Value Added

The concept of what 'value added' means has always been confusing to me. It is assumed, i think, that the answer is straightforward...but I have never really found it so. Apparently it's the case that the sun emits enough energy that ,if appropriately captured, 2 days worth of sun would sufficiently cover the entire human energy consumption for a year. In one sense, value added, would be the creation of a technology that captures this energy and i would have to work less presumably because my energy bills would have fallen...perhaps the 4hours less that i would have worked a week could be filled playing golf; as could everybody else in humanity...which might make the local club a bit busy. Alternatively i could continue to work the same amount, but would be able to buy more 'stuff'...a new set of golf clubs for example. These apparently are the old style economics of 'trade-off', opportunity cost and value creation.

For generations of economists, 'wealth creation' implies capital formation in these terms - generating and developing income-creating tangible assets. I think i can grasp this concept...i build a technology that can capture the energy of the sun in a highly efficient way, and can use this technology to generate income in some form.

In the Autumn of last year the US Census Bureau published figures for median real incomes for US families between 2000-2007. CNN at the time commented on the statistics that “...This is the first business cycle ever in which the middle class had less income at the end than the beginning” – from around $58,500 to $56,000. At around this time, the FTSE had touched a high pushing 6750, and the Dow was well above 14000. Markets were booming, both in equity and credit markets.

So while GDP growth, and a variety of market indicators reflected an economy that was growing steadily, the real incomes of the majority of Americans had actually fallen.

Away from the income generation of the average American, the growth of home mortgages exploded from an annual rate of $368.3 billion in 2000 to an annual rate of $884.9 billion in 2004, compared with a simultaneous increase in residential building from $446.9 billion to $662.3 billion. Altogether, the United States experienced a credit expansion of close to $10 trillion during these four years. By 2007, the size of the US mortgage market had reached an estimated $12trillion, of which an estimated $1.3trillion had been pushed into the hands of the euphemistically entitled 'subprime'.

At the same time as credit was expanding, so too was GDP. During 2000-2004 GDP added $1.9trillion to the country's, so the ratio of credit expansion to GDP growth was just over 5 times. During the 4 year period after the end of the 2nd world war, this ratio was roughly equal.

While consumption, residential building and government spending soared, unprecedented imbalances developed in the economy - record-low saving; a record-high trade deficit; a vertical surge of household indebtedness; anemic employment and income growth from wages and salaries; outsized government deficits; and protracted, unusual weakness in business fixed investment.

The crux of all this is that all that really happened in the US economy over the past 8years, was asset price inflation fuelled by record low interest rates. The average American was borrowing against a 'guaranteed' increase in asset prices (between 2000-2007 the average annual price increase was around 15%, stock markets showed similar annual gains). In truth, they were actually borrowing more than the expected future increases in asset prices. This is i think is technically known as Ponzi scheme. Ponzi schemes can be quite effective, if a touch morally bankrupt, as long a the music is still playing.

Charles Prince (the last Citibank CEO) was quoted in the middle of last year as saying that...

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music playing, you've got to get up and dance. We're still dancing." Charles Ponzi would have been proud.

So where are things at?

Some numbers: US Credit expansion 2000-2008 was around $23trillion. GDP growth was nominally estimated at $3.6bn over the same period. Since the highs of the housing markets in 2006 and stock markets in autumn 2007 the estimated falls in asset values that the credit expansion are financing is estimated at over $5trillion. So the US consumer is by any accounting standard insolvent. We're well past the Keynes situation: If you owe a bank a hundred pounds, you have a problem...if you owe them a $100million, it has one.

Banks, Financial institutions and increasingly Governments are largely bearing the responsibility for the outstanding debt that financed these assets. Capital ratios are falling, so banks are seeking new capital and deleveraging (trying to sell assets) to get back to appropriate capital adequacy ratios. Banks will be net sellers of assets until their capital ratios reach a 'reasonable' level, but are going to be in a vicious circle with falling asset prices...the more assets they sell, the further the prices of assets they hold will fall, forcing them to sell yet more assets to balance their capital positions.

The goal of the US bail-out currently is to try to stem the descending flow of asset prices that a forced deleveraging has created. $700bn is a lot of money, but may well be a bit like trying to fix a leak in the Hoover Dam with a tube of hand-held polyfiller.

As Milton Friedman put it: "We all agree that pessimism is a mark of superior intellect"