The Fed's Ode to Chubby Checkers

"Operation Twist" is meant to boost the U.S. economy, but it ignores the real source of household wealth

The United States Federal Reserve Bank announced last week that it would extend the timeframe and scope of its current open market bond purchasing plan, the so-called “Operation Twist.” The amusingly-named operation refers to the Fed's continued purchase of long-term bonds on the open market to replace them with the sale of short-term bonds as a way of keeping down long-term interest.

The lyrics of a classic by 1950s rock 'n' roller Chubby Checker provide an apt description of the Fed's current activities:

"Come on let's twist again, like we did last summer!

It's the economy, stupid

Yeaaah, let's twist again like we did last year!

Do you remember when things were really hummin'

Yeaaaah, let's twist again, twistin' time is here!"

That's right, Chubby Checkers, twisting time is here again. However, let me hazard a forecast here that might bring the party to an abrupt end. Operation Twist 2 is expected, like the previous Fed plans, to yield some media buzz in the near future no matter what its short-term economic results .

But it won't be any different from the previous Fed plan which was known as QE2 ( Quantitative Easing 2 ) or any future plans that the Fed will come up with next. Likely they too will be presented with a catchy nickname and some inspiring acronyms to tickle the fancy of the financial press.

One of the most enjoyable activities in capital market commentary is to explain after the fact why prices went up or down. It's zero risk and will make you sound brilliant to all who listen.

Operation Twist will also help stock market commentators frantically trying to explain in a convincing manner every upswing and downswing in the financial markets. If the markets rally, the commentators will explain it as a sign of the markets' satisfaction with the Fed's plan and an expected improvement in the economy. If the markets plunge, the commentators will attribute it to the markets' disappointment with the new Fed plan.

Without any disrespect to the hits of the 1950s, haven't we come here today to discuss economic matters? In the same week when the continuation of Operation Twist was announced, the Fed's triennial survey of individual's total wealth and economic profits was also published.

The results that were published summarized the changes in U.S. household wealth between 2007 and 2010 – three years during which the U.S. and global economy changed course from an economic high-water mark to a slowdown. As was to be expected, the numbers aren't very heartening. The table presented alongside this column shows some choice figures from the survey.

The figures that I refer to are based on the survey's median, not the average or mean. In our case, the average numbers are biased upwards, meaning that they are more misleading than the median values. The survey averages are greatly distorted by the inclusion of even a small number of highly extraordinary results in the sample. All it takes is placing one multimillionaire in a survey population of a thousand people to receive a biased figure for average wealth, even though this multimillionaire's wealth has no practical effect on that of the other 999 in the survey's population sample.

Here are a couple of conclusions that can be deduced from the statistical data. As expected, Americans' net asset values fell significantly during the three years of the ongoing recession. The median American household lost nearly $49,000 of its total wealth in the past three years. A sizable portion of this lost wealth came from the drop in housing prices, which put a $40,000 dent in the total net assets of this theoretical median household.

False paper profits

The capital loss on non-housing assets, referring largely to financial portfolio assets, was of course much smaller – less than $10,000 for the typical household. As bad as that sounds, these figures that have been at the center of news headlines are not the real problem. Home equity is a figure that people in the U.S. like to refer to obsessively, but its actual significance is negligible.

Housing market values are simply a form of paper equity, something that doesn't generate anything of real value for its owners. In reality, the family that owns its own home usually has a long-term commitment to holding the property stemming from its need for living accommodations there or elsewhere. Whenever housing prices rise, so does the value of this commitment, and so there is no real wealth created by this price change, just the feeling of being wealthy.

This feeling of wealth, that was once praised by commentators and that was such a source of happiness, was a hollow one even when housing prices were rising and led to poor financial decision-making on the part of both home-owning consumers and bank lenders. In a similar vein, the loss of this fake paper wealth isn't a reason to panic.

Even the loss of tens of thousands of dollars from various types of non-real estate property isn't a cause for concern. The real source of pain was the fall in stock prices that forced people to dip into their savings, reducing the size of their net wealth. This is a one-time drop in personal wealth. You can't really lose your lifesavings more than once.

Even so, the data still holds a fair share of bad news regarding yearly income. The most significant loss of personal wealth for the typical American household stems from the $4,000 drop in annual household earnings. The reasons for this drop are fairly obvious, but the media outlets are still likely to ignore it and the harsh implications it holds.

Annual income has a multiplier effect on household wealth. Because households receive an income year after year, the indicator of net household wealth really needs to take into consideration the present value of a household's future income stream over the long haul. This is the financial method for evaluating the asset value of buildings and companies and this is also how monetary figures are determined in tort cases or insurance company payouts for individuals whose lifetime earnings potential is hurt due to some sort of injury or accident.

For the vast majority of cases, a household's main economic asset isn't its home value or investment portfolio, but rather the household members' ability to create a steady stream of work income for years into the future.

For the purpose of demonstration, I have assumed in this article that the median household has another 20 years of expected annual income. This is simply an illustrative example that applies to the slice of the population that is between 40 and 50 years of age. Young members of the workforce will have a longer earnings' horizon, while older members will have a shorter one.

Consequently, let's construct an alternative table to the one that is presented here and take a look at how much more dramatic the decline in household wealth is compared to how it has been presented in the media. Let's see how much this loss of real estate and financial portfolio wealth is negligible in relation to lost wealth due to reduced earning power.

When you take into account the present value for 20 years of labor income, it is revealed that a decisive majority of household wealth lies within the combined annual income of the household's members, and not in the market value of real estate and financial assets. Based on the calculation done here, the median household has lost $129,000 dollars of its net wealth over three years. Two-thirds of this loss of wealth derives from a drop in joint household income, and only one-third comes from a drop in asset portfolio holdings, including owner-occupied housing. Even this figure provides only a partial picture at best, since a drop in asset value really only represents a decline in paper wealth. In contrast, lost potential earnings are a cash flow loss that affects a household's real purchasing power for everyday goods.

This is the economic problem faced by the West today. It's not the drop in housing prices, nor the plunge in company share prices, nor even the bailouts by the world's financial institutions. The true problem is with the decline in joint household income – a phenomenon that has affected us here in Israel as well. Income levels are simply plummeting and remain in free fall, certainly in real terms, and in the near future in nominal terms as well.

This is what embitters the lives of many and will lead to economic and social problems -- and no twist or any other type of dance can solve it.

The writer is the CEO of Psagot Compass Investments.