Try to get through this.. not merely the rantings of an econ-geek. The article explains in a reasonably coherent way a very important concept. The notion of Present Value of a “future income stream” is crucial in a dozen different areas of news today ranging from CA pension shortfall calculations to the banking crisis (yes, that still is out there).
The following is from a NY Times blog by Ewe Reinhardt, a Professor of Economics at Princeton U.
“I’ve lost almost $11 trillion of household wealth in the last 17 or 18 months,” lamented Senator Christopher J. Dodd, the Connecticut Democrat, on last Sunday’s “Meet the Press,” as he urged Congress to proceed with speedy deliberations on a finance reform bill.”
Eleven trillion dollars! That’s over three-quarters of our current gross domestic product.
Where did all this wealth go? Did other folks get it? Or did it just go up in smoke?
For that matter, what precisely is “wealth”? Is it something tangible we can see, or is it something intangible – something merely imagined?
In an illuminating paper on asset values and wealth, the economist Michael Reiter defined wealth in a way that makes sense to economists:
“Wealth” is the present value of the expected stream of future utility [human happiness] that an “infinitely lived individual or a dynasty” [or a nation] could hope to extract from the real resources available now and in the indefinite future, assuming these real resources are allocated and managed now, and over time, so as to maximize that present value of future utils (at the “proper” discount rate).
Two practical points can be extracted from this abstract definition.
- First, economists think of wealth not just in monetary terms — as cash, stocks, bonds and real estate — but in terms of human well-being.
- Second, and most importantly, the wealth a nation believes itself to possess is based strictly on the citizenry’s expectations about the future. It is in good part a figment of the citizens’ imagination.
To be sure, these imaginations are anchored in the tangible and intangible resources a nation has at any moment and hopes to have in the future. Among these resources are patents and blueprints that represent the current technological state of the art.
But the same set of current resources can trigger vastly different levels of imagined “wealth,” depending on the citizens’ mood.
To illustrate that these are not just the abstract musings of an econ-geek, let us look at the value of something concrete: a building. Here I draw on a tongue-in-cheek paper I once penned for Princeton alumni entitled “How Much is a Building Worth?”
What could be more real and concrete than a building?
Imagine, then, a new building that, fully leased at current rental rates, currently yields the owner $20 million in cash per year, after all of the owner’s expenses of operating and maintaining the building.
Assume the building will be in operation for 40 years, after which it will be torn down at costs that are just covered by selling the land underneath it. That assumption allows us to view the current value of the building to its owner, or to a prospective buyer, as the time-value adjusted sum of the annual net cash flows accruing to the owner(s) over the next 40 years.
The term “time-value adjusted” refers to the idea that, say, $1,000 receivable one year hence is worth less to the recipient than it is now, because something less than $1,000 could be invested today at some interest rate to grow to $1,000 a year hence.
The discount rate used in this exercise should be thought of as the rate of return that a prospective buyer of the building would expect minimally to earn on that investment to find the deal attractive. That rate is driven by three key factors:
- what one could earn on a risk-free investment, e.g., a United States Treasury Inflation Protected Security (also known as TIPs),
- the investor’s expectations about future annual inflation rates, and
- a risk premium to compensate the investor for the perceived uncertainty inherent in investing in long-lived assets such as real estate.
It is here that mood enters the picture.
If investors are exuberantly optimistic about the future growth of the economy and future rental rates, and if they believe there is little risk in such long-term investments, the risk premiums they demand tend to be low and real estate values correspondingly high. Completely irrational exuberance of the sort we have seen in recent years can easily lead to serious “underpricing of risk” and, thus, to real estate bubbles.
On the other hand, if investors are very pessimistic and worried about the risk inherent in such investments, their risk premiums rise and asset values fall. Irrational despondency can lead to overpricing risk and underpricing real estate.
Now, what is true for real estate also applies to other assets — home values, stock prices, bond prices and so on.
So let’s go back to the lost $11 trillion in wealth lamented by Senator Dodd. Where did it go? For the most part, I suspect, it just went up in smoke. It represents a loss of wealth that once exuberant folks imagined to have had and now imagine they no longer to have.
True, with its clever but untoward shenanigans, Wall Street has sucked billions of dollars out of the pockets of hard-working folks on Main Street and transferred them into the financiers’ own pockets. In this connection, merely read these articles to see how it was done.
But they didn’t amass $11 trillion. The bankers did not get that rich.
