Wealth destruction?

Can wealth have really been destroyed if it never really existed?

“Between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half (*)

I don’t see this as wealth destruction.  Fundamentally, people have realised that wealth they thought existed doesn’t exist.  House prices will not be as high in 20 years as they thought, the value of capital is not as high as the firm owner expected.

Realising this, firms and households are cutting back expenditure – they have spent too much on the past, by borrowing on wealth that would never appear.

The fear is that households and firms will over-react.  They may suddenly believe that their wealth level is lower than it really is, and they may buckle down too much.

Ultimately, what the author of that quote is arguing about it is an issue of expectations – not of “wealth creation or destruction”.  Once we realise this, it becomes obvious that trying to “increase wealth levels” by arbitrarily throwing money at people isn’t the answer – managing expectations is the answer.  Maybe …

  • moz

    But since wealth in the sense you’re using is imaginary, surely it is accurate to say that it has reduced?

    I thought “wealth” in economics was an attempt at an abstract measure of happiness (or wellbeing), and so saying that people have become noticeably less happy in the last 12 months is entirely accurate. The fact that some imaginary numbers have changed to match surely validates the theory, at least in its broadest terms. Even though the causality is probably the other way round it still validates the link between happiness and the magic numbers you’re talking about.

  • Hi Moz,

    “Wealth” is the sum of lifetime income effectively. Peoples ex post lifetime income hasn’t been destroyed – if a house was blown up it has been destroyed, but houses aren’t being blown up.

    What has changed is households expectations of their lifetime income. As they borrowed on the basis of a level of “wealth”, and they have now discovered that this wealth is lower, they have “over-borrowed” relative to where they would have. In such a situation it makes sense for people to stop, take stock, and increase their savings rates.

    So it is accurate to say that expected wealth has fallen – but I don’t think it is accurate to say “wealth has been destroyed”. I don’t think it is possible to destroy something that never existed.

  • Could the people have converted the estimated wealth into actual goods of that value at the time? If so, is it still ‘imaginary’ wealth?

  • “Could the people have converted the estimated wealth into actual goods of that value at the time?”

    Good point, good point.

    In this sense I would say that the current crisis is a “redistribution” of wealth rather than a destruction then. By not selling the property for an inflated price the current owner has effectively given a claim on resources to the person who did not buy at the previous price …

    Fundamentally, I am saying that aggregate expected lifetime income was higher than actual aggregate lifetime income – once people realise that it makes sense why we would see household’s react by cutting back spending.

    I agree that it is the same reaction to “having wealth destroyed” – I just don’t like the analogy because actual lifetime income hasn’t been negatively impacted, the expectation of actual lifetime income is what has changed.

  • “actual lifetime income hasn’t been negatively impacted, the expectation of actual lifetime income is what has changed.”

    Hmmmm, the distinction between expected and realised incomes is not something I really know about. If you can borrow against it, lend it and realise it at any time then the expected income has realised benefits. How real does the wealth need to be before ‘it exists’? Maybe agnitio knows something about asset valuation that would be useful here???

  • “If you can borrow against it, lend it and realise it at any time then the expected income has realised benefits”

    For the individual yes. But in aggregate terms there is only so much actual wealth avaliable over time – when the individual “borrows it” or “realises it” another person must be “lending” or “buying”.

    The fact that the price of a house has fallen doesn’t mean that national income has declined – it is a transfer of wealth from the home owner to a hypothetical home buyer. Falling asset prices don’t destroy production – underutilized resources, or a misallocation of resources, leads to a reduction in production.

  • moz

    @rauparaha

    I’m questioning the link between dollars and happiness. On the one hand I’ve read that money is used as a proxy for happiness because economists haven’t managed to measure the latter, but here you’re talking as though money is the thing being measured.

    I agree that for those who sold allegedly inflated assets the money they got is real, and in that brutal “things are worth what you get when you sell them” sense, we have seen a dramatic fall in how much money things are worth. Tautologically true.

    Is there research on the counter-cyclical value of money? Seems that when there’s lots of it about people are more inclined to use it as the measure of all things, but when there’s less people start focussing on non-monetary wealth. Or is the value of money in those terms nonsensical to economists?

  • @moz

    Hi Moz.

    Even if we say that people have less happiness than they did 12 months ago – could this not be the result of them “borrowing” on future happiness over the preceding period

    Rauparaha and myself are focusing on production and wealth because we can measure those things. Once we understand the trade-off associated between these things we can move on to discuss the trade-off associated with social happiness – but not before.

  • There is no absolute standard of value. “Wealth” itself is tied to the means of exchange – money – and money goes up and down by the hour.

