Value, Bubbles, S&P

by Hugh

Wealth ought to come from the creation of value. That is, by designing and selling a better shovel, you make it easier for farmers to dig irrigation trenches which increases their yield. With your shovel, their output goes from 100 to 200 units a year, and so you, as shovel-maker get to benefit from a proportion of that 100 increase. It’s “worth” giving you a cut, since your shovel added the value to their output. That, more or less, is the basis of capitalism. As time goes by, technology and methods improve, adding value, meaning we get more widget output per unit of resource input, and wealth increases.

There’s another way to make wealth though, which is easier: by cutting costs, or essentially extracting value. Cutting staff, for instance. That means you spend less money per shovel, meaning profits increase, for a while anyway.

The third way to make wealth is to borrow lots of money. The problem is, eventually you have to pay it back.

Value creation should be a long-term and sustainable wealth-generation technique; value extraction is a short-term, unsustainable wealth-generation technique. Borrowing to make wealth is probably the worst way, since it creates bubbles that burst.

I’ve been thinking about value vs wealth in the context of the global economic meltdown. I don’t have any answers at all but I am struck by the shape of the stock market curves for the past 40 years. Below is the S&P 500, between 1970 and 2009, a good proxy for the value of the economy.

S&P 1970-2009

It looks to me like there was a historically stable amount of value creation, reflected in the indexes, that for some reason in 1993/94 started to go a bit nuts. Two things drive it, I believe: low interest rates, meaning cheap debt flooding the market with money – corporate, personal, housing, financial; and increased global trade, namely with China, which kept prices and inflation low.

But it looks to me, based on this graph, that the wealth of the past 10-15 years was illusory, and that in fact the markets have dropped back to where they “should” be.

Does anyone have a better analysis of what happened in 1993/1994 when the whole thing started to go a bit nutso, in historical terms? I have a pretty surface understanding of financial policies, but this graph looks pretty telling to me.