Debt Deflation and the Illusion of Wealth

Listening to our friends on the financial media, one is tempted to think that skillful investors are somehow able to dodge the flaming asteroids of inflation as they fall to earth.  See the last few minutes of the latest installment of the David Twohy film “Riddick” starring Vin Diesel for the visuals.  

The idea of an object falling from space as a metaphor for inflation may surprise some readers of Zero Hedge, but our friend Marc Faber likes to remind us there are many ways to lose money from inflation.  Chief among them are asset bubbles instigated by the monetary emissions of reckless central bankers who pretend, at least, to believe that they can solve problems like unemployment by merely debasing our beloved fiat currency.

The whole notion of value and wealth in a fiat monetary system is relative, especially following a major catastrophe such as the Second World War.  The history of the US of course paints the WWII period as a victory for democracy, but the fact is that the disruption and dislocation caused by that conflict and the subsequent surge in population we loving refer to as the baby boom is still being felt.  My friend and mentor Alex Pollock, Resident Scholar at American Enterprise Institute, puts it nicely in a draft essay entitled appropriately “Wealth” and Illusion:

“Before 2007, central bankers convinced themselves they had created a new era, “The Great Moderation,” but what they actually presided over was the Era of Great Bubbles.  In the U.S. we had first the Great Overpaying for Tech Stocks in the 1990s, then the Great Leveraging of Real Estate in the 2000s,” Pollock writes.  “Inevitably following each of the great bubbles was a price shrivel.  Then many commentators talked about how people “lost their wealth,” with statements like “in the housing crisis households lost $7 trillion in wealth.”  But since the $7 trillion was never really there in the first place, it wasn’t really lost.” 

To the real estate bubble of the 2000s, we could add the more recent rebound of the housing sector and stock prices.  But in truth, if you take the distressed transactions out of the time series, the rebound in home prices over the past 24 months is probably in single digits.  Meaning no offense to the investors in Invitation Homes 2013-SFR1, a rent securitization collateralized by one floating rate loan secured by 3,207 single family rental residential properties, the peak in US home prices in this “cycle” probably coincided with the initial public offering of RMAX.  

More to the point of wealth illusions, consider the latest run up in the Dow and other equity market indices.  Somehow commentators in the financial media are able to talk into the camera with a straight face about investor gains in stocks, this even as the central bank is robbing consumers of real purchasing power via a steady inflation of the currency.  If the major stock market indices are at all-time highs, but the supposed risk free rate is zero, what does this imply?  Are we all wealthier because the Dow is at 15,000 or is the whole point of quantitative easing merely to boost “confidence” as the Fed’s own policy statements suggest?  Again Pollock:

“Common calculations of aggregate ‘wealth’ take the entire stock of an asset class and multiply it by the bubble prices, on the theory that financial value is what you can sell something for.  Of course, some clever or lucky individuals succeed in selling at the bubble highs, but the aggregate bubble prices can never be realized by sale.  As soon as any very great number of the owners of a bubble asset try to sell it, the bubble collapses, the evanescent “wealth” disappears, and the long-term trend reasserts itself.”

And what is the long term trend for wealth creation in America?  Pollock suggests that it is about 2% a year in real, inflation adjusted terms.  “The rate of increase may seem modest, but in fact represents a miracle of the market economy,” he notes. While this rate of increased in aggregate wealth may reassure those who care about long terms trends, it also suggests that the latest increase in equity market valuations are greatly exaggerated and probably not sustainable.

Of course the neo-Keynesian socialists who dominate the economics profession like us all to believe that the “wealth effect” of rising home or stock prices is real, but in fact, like most economic notions, it is merely an illusion foisted upon all of us by a servile financial media. Income and production, not asset prices, are the real bases of wealth.  

If you tell people the truth; that real wealth can only ever rise 2% per annum on average, nobody would give a hoot about the global equity or bond markets.  Humans like dogs and fish, prefer to chase the shiny object rather than let time and hard work grow wealth slowly.  The whole notion of the “wealth effect” is a canard and should not be mistaken with real affluence. 

Home prices, as with aggregate wealth, only really ever increase at the rate of population growth.  So if the population of households and home owners is actually declining, as it is today, what does this imply for future home price appreciation and personal wealth?  If Case-Shiller is rising at a 12% annual rate, does this not imply that home prices must soon decline to be consistent with long-term price trends?  

But as Pollock notes, “per capita wealth of the sustainable kind grows at 2%, with the inflations and shrivels of bubbles netting themselves out.  With this trend increase, in a lifetime of 83 years, Americans will on average grow five times as wealthy.  Along the way, they should avoid confusing the ‘wealth’ of bubbles with actual aggregate wealth.” 


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