Eurozone Pays the Price for Pursuing Paper Wealth

by: TradingHelpDesk

Europe continues to trail the field in the race to escape recession. The US, Asia and UK all appear better equipped to formally report positive GDP data, before the Euro-zone. The reasons for this are many. A single financial and monetary framework, for the 16 member states of the Euro-zone, has created a one size fits all policy which inevitably fails to address the unique needs of individual countries as diverse as Ireland, Cyprus and Finland.

In particular, the process of establishing a single Euro-zone interest rate across such a large economic region is just an efficient recipe for the manufacture of asset prices bubbles, and as now, a sustained recession. The Irish property market bubble is the easiest example to highlight, though the same can be said of the price of homes and commercial land in Spain. Both countries enjoyed an inappropriately lax monetary policy for years. This incorrect policy, combined with flawed banking sector risk controls, made the recent property price rally, and subsequent crash, inevitable. Credit (mortgages and loans) should be cheap, but difficult to obtain and only provided extensively to proven and prudent borrowers or those with significant collateral. Incorrectly allocated (and priced) credit always leads to economic turmoil as it corrupts the perceived fair value of risky assets. The reason is simple but often forgotten and is worth investigating.

Although the financial system contains innumerable types of financial instruments there are only two distinct groups; risk free assets and risky assets. Risky assets need to offer a premium to the buyer, a potential of excess return above the risk free rate, to compensate investors for the possibility they will lose all or some of their capital. In times of high confidence and strong economic growth, buyers are generally willing to take a lower premium as the probability of loss is theoretically smaller. In periods of uncertainty and economic weakness, investors seek a higher premium to reflect the increased possibility of capital erosion.

The exact premium over the risk free rate will depend on the individual characteristics of the risky security. For example, the risk premium of shares in a newly listed technology company with growth potential but unproven revenue needs to be higher than the risk premium embedded in the shares of a mature utility company with secure cash-flows. The principle is the same however. Investors need to understand the risk of a transaction, correctly identify a likely return, and decide whether the risk/return profile is attractive relative to the return provided by a risk free asset, such as cash. Investors as a whole have consistently failed to accurately identify the risk/return profile of risky assets.

There is also widespread confusion between creation of real economic wealth and financial paper wealth. Few financial transactions create economic wealth. (The velocity and circulation of money is a different issue.) Sustained economic growth is achieved via the creation of real wealth. A financial transaction, for example the buying of gold, listed shares or in-circulation bonds is not the creation of new and real wealth. It is the transfer of wealth (an investment opportunity cost) from those who executed the transaction at an unfavorable time to the opposite party who bought/sold at a time where the asset was mispriced in their favor.

Let’s use Microsoft (NASDAQ:MSFT) shares as an example. The company is listed. If you buy Microsoft shares from your broker, Microsoft doesn’t get the money. The seller of the shares receives the proceeds. Post-transaction there are only two scenarios. The shares will go up or down. If they go up the buyer is profiting at the expense of the seller (who should have held). Wealth has not been created, all things being equal. Likewise if the shares fall, the excess profit above fair economic value received by the seller is offset by the buyer’s losses. If there are more buyers than sellers then the price will rise, but new real wealth is not being created. It’s just paper wealth. Nominal paper wealth, unless supported by real assets of similar economic value, is always vulnerable to collapse.

Now add into this paper wealth environment banks with weak risk controls, who lend consumers, investors and institutions cash, some of which is used in the purchase of paper assets. Buying increases, asset prices are inflated, bubbles are generated and the only winners are the few who through luck or rare judgment sell their assets at the inflated (incorrect) prices.

Of course some financial transactions, a minority, can potentially create wealth. When a financial transaction gives entrepreneurs or companies additional cash and that cash develops a new product, a new drug or an asset that produces a new revenue stream, then real economic wealth is created. But most financial transactions do not. Successful stockbrokers, who trade in listed securities buying and selling assets at the optimum time, are therefore not creating new economic wealth. They are reallocating society’s existing wealth from shareholders who buy or sell at the wrong time to their clients.

Some economists will nominate the circulation, or velocity, of cash generated by these paper financial assets as having economic benefits. My response is the circulation of cash in mispriced financial transactions is less useful, in fact it’s positively harmful, when compared to the other option available which would be to circulate the cash through the economy via consumption of goods rather than in flawed ‘asset bubble’ investment practices.

In conclusion, let's return to the examples of Ireland and Spain. Both countries, burdened with an inadequate Euro-zone monetary framework and a flawed banking sector, allowed the manufacture of paper wealth to out-strip real economic growth by a dangerous margin. In the depths of a European recession, the ECB is evidently ill-equipped to identify the difference between paper wealth and real economic wealth or tackle the problems generated by the gap between the two.