    If people all thought something was worth a roughly some amount (give or take some minor proportion) than that IS what it is (was) worth. If something happens that changes that shared view in a downward direction, then wealth as certainly been “destroyed” in so far as the value of thing in question has declined. Of course this value isn’t realised until the item is actually exchanged….so such changes are both unreal (not realised) or real (realised – or revalued for accounting reasons).

    In December, the NZ $ was worth 58 cents US. Now it is worth about 50 cents US. When buying goods valued in US$ (which includes most of what we make here in NZ, too) then we have all had a huge pay cut in the past 10 weeks.

    That is destruction of value and wealth and it is very real. It is also entirely dependent on what the people in that market are willing to pay today….in other words, their shared view of the value of the things.

    It’s all in our heads. Period.

  • “In December, the NZ $ was worth 58 cents US. Now it is worth about 50 cents US. When buying goods valued in US$ (which includes most of what we make here in NZ, too) then we have all had a huge pay cut in the past 10 weeks.”

    Yes, in the short run when wages are fixed this is indeed a pay cut. Although, on the otherside of the ledger, there are people in NZ who get paid in $US (exporters) who have had a huge pay increase as a result of this change – exchange rate movements redistribute wealth between exporters and importers.

    “There is no absolute standard of value. “Wealth” itself is tied to the means of exchange – money – and money goes up and down by the hour.”

    There is relative prices here – when the price of something falls is does not mean that incomes have collapsed, it means that the good is now cheaper relative to other goods.

    When the price of a house falls the person with a house does end up with a lower lifetime income – but the “person” who brought the house can do so without giving up as much other resources – increasing their real income.

    Overall, I’m not convinced that a fall in house prices constitutes a “destruction of wealth”. The negative impact stems from people borrowing from overseas to fund consumption now – because they think that the inflated house price is wealth, when it is illusionary.

    In this case, the popping of the housing bubble will lead to people drastically increasing savings – as it should. The only question is “do household’s go too far the other way”? Has their expectation of house prices now gone too negative? I don’t think so – which is why I don’t think we can implement policies to help any crisis stemming from a domestic housing bubble.

    Furthermore, in terms of international wealth – I think this all counts as a transfer from borrowing countries to lending countries. As long as the borrowing countries don’t default (or inflate the value of their dollar) they have realised their lifetime income is lower than expected in terms of the goods that people overseas sell.

  • @Matt Nolan
    Haha, a transfer of wealth from my expected future self to a hypothetical future buyer? This wealth thing seems to involve an awful lot of non-existent people!

    “Falling asset prices don’t destroy production – underutilized resources, or a misallocation of resources, leads to a reduction in production.”

    I’m curious about this. If asset prices fall then people’s lifetime expected income has decreased. Consequently they choose to save more and spend less now. Doesn’t the decrease in aggregate demand lead to a drop in production and underutilized capital, relative to the previous level? I know my macro is pretty poor so I am looking for guidance here, not trying to nitpick 😉

    @ moz

    As Matt said, we don’t measure happiness by wealth; however, when wealth increases, happiness usually does too. So we might use the direction of movement of wealth as a proxy for the direction that happiness is moving in. I think trying to tie them any closer would go too far.

  • “Doesn’t the decrease in aggregate demand lead to a drop in production and underutilized capital, relative to the previous level? I know my macro is pretty poor so I am looking for guidance here, not trying to nitpick”

    You are 100% correct – that is exactly how people see it.

    However, I don’t really like this conceptualization of AD – as it only seems to be partial, there is no price adjustment.

    Fundamentally, aggregate wealth must stem from the aggregate claim on resources – changing house prices does not influence the aggregate production function, and it does not influence the set of resources. What it does influence is relative prices.

    If prices are unable to adjust, then we can end up in a situation where resources are under-utilized. This is why I often mention market failures in the labour or credit markets. If the real wage does not fall when people realise that lifetime wealth is lower – then supply for labour will exceed demand. This is because people will stop borrowing from overseas to fund consumption, and as a result the static marginal product of labour will fall.

    In this case we have under-utilized workers. If prices could adjust then we move back to equilibrium in the labour market and everything is cool.

    However, if this is the case the relevant market failure is the fall in house prices – it is the lack of price adjustment in the labour market. As a result, the best solution is too have a flexible labour market – not to mess around with the asset market.

  • “there is no price adjustment”

    I meant relative price adjustment – sorry.

    The change in house prices is a relative price change – but it does not influence the aggregate production function.

    If prices can adjust we can appeal to Say’s Law to say it is fine (supply makes its own demand). If prices don’t adjust then we can bitch about how prices should adjust 😛