Montreal, April 15, 2005 No 153




Chris Leithner grew up in Canada. He is director of Leithner & Co. Pty. Ltd., a private investment company based in Brisbane, Australia.




by Chris Leithner

          On several occasions during 2003 and 2004, politicians announced and print and broadcast media dutifully parroted that Americans, Australians, Britons and Canadians have never been richer than they are today. In Australia, for example, the median net worth of households (net of mortgage and other debt) is presently approximately $A250,000, and in recent years it has increased at an annualised compound rate of roughly 7%.


          This increase is partly the consequence of the country's relatively high (by international standards) level of share ownership. But given their even higher level of home ownership, and the fact that the capitalisation of the average family's home greatly exceeds that of its share portfolio, the increase of Australian households' net worth (like that of their counterparts in these other countries) owes most to the sharp increase of the price of residential real estate. The family's home, most people emphatically agree, is its most valuable asset.

          Yet this rise of median household net worth which media coverage typically and erroneously interprets as an increase of wealth is largely illusory (see also Letter 45). Why? There are two reasons. First, if time is money, as Ben Franklin quipped, and if lack of time is dearth of capital, as Ludwig von Mises demonstrated, then wealth is time. An appropriate measure of a household's wealth, in other words, is the number of years that the stream of income generated by its assets (as opposed to the salaries of its members) can maintain a desired standard of living. My guess, bearing in mind its innate subjectivity, is that the wealth of the median household in these countries is no more than three years. If so, then few are wealthy.

          Second, a real increase in the wealth of individuals and households, as Paul Kasriel emphasises in an excellent article ("Wealth Illusion", 22 October 2004), presupposes the expansion of the capital stock and of the productivity of the capital that they own (see also Letter 41). Alas, according to Kasriel's analysis of American data (trends for Australia, Britain and Canadian households differ in various ways but are roughly comparable), "in recent years, growth in our capital stock has slowed and the composition of the slower growth has moved in favour of McMansions and SUVs, which do little to increase the productive capacity of our economy."

          Kasriel notes that a household's net worth increases either because expenditure falls relative to income ("saving") or the market prices of assets acquired through past saving rise ("capital gain"). During the last quarter-century, most people have rejected the first option. In Australia, for example, the household savings ratio (i.e., saving as a percentage of household disposable income) averaged approximately 10% during the 1960s. During the 1970s it rose to 12.5% and at one point as spiked as high as 18% and in 1975-1980 averaged 15%. But since the early 1980s it has fallen steeply and almost without interruption: during the 1980s it averaged 10%, during the 1990s it averaged 5%, since 2002 has been below 0 and is presently as low as minus 3% a level not seen in this country since the 1930s.

          How, then, has the median net worth of Australian (and, by extension, other) households risen in recent years? The liberalisation and deregulation of financial services during the 1980s enabled and the irregular but cumulatively very appreciable decrease of interest rates have encouraged households to borrow. Households' borrowing has financed not just current consumption (i.e., the purchase of clothes, dinners and holidays) but also non-current consumption (i.e., the purchase of cars, appliances and real estate). And thanks to the decrease of interest rates, the prices of stocks, bonds and residential real estate have generally increased. Asset price inflation, in other words, has swelled individuals' and households' balance sheets. In response to these developments, they have "leveraged" their balance sheets ever more aggressively. They have borrowed, in other words, partly to buy things whose prices have risen more quickly than income. During the 1960s and 1970s, total Australian household liabilities rose from 40% to 45% of average annual income. In the 1980s this ratio rose more quickly (from 45% to 65%); during the 1990s it accelerated even more rapidly (from 65% to 110%); and since 2000 it has rocketed from 110% to 155%.

Two Unheralded Risks

          By borrowing against a home whose price is rising, sometimes substantially, households have been able to "extract equity" and consume the proceeds; and the growing magnitude of extraction has enabled them to increase their consumption at a rate that has greatly exceeded the increase of household income. But all financial transactions incur risk, and the most immediate risk of this behaviour is the sturdiness of the assumption that the prices of households' assets, particularly houses, can continue to rise much more quickly than income. A less immediate but ultimately much more significant risk is the weakening of the capital structure. A weaker structure today implies sluggishly growing or stagnant or even falling living standards in the future.

          Using American data from 1952 to 2003, Kasriel has charted the relative importance of savings and capital gains as components of households' net worth. In the mid-1990s, the impact of capital gains began to outstrip savings by a wide margin. From 1995 to 1999, a steady increase in the prices of the household's portfolio of stocks drove the increase of its net worth; and since 2000, increases in the market price of the family home have done so. During the period 1952-1994, capital gains on stocks or real estate were, on average, 1.7 times greater than household saving; and from 1995 to 2003 these gains averaged 4.4 times household saving. Consumers, cheered by politicians, concluded that capital gains are and that savings are not the route to higher net worth.

