The Shifting Sands of Economic Reflexivity

Different economies have leaned on distinct forms of financial market intervention to combat cyclical downturns at various points in history. Historically, policymakers have tended to respond to economic slowdowns by lowering interest rates and stimulating the housing market. However, economic reflexivity reveals that support for the economy can take many forms depending on the time and structure of the economy. Sometimes, support comes from massive infrastructure projects like high-speed railways. At the same time, in other periods, economies turn to fiscal measures like digging holes and filling them up—i.e., public works to create jobs.

Reflexivity—the idea that financial markets and economic reality feed off each other—offers a lens to see this change. In earlier eras, falling interest rates reliably spurred housing booms and consumer spending as homeowners refinanced and businesses borrowed cheaply. But now, the U.S. economy’s reliance has tilted heavily toward equity markets and asset valuations. While some cheer falling commodity prices or modestly declining bond yields as signs of relief, these are distractions from a deeper truth. A collapse in equity valuations would inflict far greater damage than any marginal benefits from lower risk-free rates, a reality obscured by the perpetual optimism of analysts and the political need to project positivity.

Behind closed doors, decision-makers must grapple with this new structure, where equity wealth underpins consumption, investment, and government revenues. Ignoring them risks misjudging the tools needed to avert a downturn. The noise of short-term wins—cheaper oil or a dip in long-term yields— should not drown out the evidence across economic dimensions. 

Consumption’s New Anchor—Wealth Over Income

For decades, American consumption was anchored by income—wages from jobs and business profits. But that foundation has eroded. Over time, the cost of living has outpaced income growth. Median wages have barely budged in real terms since the 1980s, while essentials like housing and healthcare have soared. 

Wealth has stepped into this breach. In early 2022, U.S. household net worth reached a staggering 8.3 times disposable income, far above the 5-to-6-times range of the 1990s. Even after a market pullback, it hovers around 7.5 times income, a level that has kept consumption humming despite dwindling savings. 

Visa’s research in 2023 revealed a seismic shift: households now spend 34 cents of every dollar of wealth gained, up from just 3 to 4 cents pre-pandemic. This amplified wealth effect explains why spending held firm in 2022 and 2023, even as pandemic-era cash buffers evaporated for most lower- and middle-income families.

Wealth dependencies are taking many forms. Employees cash out stock options from employers, retirees draw down swollen 401(k)s, and even notional gains in private holdings bolster confidence to spend beyond paychecks. 

In short, the increase in the cost of living has had minimal economic impact, largely because a significant portion of the population has been offsetting these rises through substantial wealth gains.

The Government’s Hidden Stake in Equity Markets

Government budgets, too, have grown entangled with asset markets. Capital gains taxes have ballooned in importance. They accounted for as much as 14% of federal receipts a couple of years ago. States like California feel this even more acutely; in 2021, capital gains hit 11.3% of personal income.

Beyond capital gains, other revenue lines amplify this link. Stock option exercises—common in tech and beyond—generate taxable income that spikes in bull markets and fades in downturns. Corporate taxes also rise with market-driven profits. This sensitivity to asset prices makes government revenues increasingly pro-cyclical. A market drop doesn’t just dent capital gains; it ripples through these interconnected channels, threatening budgets at a time when spending demands rise and the need to cut the fiscal deficit is also high. 

Investment’s Equity Addiction: Mega Caps vs VC/PE

Mega Cap concentration in the corporate sector aggregates hides underlying fragility in the broader market. Small and medium-sized businesses' funding needs have skyrocketed in recent years, but only partly because of depressed profitability. Others, especially newer ventures, were built on blueprints promising profits only after years of heavy investment.

Venture capital and private equity-backed firms are the beating heart of this investment landscape, pumping life into consumption through jobs and wealth creation. These outfits—responsible for 11% of U.S. private-sector employment, or over 12 million jobs, and 21% of GDP in revenue—rely on a steady oxygen flow of funding.

An extended drought in equity capital would spark quakes that ripple far beyond their balance sheets. Unlike the Lehman crisis—a deep, sudden jolt—these shocks might not plunge as low but could drag on longer, toppling dominoes across the economy. The collapses will not be spectacular, and the banking system may remain safe in general, but in many ways, the falls of a large number of start-ups and SMBs could be as economically, politically, and geopolitically damaging as the worst of the episodes from the past.

A funding freeze kills startups, stalls innovation, and critically harms the country in geopolitics, as we covered in our last article.

The Fading Power of Housing and Debt

Housing, once the economy’s reliable spark, has lost its punch. In past cycles, falling interest rates unleashed refinancing waves, putting cash in homeowners’ pockets and boosting spending. Today, that channel is clogged. Over 60% of U.S. mortgages carry rates below 4%, with nearly a quarter under 3% locked in during the low-rate era. With rates near 6.5% in early 2025, even a drop to 4% wouldn’t tempt most to refinance, leaving little room for stimulus through this route.

Commodity price falls have an even lesser ability to support. Like interest rates, their falls will help, but they cannot prevent the vicious-cycle risks from the higher cost of risk capital and wealth losses to falls in employment, business investments, consumer activities, and government revenues.

Stocks now rival homes in household wealth—$56 trillion in equity value versus $48 trillion in real estate by late 2024—and 61% of adults own them, nearing the 65.8% homeownership rate. Their liquidity makes them a more immediate buffer; families can sell shares faster than tap home equity at today’s rates. A stock crash, though, would hit harder and faster than a housing dip, given the impacts we discussed in this article.

If the Fed Wants to Do More Than Pay Lip Service

Policymakers must not be swayed by the siren calls from the President and a handful of prominent voices urging a singular focus on interest rate cuts to tame bond yields. If the goal is to bolster the U.S. economy genuinely, they must look beyond the cost of debt. To the extent that its regular measures help equities, with or without the desired impact on bond yields, they should count the steps as a success. But, rate cuts alone may not cause risk premia to begin declining. The sooner the policymakers begin working on preventing the fallouts discussed above, the more will be their effectiveness in preventing horrible outcomes.

History offers lessons. In 1998, Hong Kong bought stocks to fend off speculators, stabilizing its economy. Japan’s central bank owns chunks of its equity market to fight deflation. The U.S. Fed, in 2020, backstopped corporate bonds, lifting stocks and averting collapse. Direct equity intervention here is unlikely—lacking sovereign funds or political will—but the principle holds.

The courage to act preemptively is rare, given the likely interpretations of any move to support equities as extending lifelines to the rich and powerful. Banning short sales or mimicking Japan’s ETF buys feels far-fetched without a crisis. However, early and public recognition of where real economic risks arise will help, even if they do not stop those tweeting victories from oil price or bond yield declines.

Given the economic entanglements of the day, we do not see the wealth destruction aftermath.