may call nearly indispensable to anyone who would continue to be a poet beyond his twenty-fifth year; and the historical sense involves a perception, not only of the pastness of the past, but of its presence; the historical sense compels a man to write not merely with his own generation in his bones, but with a feeling that the whole of the literature of Europe from Homer and within it the whole of the literature of his own country has a simultaneous existence and composes a simultaneous order.”

It should also be pointed out that not all efforts yield the same results for different individuals. Some can make a near-heroic effort to gain a more comprehensive perspective and still fail, while to others the more comprehensive perspective is attained as a natural and normal outgrowth of intellectual endeavor. Wisdom may come with tears or without tears, or it may elude a given individual entirely, if that individual lacks a talent for objectivity.

As with tradition, so too with the longue durée: if you want it you must obtain it by great labour. Since the ordinary business of life in industrialized society is in itself a great labor, the individuals who can rise above the level of their circumstances and make the effort to acquire the perspective of the longue durée are few and far between — as few and far between as, for example, the number of people who keep themselves in really good physical condition when they are surrounded by unhealthy foods and uninterrupted opportunities for sedentary occupations.

Mass man is a product of the structural forces of mass society. By the time that humanity reaches a critical mass, as it were, of enough individuals in one place, society is changed by virtue of the mass alone. Once the Industrial Revolution began the concentration of workers in urban centers, drawn away from their distribution over the countryside under the agricultural paradigm, the critical mass requisite for the advent of mass society was rapidly achieved.

Mass man is not only a product of mass society, but mass man also shapes mass society in turn. Any human universal, any expression of human nature, will also be expressed en masse by mass man and therefore eventually become a feature of mass society. This includes the emotional life of mass man. The mass emotional life of mass man is at times a vulgar and unpleasant thing to behold, but it is no less authentically felt than the feelings of the most rugged of rugged individualists. Not surprisingly, mass man is most focused on the ordinary business of life, and the emotional life of mass man is thus mostly circumscribed by the ordinary business of life. It is to be expected, then, that mood swings between exuberance and despondency over the economic life of mass man — or, if you prefer, the emotional life of homo economicus — will be one of the structural features of mass society.

Both the wealth effect and the poverty effect are the emotional equivalent of noise trading. The masses as masses do not and cannot assume the perspective of the longue durée. The masses are rooted in the institutions of mass life, and as such they respond to statistically measurable forces. If things are going well, the masses talk about it (often through the mass media), and the entire mass community is buoyed up by the optimism. This we could call ameliorization through irrational exuberance. When things are not going well, the masses talk about this too, and the entire community is discouraged by this pessimism. This we could call immiseratization through irrational despondency.

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