Financial Wealth Illusion and Bubbles

Published on October 8, 2009

The Economist published an insightful article today regarding the nature of wealth.  The article merits some additional thought given the relationship between the nature of bubbles and the illusion of rising levels of financial wealth that are not backed up by claims on rising levels of real assets.

The main premise of the article is simple enough.  Real wealth is represented by goods or products that individuals wish to consume or things that allow for the production of more such goods and products in the future:

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.

As the article points out, financial assets are really just a claim on real wealth and the only purpose of accumulating financial assets is to defer consumption in the hopes of being able to purchase more goods and services in the future through intelligent investments.  Even savers who are not motivated by consumption in the future are implicitly counting on their financial assets to be converted into real assets at some point either by their heirs or charitable organizations they support.

Why is this relevant to the formation of financial bubbles?  Most bubbles seem to occur when individuals forget that financial assets are really just claim checks on real wealth and start to see the financial asset itself as actual wealth.  If the price of a stock starts at a level equal to the value of its real assets and proceeds to double while the underlying assets owned by the company stays the same, the owner of shares in the company is no richer in terms of real assets but feels richer due to a rising quotation on the stock.

Obviously, if this individual converts the stock to cash at that time, he will have the opportunity to spend that cash on real assets, but the economy as a whole is no richer since the buyer of his share of the company is proportionally poorer for overpaying for the financial asset.

Investors can protect themselves against the tendency to equate financial assets with real wealth by making an assessment of the real assets behind a financial instrument.  While this is more intuitive when evaluating a business, the price of a home is also connected to its value as a real asset by the rental income that could be obtained from the asset.  Looking at the earnings yield, or capitalization rate, of real estate and comparing the rate to historical norms (and common sense) would have prevented the purchase of homes during the housing bubble in the most grossly overvalued markets.

If more individuals viewed financial assets as merely proxies for real wealth, there would be fewer bubbles because there would always be a “reality check” on the price of financial assets that would restrain wild speculation.  However, with human nature being what it is and the ability to quickly trade financial assets only increasing over time, it is optimistic to think that individuals will start looking at financial assets any differently than they have in the past.

On the bright side, while this is bad for the economy as a whole, it is good for investors looking for mispriced financial assets.

Financial Wealth Illusion and Bubbles
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