Pragma Synesi – interesting bits

Compendium of interesting bits I come across, with an occasional IMHO

The nature of wealth

Financial assets are  a claim on real wealth, not outright wealth.  From the October 8th 2009 edition of The Economist:


The nature of wealth

The world confused financial assets with real ones

AT THE heart of the current crisis is a fundamental confusion about the nature of wealth. Think about it from the perspective of a Martian. Were an extraterrestrial to be shown a room full of gold ingots, a stack of twenty-dollar bills or a row of numbers on a computer screen, he might be puzzled as to their function. Our reverence for these objects might seem as bizarre to him as the behaviour of the male bowerbird (which decorates its nest with shiny objects to attract a mate) seems to us.

Wealth consists of the goods and products we wish to consume or of things (factories, machinery, an educated workforce) that give us the ability to produce more such goods and services. Financial assets arise from the desire to postpone consumption so that money can be saved, either for precautionary reasons or to invest so that more goods and services can be consumed in the future.

Looked at in that way, financial assets are not “wealth” but a claim on real wealth. If those claims multiply or rise in price, that does not mean aggregate wealth has increased. If a pizza is cut into eight instead of four slices, there is no more food to eat. If everyone sitting at the table is given shares in the pizza and the share price rises from $1 to $2, the meal will still be no bigger.

The fundamental reason why equity prices rise over time, for example, is that they are linked to the goods and services being produced by companies. As the economy grows so do the revenues of such firms. Assuming margins stay the same over time, profits will also rise and cashflows to shareholders will increase.

This truth is obscured by the business cycle, which causes revenues and margins to fluctuate, and by the vicissitudes of investor sentiment, which cause shares to be derated and rerated (the dividend yield to rise and fall). A rise in share prices that is caused by a rerating does not make us richer in aggregate, unless that rerating represents an accurate prediction about an improvement in an economy’s long-term growth rate.

People nevertheless use the stockmarket as a barometer of economic health. So a rise in equity markets can be (and has been) seen by governments and central bankers as evidence that the economy is headed in the right direction. That can lead to policy mistakes, such as a lax monetary stance, and further irrational exuberance.

Housing is more complicated than the stockmarket since people get utility from their homes (shelter, relaxation) while simultaneously treating them as assets. Even so, a rise in house prices that outpaces GDP growth does not make a society richer. Instead, all that is achieved is a transfer of wealth from first-time buyers to retirees exiting the property market.

In theory house prices can rise faster than GDP for a while if citizens decide to devote more of their incomes to housing services (for example, they may prefer a bigger flat to a bigger car). In practice it is hard to disentangle such structural shifts from the speculation that is prominent in all property booms.

It is the link between speculation and asset prices that explains this crisis. The ability to borrow money to buy assets fuelled the rise in asset prices. And the wealth effect of higher prices persuaded those in English-speaking countries to borrow money to sustain consumption.

Not long ago the BBC transmitted a programme about credit-card use. One man said he felt “wealthier” because he was given a credit-card limit of £5,000 ($8,000). Of course, once he used the card he was poorer. Not only did he have to repay the £5,000, but he had to service a double-digit interest rate as well. Similarly those who buy an overvalued asset with borrowed money have not made themselves richer but poorer.

Thinking about wealth in this way is also useful when assessing rescue packages for the economy. Will these policies boost the amount of goods and services the economy produces in the long run, or will they have consequences that actually restrict economic activity? Does quantitative easing really boost wealth or simply create more claims on the same underlying pool of assets?

Central banks have repeatedly intervened to rescue financial markets, or paper wealth, over the past 20 years. But have they propped up prices at levels that simply do not reflect the long-term fundamentals? The ingenious schemes of John Law, an 18th-century financier, to hold up the share price of the Mississippi trading company broke down in the end because the delta was not the El Dorado he promised investors, but a fetid swamp.


October 19, 2009 - Posted by | economics, investing | , ,

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