The Wealth Delusion

Often in these pages we have attempted to hammer home the difference between investment and speculation. The former creates wealth, the latter consumes it. The former is based on work, the latter is based on rents. Investment increases the wealth of society; speculation appropriates wealth created by others. It is a distinction that has been lost in the last 30 years, and with disastrous consequences. Just how much the line between investment and speculation has been blurred is documented by Tom Streithorst in the pages of The American Conservative. Tom points out that,

In the past four years, America’s 500 largest corporations made a profit of $2.4 trillion, more than 4 percent of GDP. Did they use it to increase productive capacity, improve quality, or strengthen their balance sheets? No, $1.7 trillion went for stock buybacks and $900 billion for dividends. Of the $2.4 trillion they made, they passed on $2.6 trillion to their shareholders. They gave away more than they made and invested nothing.

Investment, as defined by Adam Smith, Max Weber, and most economics textbooks, is the use of deferred consumption for the purchase of capital goods, which create a cash flow in the future. For the past generation, however, when most of us used the word “investment,” it meant that a greater fool could be found to buy our house or share of a derivatives contract for more than we paid.

A society that does not invest does not grow. It may appear to grow for a time, but this will turn out to be a delusion. The delusion is based on rising asset prices, which make people feel wealthier, even when they are actually poorer. So when a person rejoices that the price of his home has doubled, he does not think that so has the price of replacing it, so have the taxes, the insurance, and everything he puts in the home. He thinks that his home is his best investment, and that he doesn't really need to save; rising home prices will see him through retirement.

And yet, when his three-bedroom home doubles in price, does it magically become a six-bedroom home? Does its utility increase in any way? There may be some actual increase in value, due to population growth in the area, but the house in general is no more useful than it was at half the price.

The history of the real growth of the economy indicates why the recent asset inflation was not growth at all:

Barry Eichengreen, perhaps the leading economic historian of the Golden Age, tells us that much of the growth in Europe after World War II was due to a social pact. Labor agreed to restrain its wage demands, and in return, capital agreed to reinvest most profits into the business. As productive investment rose, so did worker productivity, and between 1950 and 1970 real wages more than doubled. Investment in productive capacity works: it makes the entire society richer—entrepreneurs, bankers, and workers alike.

That compact has broken down. As finance has grown to dominate the rest of the economy, with interest payments as a share of GDP rising from under 1 percent to over 16 percent, real productive investment has declined. If you build a factory or invent a new product using borrowed money, you create a cash flow that allows interest payments to be paid no matter what happens in the financial markets. But when “investment” creates no new productive capacity, when the link between financial investment and the real productive economy is broken, finance becomes a faith-based enterprise in perpetual asset-price increases. When that faith begins to crumble, the debt structure has no foundation to hold it up.

To those who understand the distinction between investment and speculation, the current crises comes as no surprise. But it also points to the way out of our dilemma, a way that is, alas, not being taken by the Obama administration:

The current crisis gives us an opportunity to rethink the link between the financial and real economies. For too long, those working in the productive economy of goods and services have subsidized bankers and traders who have done little to make the rest of us richer or more productive. Since we are bailing out their stupid bets, let us insist that from now on their investments serve our common future. We can no longer afford paper “investments” that merely represent a hope that since asset prices have gone up in the past, they will continue to do so forever.