Sunday, May 2, 2010

The illusory nature of asset values!

Superb post by Uwe Reinhardt in Economix about the illusory nature of asset values and asset-backed wealth. He points to a paper by Michael Reiter who defined wealth as

"'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)."

Prof Reinhardt uses the graphical illustration of the net present values of a building at different discount rates and asset value growth rates, to show how widely the building wealth (as assessed by its value) can vary even with small changes in the aforementioned assumptions. And underlying these assumptions is the expectations (about future economic prospects of both the building in particular and economy in general) held by investors,

"... 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."

Therefore, Prof Reinhardt writes, the wealth creation due to investments in a building can manifest in two ways,

"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."

Update 1 (15/5/2010)

Uwe Reinhardt has more on the enduring arguement over which is superior - the "neoclassical" or "liberal" theory of capitalism and "communitarian" or "stakeholder" theory; and how companies create "value" and distribute it among various stakeholders.

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