Wealth Creation and Wealth Destruction
When Adam Smith wrote ‘The Wealth of Nations’ he laid the foundations of modern economic theory by exploring the relationship between wealth and money. Over the years this theory has developed but it has almost exclusively concentrated on money at the expense of wealth. This is a pity as the concept of wealth fills some of the spaces a pure money centric theory leaves out.
‘Wealth Creation and Wealth Destruction’ returns to the concept of wealth and its relationship to money. In doing so the book presents a number of new concepts central of which is defining wealth in the form of time, the time to create on the one hand and its useful life on the other By defining wealth in these terms provides a constant which along with other tools provides a fresh look at the dynamics of an economy. These tools include an alternative driver for money supply growth- interest rates dividing the economy into two- the real and that based on assets and redefining the human driver in economics from best price to compromise.
The result is a theory that accommodates Keynesian, Monetarist and other established economic theories but provides its own unique insights including a previously unconsidered form of inflation that offers an understanding and mechanism for hyperinflation, the policy of price stability, the Fisher Effect and an explanation for growth.
Within this framework the economic consequences of value, risk, the savings industry, international trade, booms and bubbles and the markets in a wealth context are considered. Finally ‘Wealth Creation and Wealth Destruction’ considers the future of western societies from this perspective and suggests that without significant changes, these economies face a bleak future.
The basis of the wealth theory is that money is too variable to be a measure of wealth and the solution is measure goods and services as a function of time, the time to create and the time it takes to consume. From this we can determine if that a wealth creation activity is one where the products’ life is longer than the time to create it and vis-a-versa. So in its simplest form a chair that may take a few hours to make will have a life of several years; if it is used within a factory it will be an act of wealth creation, but if it ends up in a home it is one wealth destruction. Hair dressing on the other hand is purely an example of wealth destruction.
The benefits of viewing wealth in this way, which I have coined the phrase richesse (Chapter 1), is in the aggregate. This allows the impact of all sections of an economy to be analysed including the non-productive parts such as the retired and unemployed. As the definition of profit will be the same in richesse term as monetary, richesse can be substituted for money in current economic theory with similar outcomes (Chapter 3). However the two start to part when value is introduced. Value is the need or want we place on a particular item of wealth. The richesse or life will remain the same but the price could vary for a variety of reasons. It is at this point that richesse provides a constant that money cannot. Its usefulness becomes apparent with inflation. This is well understood of which new money is often portrayed as the cause. However the same effect is produced by a reduction of richesse even when the money supply remains constant. The classic cases of hyperinflation, Germany, Argentina and Zimbabwe (Chapter 7), can be viewed in this context but similar and lesser forces are acting on all economies.
Clearly to understand inflation one also needs to understand how money is created. As with inflation this appears to be well understood; in a fiat system banks create commercial money and governments the new bonds to back it but the precise link is a vague. It is one of the premises of this book that the growth of money supply is directly linked to interest payments (Chapter 6) and this is borne out by historical data. Borrowing will fund new richesse creation and the interest payments associated with this new wealth expand the monetary economy to accommodate it. However borrowing is not limited to wealth creation but is commonly used to buy homes. Where the house is a new build this is new richesse but not for an existing home, in this case the money will be lent for existing richesse, the result is an increase in the money supply without any corresponding wealth; to use a calorific metaphor the money created is junk or empty pound or dollars. Thus borrowing for existing assets will introduce inflationary pressures (Chapter 11). These two points are illustrated by the experience of 1980s Britain with the sale of council houses combined with a monetary policy of high interest rates to control inflation but it led to the exact opposite.
Inflation can also be viewed through the Fisher equation P=MV/T. Traditionally the velocity of money and transactions are considered to be constants with money supply fluctuating with prices. However if we consider transactions to be a function of richesse an increase or decrease will have a similar effect. The basis of this substitution is that transactions are events where wealth will either be created or destroyed.
The volume of money in circulation is another important component to understanding an economy. This again is illustrated by the Fisher equation where an increase or decrease in the money supply has a corresponding change in transactions when velocity and prices remain the same. When an economy like the UK is looked at as a whole the money supply appears constant if not growing. However if we only concentrate on the real economy the money in circulation is much more variable due to saving and bank lending which in turn appears to be linked to GDP (Chapter 14).
