Wealth Destruction

I’m on a blog break this week and all posts are reruns. The next new post will appear in the new year. This post originally appeared on 26 March 2009 on The Finance Buff. Visit the original post for comments.

In 2008 U.S. households lost just over $11 trillion in wealth, or 20 percent off the 2007 peak. Most of that loss was in the value of housing and equity holdings. Some have asked, “Where did the money go?” (Google this phrase and you’ll see it is a hot topic.) This question is actually pretty easy to answer, and I will do so. But I also find it interesting to explore why it is asked.

First of all, when asset values are growing very few ask, “Where did the money come from?” Perhaps we take for granted that asset prices rise over time and rarely stop to think about the source of the value. Nevertheless, when things go bad many people want to know where their money went.

But assets like houses and stock shares are not money in the same sense that cash, checking account balances, or money market funds are money. Such financial assets are valued in money (dollars in the U.S.) and are bought and sold for money, but they’re not money: houses are shelter (clearly not money), an equity share is a unit of corporate ownership (not money either). In fact, for the purposes of considering abstractly their market value you can think of stocks and houses as consumer goods, like toasters or iPods.

The value of an asset is determined by the market: supply and demand. The price today is different than the price yesterday or tomorrow. Maybe yesterday everyone wanted an iPod so it had a high price. Tomorrow everyone decides to buy the new brain implant and the iPod’s price plummets. The value of all those iPods on shelves or in circulation drops.

The same thing happens to houses and stocks. When the market for them weakens, wealth is destroyed, but only insofar as wealth is measured by the value of those assets. No actual money is destroyed, and nobody gets an offsetting gain. No money went anywhere.

Fundamentally, numbers are abstract. When you subtract two from four nothing tangible is destroyed. Nevertheless, the answer is two. Where did the other two go? I guess the same place it came from. There is not a fixed supply of twos. The price of a house is just a number. It goes up and down. When it goes up we say that there is more house-wealth. When it goes down, some wealth has been lost. Still, no money has been destroyed since houses are not money. Nobody gets an offsetting loss when your house appreciates, and nobody gets an offsetting gain when it depreciates. The money value of houses (or assets in general) doesn’t go anywhere.

Why do we ask, “Where did the money go?” during an economic downturn? Why is there a notion of conservation of the money value of assets, that everything is zero-sum? I think the confusion stems from two other ideas in finance and economics. One is the zero-sum nature of a transaction. When I buy a toaster from you for $20, my $20 becomes yours and your toaster becomes mine. There is no overall change in money or toasters between us. Both obey the law of zero-sum (my gain is your loss, and vice versa).

Another concept related to the conservation of money is the size of the money supply. The total amount of cash in circulation is fixed, until the Treasury Department prints more. We do not normally think of cash being destroyed, of piles of currency going up in smoke. (Currency can devalue so there is a sense in which it isn’t that different from an asset. Let’s not go there.)

So, if we have the notions of zero-sum transactions and a fixed money supply we are easily tricked into thinking wealth cannot be destroyed in aggregate. My loss must be somebody’s gain. The money must have gone somewhere. But, as I said, assets are not cash. And, while a transaction may be zero-sum, what happens later to the value of the assets that were transferred is not zero-sum. When the toaster I bought from you depreciates to $10 you still have the $20 I gave you. That I may now only be able to trade my toaster for $10 on the secondary toaster market has nothing to do with the $20 I paid you for it. You do not achieve any further gain for my loss of toaster-wealth. My declining wealth in toasters is my own, offset by nothing.

So, where does the money go when wealth is destroyed? Answer: the same place the two goes when you subtract it from four. It was a number. It wasn’t money. Wealth, yes, with value denominated in money, yes. But money itself, no.

Hidden information below

Subscribe

Email Address*