Illusory Wealth

The Federal Reserve recently reported that the net worth of American households grew by $9.8 trillion, or 14 percent, last year. $5.6 trillion of this increase came from the stock market and $2.3 trillion came from rising home prices. The increase in household net worth is also called an increase in household wealth.

This increase is a good thing. Individual households, on average, have a higher net worth or wealth, which, by spending it, can be realized in the form of more goods and services consumed. However, households as a group cannot realize more consumption of goods and services since the quantity of goods and services available does not rise with stock or house prices. The fallacy of composition is at work.

The most familiar example of the fallacy of composition is that you can see better at a football game if you stand up. However, it doesn’t work if everybody stands up. The advantage is real only if most people don’t try to realize it.

The fallacy of composition is fairly obvious in monetary economics. Give individuals more money and they are wealthier. They can buy more stuff. However, giving the economy more money doesn’t, per se, make an economy (all of us) wealthier. There is not immediately more stuff to be bought. More money involves money illusion, except for those that win the race to the store. The same is true of wealth that can easily be converted into money for spending.

Does counterfeiting, which creates more money, albeit fake, create wealth? Yes for the counterfeiters who get away with it. They can exchange their fake money for real goods and services. However, since there are not more goods and serves to be had, their benefit is at the expense of the rest of us, who have the same amount of money and other wealth, but fewer goods and services available to us.

There is a fundamental difference between income and wealth and between wealth created by higher real incomes and saving and wealth created by rising housing and equity prices. Higher income increases wealth both in money terms and in real terms. The additions to wealth through income are matched by an equal value of additional goods and/or services being produced.

I started by saying that the reported increase in household net worth or wealth was a good thing. By making us feel better about our finances, a “wealth effect” can increase our willingness to spend and thus create real wealth if we have sufficient slack in the economy. But, if you want to cash in some of that money wealth, you’d better beat your neighbors to the mall.

 

Comments (14)

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  1. Glen says:

    The “wealth” from owning stocks is the cash flow from future earnings/dividends. If the price of those future earnings increases, that’s inflation, not wealth. Higher stock prices just make it harder to purchase additional future cash flow.

    • Marvin McConoughey says:

      I agree, Glen. The best time to buy stock in my view is when prices are low relative to dividends. Missing, of course, is any reliable flashing green light to identify that point. Still, an adult lifetime of stock buying and dividend reinvestment has done very well for a great many people. Even putting money under the mattress for 30 years and suffering the buying power decline would leave most people better off than spending it on drugs and tobacco.

  2. Lucas L says:

    Also considering that the increase in wealth occurred due to the price increase tied in long term assets, the wealth is illusory, not actually realized just now. Regardless of the increase in the house price, only a small percentage of households will actually sell their home and most of them they had already made their mind about selling it in the first place (regardless of price). The increase in stock markets signals that the economy is performing better and that boosts confidence and thus spending. But, because the majority of the investors are holding to their position, as we are in a bullish market, the wealth is not realized either. It is true the increase in wealth is an illusion, yet because people believe in this illusion, they will spend more, and generating income in the process.

  3. Alberto D says:

    Is this an indication that the economy is going to improve or that a new bubble is being created in the economy? You can build a case for either one. As Lucas said that the illusion will lead to higher spending and consumption. But, if we spend money we don’t have, a bubble can be formed if we are spending in things that have an artificially high price. In your opinion, which scenario is more plausible? Thanks.

  4. Gregory T says:

    It looks that the economy is picking up; the increase in household wealth reflects that. Although it hasn’t been realized just yet, it gives us a positive outlook. More opportunities will arise as the economy turns, let’s hope that we can leave the Great Recession behind and start focusing on how to prevent the next one.

  5. Bernard K says:

    You compared the increase in household wealth to the gains of counterfeiting. Does it mean that those who are increasing their wealth are doing so in the expense of others? Or that their additional wealth, which is not realized, comes from the pockets of others?

    • Marvin McConoughey says:

      Bernard K. Thanks for a good question. Whether those who increase their wealth do so at the expense of others has to be determined on a case-by-case basis. Bernie Madoff victimized many of his clients. Someone who sells a production-increasing tool to a buyer may be helping both to increase wealth. It is partly up to the buyer to know what his investment and to make good use of it.

  6. slotowner says:

    This summation is inaccurate because the US is not the only source of goods, wealth, or production. The US is only a part of the World economy. It can cash its wealth to buy a bigger portions of what the world produces.

    The real issue is whether wealth increase due to Home Equity & Financial assets are real or illusionary. When you look at household wealth it is made up Home, Financial Assets, & also ran. Most of what a household owns is a home & savings either in a bank or something financial. Anything big, valuable, & productive is usually owned by a company & the stock in that company is owned by a household. You can have fake inflationary rises in these categories but usually they increase because they have built a whole bunch of long term valuable stuff.

    Most of what makes people happy are usually consumed or in the also ran assets category. When their wealth rises they can sell a bit of their productive stuff to get a good amount of this. This has been why the World living standards have been improving for centuries just like World Household wealth has been rising.

    If Mr. McTeer thinks that this increase is a bubble, I’d like to hear his support but his general idea that this increase is an illusion because it is base on financial & housing is bogus. That has been the means for the increase since the 1900’s.

  7. DNB says:

    Maybe an extreme scenario is to give out one million bucks to each household and ask whether people are feeling richer and the economy is improving?

  8. DNB says:

    Packing trash will always lose badly, as trash is always trash. Lipsticking a pig is a trick played by market makers for years. My next door neigbor would pay multiple P/E prices for a hen that doesn’t lay eggs. I won’t.

  9. BigEd says:

    It is hard to believe that Mr. McTeer was actually a President of one of the Federal Reserve Banks — and therefore he had some significant influence over the monetary policy of the world’s largest economy.

    Increasing household net worth certainly does lead to increased household consumption; and increased household consumption leads to increased business output — which leads to increased business investment, which leads to higher employment, which leads to increased tax revenues, etc., etc.

    At a time when the nation’s economy is operating well below full capacity increased household net worth is something to be cheered. The Fed — with its very low interest rate policy — has done what it can to pull the economy out of its doldrums. Judging from Mr. McTeer’s comments here he thinks that effort was not worthwhile.

    The best thing that can be said about this article is that Mr. McTeer is confused: ‘money illusion'(??); counterfeiting (??).

    Richard Fisher is somewhat of an improvement: he at least sees the dangers of disproportionately oversized banks.

    • Marvin McConoughey says:

      Hi BigEd As usual there are short term and long term outcomes of economic policy. The use of stimulus can, sometimes, help the economy short term. It is far less certain that it helps an economy in the long term. Despite thousands of economic studies, the long term forecasting ability of economists remains slight.

      My belief is that stimulus long term outcomes are unknowable.

      We have now had several months of small inflation increases and it will be interesting to see if this is temporary of the beginning of a longer term trend. Fed Chairwoman Yellen’s assurance to Congress that the Fed can control inflation may have some short term validity. She and her colleagues have no magic insight into the longer term future.

  10. Randall Burns says:

    I would be careful here. Increases in the value of land and stocks is a bit different than real, tangible investment or even R&D. The first may reflect simply greater investor confidence in long term stability.The latter is more related to actual creation of wealth by true capital investment rather than speculation.

  11. Auguto says:

    Hi, im from Spain. movements of the economy are uncertain but we can always predict the future in some of its factors. Economic studies are of great importance.
    Thanks for your information, always very interesting