This leads to the conclusion that the economy is divided into two parts the real economy and the asset economy (Chapter 10). There will be movement of money between the two but they can be considered parallel and separate to each other. This separateness allows them to operate in different ways, the real economy is generally Keynesian in nature as richesse can expand provided there is sufficient money and demand in the system as illustrated by the connection between GDP and money supply without necessarily impacting on prices (Chapter 6). The asset economy is different, as assets are derived from the real economy it is harder to create new ones so an influx of money will lead to price rises or a monetarist explanation (Chapter 10). It is the movement between the two that provides a driver for the economy. Savings and loan repayments pass from the real economy to the asset part and investments and loans flow in the opposite direction. When the flow is in the two directions equal to each other the economy is generally stable but invariably it is out of balance, leading to a contraction or growth.
At this point it is worth describing what an asset is to develop subsequent arguments. Assets are neither money nor richesse but a combination of the two (Chapter 8). An asset represents a future income, either from the future profits of companies or rents from properties and it is this feature that allows them to maintain a financial value and assets that are a store of value rather than money which is purely the trust invested in a token (Chapter 3). The intrinsic value of an asset will be based on its returns and any increase in price should represent an associated growth in richesse. Finally there may be more money entering the asset economy than can be usefully invested productively and as a reduced return is better than no return this causes prices to rise (Chapter 15). However any rise in asset price is usually associated with growth in the real economy whereas it is more likely have occurred due to an influx of money. This surplus money will often remain in the asset economy to become a commodity in its own right (Chapter 10) and with no reference to richesse or the real economy has all the appearance of operating in an inflation free environment where it retains its value despite prices rising.
There are three interesting points to note about this money as a commodity:
1) Generally saving with banks and other financial intuitions is seen as being beneficial to an economy as they are reinvested but when the saving is in the form of hoarding the money is removed from circulation leading to a reduction of transactions and richesse. However there is another way in which to view this; as new money is nominally the result of interest repayments which created new richesse then the two are related as subsequent wealth creation will be from the circulation of this money. When that money is removed from the real economy so its association with the richesse it represents will be lost. This will generally be the life of the wealth so bread will be almost instantaneous whereas houses will last decades. Therefore when money is returned to circulation after a period of hoarding it will be the equivalent of new money being injected into the economy and thus an inflationary pressure. Likewise the ‘money as a commodity’ in the asset economy will have also lost connection with richesse and can be considered a form of hoarding. The irony is that saving this way is promoted as a way to beat inflation where it may well be the cause (Chapter 11).
2) Continuing with the same theme of lending creating the new money that is associated with new richesse, then lending to buy existing assets will be purely inflationary. The money supply will have increased without any corresponding richesse being created. This may not be directly apparent in the asset part of the economy, where there is no richesse and rising prices are viewed as growth however it will manifest itself when the money created is used in the real economy, as dividends or to buy real commodities and property.
3) Another implication of lending in the asset economy is relatively risk free, as assets by their nature will retain their monetary value especially when this large body of ‘money as a commodity’ has nowhere else to go (Chapter 1). Therefore lending or leverage purely for trading provides a guaranteed profit, and explains increasing bank profitability even during the bad times. It will also move assets from those who do not have access to this lending to those who do.
With the asset economy being self-sufficient during down turns in the real economy there is no incentive for money to be invested in the real economy. Another feature working against the real economy in a downturn is loan and mortgage repayments. By their nature the original loan will come from the asset economy to where the repayments will return which in turn will contract the money supply in the real economy further depressing economic activity. Thus a ‘catch 22’ situation arises where an economy will only return to growth when money travels from the asset economy to the real economy but that will not happen until growth restarts (Chapter 15). Such a situation will only sort itself out once the majority of loans have been settled and the money is used to buy goods and services. As most of these loans are mortgages this could be up to 25 years. In previous recessions it has been much shorter as inflation and mortgage pay downs reduced the time for these debts to be cleared but the recently developed habit of drawing equity out of one’s home ensure that it will last longer this time. Throughout this period transactions will fall along with the aggregate richesse so when money starts to return to the real economy from the asset part inflation will occur (Chapters 21).
This is not to say that inflation is a bad thing per se the wealth theory shows it to be a symptom rather than a disease in its own right (Chapter 7). Richesse inflation may well be an economy’s self-correcting facility, as richesse declines so money loses its value which in turn necessitates those living off their savings etc. to return to or invest in wealth creation. In much the same way as Adam Smith described the invisible hand of the markets so the other hand will be inflation (Chapter 21).