"Thanks to the decrease of interest rates, the prices of stocks, bonds and residential real estate have generally increased. Asset price inflation, in other words, has swelled individuals' and households' balance sheets."

          Far better than most contemporary economists, who seem to comprehend it not at all, Kasriel understands the concept of capital. He notes that capital stock is conventionally defined as the sum of business assets, private residential housing, consumer durables and government property. Although he does not explicitly say so, he seems to recognise that residential real estate, consumer durables and government property are not capital goods and therefore that they should not be regarded as components of the capital stock. With a few caveats, these things are better regarded as consumption goods (see Letter 41).

          Kasriel makes a second point about the nature and contemporary misconception and hence misallocation of capital. "Just because an existing house goes up in [price] does not necessarily mean that the more expensive house 'produces' more actual housing services. Does a rise in the price of the house enable more people to live in it? Does the increase in the price of an existing drill press necessarily mean that the drill press is now capable of drilling more holes in an hour? The economic wealth of a nation is related to an increase in the number of drill presses, not the nominal value of the existing stock of drill presses. The more drill presses an economy has, the more holes can be drilled in the production of other goods. The greater the capital stock of an economy, the more productive is its labour force. In short, the greater the capital stock of an economy, the more goods and services that economy is likely to be able to produce" (italics added).

          Kasriel examines the development in recent years to America's capital stock, and the relationship between capital stock and household net worth. Before and during past periods when the stock of capital grew, the composition of the increase in household net worth was skewed towards saving. He also finds, generally speaking, the more that households save the faster the capital stock subsequently grows. But the late 1990s upset this rule. The stock of capital grew at a pace that was moderate by historical standards; yet this growth owed little to the savings of households. Instead, the late 1990s was a time when foreigners' investment in the U.S. reached unprecedented levels; and their savings and investment more than offset weak and weakening saving by American households. Without foreign investment, the growth of America's capital stock during these years would have been lethargic. The real "coalition of the willing" are the foreigners willing to subsidise Americans' (and Australians' and Britons') insatiable appetites.

Ornaments Versus Streams of Income

          Kasriel provides actually, he restates for the legions of people who have either forgotten them or never learnt them two critical insights into the nature and causes of the growth of wealth. The first is that it owes much more to savings than to capital gains. The second insight is that wealth also depends heavily upon the composition of capital stock. In particular, wealth presupposes an increase in the number of "drill presses" (i.e., true capital goods that increase production and productivity). In sharp contrast, the prominence of consumption goods mislabelled as capital goods (things such as owner-occupied real estate, military and other government expenditure and the like) is a possible consequence but certainly not a cause of wealth.

          It follows that some forms of capital as it is conventionally defined but not others generate wealth. "For example, housing is part of the capital stock. But does a physically bigger house with [more lavish ornaments] enable the occupants to produce more widgets? Does the massive SUV driven by the suburban Mum [enable] her or anyone else to produce more widgets? Bigger houses and bigger household vehicles add to the nation's capital stock. But I would submit to you that increases in business equipment and business structures are more reflective of a nation's wealth than increases in consumer durables and houses." Buying a plasma screen TV, in other words, does not make you richer; instead, the accumulation of income-generating assets such as productive business equipment and structures will enrich you enough to afford consumption goods like fancy TVs.

          Kasriel examines the composition of America's capital stock over the years. Most notably, he ascertains whether production- and productivity-enhancing "business" capital is becoming a greater share of the total stock of capital. Its percentage rose sluggishly during the 1990s, in 2001 it began to fall and in 2002-2003 it decreased at the fastest pace since the early 1950s. In conclusion, he asks "if the share of the business capital stock is falling relative to the total since the stock market and business investment bust of 2000, what shares are rising? You guessed it McMansions and SUVs are gaining as a share of the total capital stock. So, in the past four years, not only has the growth in the nation's capital stock slowed, but the growth in the truly productive part of that capital stock the business capital stock has slowed even more."

          Americans and in differing degrees, Australians, Britons and Canadians are tending their fields less diligently and are eating more of their seed corn. Here, then, is the example par excellence of an improperly diagnosed ailment that continues to receive insufficient attention. Many people are consuming their wealth (which is more meagre than they suppose) in order to finance today's lifestyle; in so doing, and in cahoots with their governments, they have decided to ignite a short-term, meagre and debt-fuelled boomlet rather than address long-term problems. To the very limited extent to which the impairment of capital in these countries has been diagnosed, policymakers have treated it incorrectly.

          In short, policies that encourage saving and investment and do not sanctify spending and consumption are required (see "Why Have They All Been Fooled?"). But to expect politicians to change their profligate spots is to suppose that leopards will become vegetarians. As a result, potentially severe disorders have been bequeathed to the future (see also in particular "The Robinson Crusoe Ethic Versus the Distemper of Our Times" and "A Tale of Two Islands").