The Daily Reckoning PRESENTS: Since when, asks Kurt
Richebächer, do rising share prices constitute wealth
creation? The answer may surprise you...or not.
PHANTOM WEALTH
By Kurt Richebächer
[
www.dailyreckoning.com]
Strikingly, the late great bubble of 1996-2000 in the U.S.
stock markets represents the first time since economic
thinking started that this kind of wealth creation -
through rising asset prices rather than through capital
formation - found overwhelming attraction and admiration.
The old economists never gave it any serious consideration.
They flatly discarded it as pseudo or phantom wealth.
What the rising asset values effectively create is a
corresponding rise in claims on the economy at the expense
of those who do not own such assets. But this is wealth
redistribution, not wealth creation. More importantly, this
kind of wealth creation involves no gain in current incomes
and productive capacity. To the extent that it actually
boosts consumption at the expense of investment and the
foreign trade balance, the net result from a macro
perspective is overall impoverishment.
For the first time ever in the history of economic
thinking, economists - that is, American economists - are
claiming that growing asset prices represent fully valid
wealth creation. In 1996, an article in Foreign Policy
entitled "Securities: The New Wealth Machine" effectively
explained that the financial markets have become the most
powerful generator of wealth.
Verbatim: "Historically, manufacturing, exporting, and
direct investment produced prosperity through income
creation. Wealth was created when a portion of income was
diverted from consumption into investment in buildings,
machinery and technological change. Societies accumulated
wealth slowly over generations. Now, many societies, and
indeed the entire world, have learned how to create wealth
directly. The new approach requires that a state find ways
to increase the market value of its stock of productive
assets. Several countries have successfully directed their
economic policies toward that goal, achieving and
sustaining faster growth rates than were once thought
possible..."
Nowadays, wealth is created when the managers of a business
enterprise give high priority to rewarding the shareholders
and bondholders...In such a strategy, "an economic policy
that aims to achieve growth by wealth creation therefore
does not attempt to increase the production of goods and
services, except as a secondary objective."
We wondered whether we should reprint such ridiculous
economics. We choose to do it because this economic
nonsense concisely reflects the confused thinking behind
the new equity culture that has spread from America to the
rest of the world. Economies exist for the securities
markets, say the new equity thinkers; the markets, not the
producers in the real economies, create the nation's
wealth. Besides, they say, the markets do this much more
efficiently by pleasing shareholders and nobody else.
There is one consideration, however, which makes the
transient and ephemeral character of wealth "creation"
through the markets poignantly clear - namely, the way it
is calculated. Trillions of dollars of new wealth simply
arise from the common practice of treating the value of the
whole outstanding stock of assets as if it could be
calculated based on the last stock trading price...which,
as a rule, is of marginal size. It is like printing wealth.
Indisputably, the new imperative to maximize shareholder
value induced profound changes in corporate strategies. For
better or worse, that is the question. Wall Street's
propaganda machine, greatly assisted by confirmation
through Mr. Greenspan, hammered into people's heads that in
America, "unprecedented technological advances in high-tech
technology and corporate governance had ushered in a New
Era in which businesses were making unprecedented gains in
productivity and profitability". Rapidly spreading belief
in this nonsense kindled fantastic profit expectations
that, in turn, helped kindle the steep rise in stock
prices.
Realizing that the traditional process of profit creation
through capital formation was much too tedious to satisfy
the new, grossly inflated profit expectations in the
market, corporations switched massively to new strategies
that seemed to promise much quicker and higher returns.
Thus, mergers, acquisitions, restructuring, downsizing,
outsourcing, cost-cutting, stock buybacks and creative
accounting became the main characteristics of the corporate
strategies to expand.
While the consensus has been trumpeting a profit miracle,
we have been protesting for years that this is impossible.
What led us to this opposite conclusion were simple,
compelling macroeconomic considerations. They say that
there is ultimately but one single way for businesses to
increase their profits in the aggregate, and that is by
mutually increasing their revenues through higher
investment spending. With this rule in mind, we realized
that all those new corporate strategies meant to boost
profit creation when taken together could only have the
opposite effect of depressing profits.
In fact, at the height of the boom, executives and firms
faced sharply falling profits, while the prices of their
shares, reflecting the inflated profit expectations, were
soaring. Most importantly, Mr. Greenspan eagerly supported
the stock market boom not only with absurdly euphoric
statements, but also with record-high money and credit
creation.
Confronted with tremendous pressure from the markets to
meet the grossly inflated profit expectations, the great
corporate account rigging developed for a straightforward
reason. It was the need and desire to cover up the
increasingly desperate corporate profits picture,
contrasting dramatically with the former high-riding
promises. Manifestly, the unfolding epidemic of accounting
frauds is not just bearing witness to an unprecedented high
level of greed. The far more important aspect is its deeper
cause: the horrible reality of Corporate America's worst
profit performance in the whole post-war period.
Measured as a share of GDP, profits today are at their
lowest level in the whole post-war period. During the last
year of the boom, in 2000, before-tax profits of
nonfinancial firms were equivalent to 4.3% of GDP. That was
down from 6% of GDP in 1997. This plunge of profits has to
be seen against the backdrop of 18% GDP growth during this
period.
More recently, profits are down further to 3% of GDP. What
has hammered the stock market is plainly not a lack of
confidence but collapsing profits.
Regards,
Kurt Richebächer
for the Daily Reckoning