Richesse allows another insight into the economy as we divide wealth into long and short term (Chapter 1). Long term richesse are the traditional items we associate with wealth, cars, furniture etc. Short term wealth includes food and energy, anything that needs to be replaced frequently for its continued benefit. In this category we can also include the service industries such as bars and hairdressers. When looked at the part of the economy that relates to short term wealth is surprisingly resilient even in down turn, partly because of need but even the frivolous industries remain relatively unaffected out of habit. Long term wealth on the other hand is much more volatile (Chapter 15). By its nature the repeated need for short term wealth makes it demand fairly constant however durable goods will last for a long time so demand will fall away once everyone has whatever item is needed and will only pick up at a lower level once the cycle of replacement sets in. Fashion will be one of forces that work against this as items are replaced before the end of their useful life but this introduces more volatility into the economic cycle as demand will be high in boom years but the remaining life will be utilised during a slump suppressing demand. The boundary between the two becomes a little blurred for the likes of cars which by their nature have a long life but their constant use requires continual replacement. Thus short term wealth gives stability to an economy and long term wealth the growth but volatility. This highlights one other point of wealth that it is needed (Chapter 1).
The concept of wealth as time combined with need provides another tool to understand the economy that of shape. For a balanced and sustainable economy the wealth-hours created should match those destroyed (Chapter 14). A situation where either side is significantly greater than the other could indicate future trouble. When richesse creation is greater it could indicate a bubble and when its destruction is higher a wealth crunch (Chapter 14). By itself this is a powerful tool but it allows further analysis by comparing the wealth in or across individual sectors.
One of the economic puzzles of the last few decades has been that of growth and the consensus opinion that has developed is that it has been due to innovation, this is only part of the story. The continued expansion of money through the need to lend and interest rates has been one part as has the distribution of money (Chapter 14). Another puzzle that has fascinated economists over recent years but with little progress is the relative nature of prices. Wealth offers an explanation that relative prices are principally determined by the ‘bookends’ of taxation and property (Chapter 20).
This explanation given above fits our understanding of how economies behave but it is a very mechanical view of the economy and is based on some assumptions of human behaviour. But what are those assumptions? Traditional economics states that it is down to markets where everything is determined by best price which boils down to the economics of thrift. This is useful to describe the corporate world where it is hard wired through accountancy and company law but it does not or cannot explain the sizes of current economies. Under a thrift system we would expect everybody to maximise the useful life to everything they own. This would at best create a stagnant economy and, with new technologies and techniques to extend the life of individual richesse a contracting one. Whilst we may choose to be thrifty we can also be profligate and it is this that drives the growth of economies; the economics of plenty (Chapter 4). To understand what is happening we need to return to the market stall and our assumption about the negotiations. Rather than seeking the best price what is actually happening is a process of compromise between the customer and the stall holder, not only on the price but each party’s own needs and choices. Thus the transaction is made on the ‘balance of compromise’ rather than best price (Chapter 4). This subtle change makes price just one of the considerations along with aspirations and moral values. With a wider range of motivations we can explain why the rich are less price conscious than the poor; why older workers are less inclined to do overtime than their younger counterparts and also the darker side where the need to compromise is one -sided such as health. Risk can be treated in the same way (Chapter 10) where it is what one will lose rather than gain that will determine the likelihood, therefore it will be the young or the poor who usually have least who will take such chances. When it comes to providing incentives to people to invest it is more likely that they will respond to a potential loss like inflation rather than minor gains such as tax allowances.
Lending is a key component to growth, not only does it lead to the new wealth and associated money but it also regulates the economy. There is nothing new in this statement as interest rates have always been used to control the economy where inflation has always been seen as an indicator. The usual reason given is that excessive lending can be worse than too little. So how to define sustainable lending? Economies are not defined by the amount of richesse but by transactions which will be dependent on the distribution of money that are in turn reliant on employment. As the paying off of a loan is dependent on future transactions it will only be sustainable if there is the associated employment for the life of the loan (Chapter 14).
This view also provides an alternative rational for price inflation where shops are continually probing the prices their customers will pay in order to maximise their profits. With each price rise the customer will on the ‘balance of compromise’ not buy it, go elsewhere or pay up where the compromise is between money, time and doing without. Generally the richer we feel the more inclined we are to compromise on price and in doing so slowly allow the shops to absorb a proportion of any new money created. This is a slightly different reason given when interest rates are set to control the economy, i.e. workers demanding more, but the results are the same.
Richesse not only presents an independent means of measuring inflation but also incomes across time and geographical borders.comments powered by Disqus