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.