Wealth is health: a €2.5 trillion default would be fatal

Fri, Jun 22, 2012, 01:00

ECONOMICS:WHAT WOULD be more disastrous: to lose everything you own or to lose your job?

Ask that question to a favela-dweller in Rio de Janeiro and the answer is likely to be the latter. Without an income, you quickly go hungry when living at subsistence levels in countries without social safety nets.

Besides, those unfortunate enough to be living in slums own little or nothing. They don’t have much to lose.

Ask an Irish person the same question and most would answer that job loss is preferable to the loss of home, pension, life savings and everything else. One reason is that, mercifully, the jobless tend not to starve in this country thanks to the welfare state.

But also important is that most people in rich countries have a lot to lose. The average person accumulates wealth in multiples of his or her yearly earnings. Even after huge declines in Irish wealth, mostly because of the halving of property prices, net worth (the value of assets less liabilities) of all households together is about five times greater than annual disposable income.

None of this should surprise. Man in a state of nature consumes everything he produces. He is not in a position to salt anything away. But when he begins to master nature the development process kicks in. As it accelerates, more is produced. There is then scope to start putting a little aside. A little saved year upon year becomes a lot over time. That is how economies grow rich.

Wealth – as opposed to income – has tended to receive amazingly little discussion by the economics profession. When even serious organisations, such as the International Monetary Fund, and high-brow financial media compare the wealth of nations, they almost always use gross domestic product per head of population.

This misleads for two reasons. The first is a mere quibble: GDP is an output measure. Gross national income, as the term suggests, is a more accurate measure of income.

The second reason is much more important. As the Brazil/Ireland example hints at, disparities in wealth are much larger than disparities in income between the developed and developing worlds.

The chart illustrates the differences across the euro zone for selected countries. Among those who use the single currency, the former communist countries are poorest. And they are far more asset-poor than income-poor.

While the average Dutchman’s income was three times higher than his Slovakian counterpart in 2009 (the most recent figures available), his financial assets – shares, pension funds, cash in the bank and the like – were 14 times greater.

History explains most of the disparity. Western Europe industrialised earlier. Its citizens accumulated unprecedented wealth in the first era of mass prosperity after the second World War. While free Europeans were getting rich, those on the wrong side of the Iron Curtain were deprived of that freedom.

The chart also shows how savings over decades accumulate so that the ratio of wealth to income rises. Until recently, that was considered an unambiguously wonderful state of affairs. And it is.

But how to store it safely? This question has preoccupied many people since the financial crisis erupted half a decade ago. A recent IMF paper even pondered whether any assets are truly safe. Government bonds were once thought to be the safest way to store wealth, but the financial crisis has changed that – probably forever. Ditto for any bank-related assets – shares, bonds and even deposits.

Financial assets are particularly problematic. Unlike a house, for instance, which, once paid for, has no matching liabilities, all financial assets have matching liabilities. That means that writing down one person’s debt results in the evaporation of somebody else’s wealth. This is what makes the current crisis so frightening.

Spain and Italy are very close to being locked out of the bond market. If that happens, the resultant €2.5 trillion default would be the biggest financial event in history, dwarfing Lehman’s collapse and Greece’s default. No governments – not even those in the most creditworthy countries – would have the resources to prop up their financial systems. The bars in the chart would crumble like collapsing towers. Europeans have a great deal to lose if their leaders don’t act soon.

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