The Conceit of Central Bankers and the Brief Illusion of Wealth

Before the current yield-seeking bubble implodes, I expect, in the same manner as every prior speculative episode across history, it’s worth examining the key conceit of the central bankers that produced it. The misconception is straightforward, and is the same notion that ultimately produced the yield-seeking mortgage bubble that imploded into a global financial crisis less than a decade ago. It is the false belief that “wealth” is embodied in the price of an asset, rather than the stream of cash flows it delivers over time. That belief is quietly reflected in every reference by central bankers to “wealth effects.” It is equally reflected in memory-impaired statements suggesting that, in response to recovering home prices, families should begin extracting some of that “wealth” as a way to finance more spending.

I use the word “conceit” for these views because they are more than just ideas. Rather, they reflect a self-congratulatory delusion that by distorting asset markets, central bankers themselves can be credited for having created “wealth” for their nation.

The problem is this. While encouraging yield-seeking speculation may boost the paper price of an asset, the only way to “capture” that gain is to sell the same overvalued asset to someone else. The elevated price does not reflect wealth creation, but merely creates the opportunity to obtain a wealth transfer from some poor soul who will end up holding the bag. Over time, the only true “wealth” embodied in the asset is realized via the long-term stream of payments that the security delivers into the hands of successive holders.

Those cash flows themselves must come from somewhere. Indeed, from the standpoint of the full economic equilibrium, we can go even further in describing what actually constitutes “wealth.” As I detailed in Stock-Flow Accounting and the Coming $10 Trillion Loss in Paper Wealth:

“When one nets out all the assets and liabilities in the economy, the only thing that is left - the true basis of a society’s net worth - is the stock of real investment that it has accumulated as a result of prior saving, and its unused endowment of resources. Everything else cancels out because every security represents an asset of the holder and a liability of the issuer. Conceptualizing ‘saved or unconsumed resources’ as broadly as possible, the wealth of a nation consists of its stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, inventions, organizational knowledge and systems), and its endowment of basic resources such as land, energy, and water. In an open economy, one would include the net claims on foreigners (negative, in the U.S. case). Understand that securities are not net economic wealth. They are a claim of one party in the economy - by virtue of past saving - on the future output produced by others.”

To illustrate the scope of central bankers' conceit in this speculative episode, the chart below shows household financial assets as a ratio of household disposable income. Certainly, the immediate impression is that households have never been as “wealthy” as they are today. So take in this chart for a moment, but hold on for the one that follows next.

One of the features of the foregoing chart that might create a reason for pause is the collapse in the ratio of household financial assets to disposable income during 2000-2002 and 2007-2009. Somehow, the asset valuations don’t seem to be as durable as one might wish, and indeed, we can show that this is the case. High valuations are simply followed by correspondingly weak subsequent returns.