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The great wealth illusion

Magicians never like to reveal the truth behind their tricks
Jasmine Yeo
Investment Manager

Harry Houdini was a master of deception. He mystified crowds with his death-defying routines, appearing to flout the laws of nature. From 1891, Houdini traded on the illusion of immortality – until his death in 1926. Today, in the theatre of financial markets, we remain just as beguiled by the power of illusions. And there is one investors should pay particular attention to – the bezzle.

Economist and historian John Kenneth Galbraith described a “period during which an embezzler benefits from stolen money, but the victim does not know he has lost it.”1 In this time, there is a net increase in ‘psychic wealth’. The bezzle is the amount by which they collectively feel better off, between the creation and the destruction of the illusion.

Think of the bezzle another way. Imagine you have a chocolate bar stored in your kitchen cupboard. You scurry home excited, only to find that someone else has snaffled it without telling you. Until that moment, both you and the perpetrator had a warm fuzzy glow of endorphins and anticipation but, for one of you, it was entirely illusory.

And the bezzle isn’t confined to larceny. Charlie Munger, Vice Chairman of Berkshire Hathaway, described a functionally equivalent bezzle – or ‘febezzle’ – the psychic wealth that can be created via legally appropriated money. He defined this as asset values temporarily exceeding their real economic utility. Thus, a divergence occurs between reported (market) and fundamental values. Whereas Houdini’s magic drew gasps of delight, illusions in financial markets can come with ruinous consequences.

What you own versus what you make

From the 1950s until the early 1990s, the fundamental value of the US economy (measured by GDP) was roughly equal to American households’ net worth (Figure 1). Wall Street (in yellow) accurately reflected the productive value of Main Street (in brown). Since then, asset prices have diverged from their underlying economic utility, sending ‘psychic wealth’ to record highs. But how can net worth so materially outstrip the productive capacity of the economy? How can you be worth more than you produce?

Forty years of globalisation brought us cheap goods, cheap energy, cheap labour. These forces kept inflation low, pinned interest rates and risk premiums to the floor and ultimately made capital inexpensive. Borrow more, spend more, grow more.

The result was a golden era for asset owners, and the rise of portfolio values created a substantial wealth effect. After all, investors’ behaviour tends to reflect the value of their portfolios.

Click chart to view larger image

The bezzle is the amount by which they collectively feel better off, between the creation and the destruction of the illusion.

Psychic wealth, real liabilities

The true cost of the illusion is only exposed when the liabilities of the debt which powered the illusion become due. This is unlikely to happen overnight. Market sell-offs can make a dent in households’ net worth, but the scale of the correction required for asset prices to align with economic value is of a magnitude beyond even the most bearish contemplation.

Policymakers’ attempts to close the gap by stimulating economic growth have been unsuccessful. In fact, fiscal and monetary expansion in response to the pandemic stimulated asset prices considerably more than it did economic output. Magicians never like to reveal the truth behind their tricks. If the bezzle is to be corrected, we think the mechanism will be more subtle. Asset owners will eventually pay for illusory wealth via financial repression, as the rate of inflation stays above the rate of interest and gradually erodes the mounds of capital built up over the past half century.

Tricks today

Magic also occurs at the microeconomic level. One need look no further than the technology sector for further evidence of the bezzle at play. Companies like Uber and Deliveroo were loss-making for well over a decade, but traded at rich valuations. Investors were willing to pay up for these businesses given the promise of future growth. But rising interest rates have closed the book on the free money era. No longer are investors able or willing to flood companies with capital in order to grow their market share. These companies can’t afford to keep prices artificially low, and millennials are discovering that their lifestyles are no longer being subsidised by growth-seeking investors. Light regulation can widen the scope of the bezzle, perhaps nowhere more so than in crypto land. Last year’s implosion of FTX – one of the highest-profile crypto exchanges – made billions of dollars of psychic wealth vanish in a puff of smoke. Will all cryptocurrency wealth prove illusory? On that, the jury is (quite literally) out.

Asset prices have diverged from their underlying economic utility, sending 'psychic wealth' to record highs.

As public markets crashed last year, valuations in private markets held firm. But is there more to this stability than meets the eye? Private assets are currently valued at a record premium to their public counterparts, but are they immune to recessionary fears or the effects of tight monetary conditions? Unlikely – they exist, after all, in the same economic reality. Rather, private equity houses have yet to mark down the values of their assets to reflect the prices others are willing to pay. So are their fees, collected in cold hard cash, based on an imaginary valuation?

Revelation

Perhaps it’s all part of the same trick. The bezzle isn’t necessarily a fraud or Ponzi scheme. It simply describes the accumulation of wealth which – when economic reality catches up – proves illusory. A bezzle becomes insidious or dangerous when imagined wealth is used as collateral for real world liabilities. As John Stuart Mill put it: “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” Sadly, when the macroeconomic bezzle is revealed, we will all have to absorb its cost, through a combination of higher taxes, inflation and financial repression. Unlike for Houdini, there may be no miraculous escape.

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  1. Galbraith (1955), The Great Crash 1929

This article first appeared in The Ruffer Review 2023.

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This article does not take account of any potential investor’s investment objectives, particular needs or financial situation. This article reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and

Ruffer shall bear no responsibility for the opinions offered. This financial promotion is issued by Ruffer LLP which is authorised and regulated by the Financial Conduct Authority in the UK and is registered as an investment adviser with the US Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. © Ruffer LLP 2023. Registered in England with partnership No OC305288. 80 Victoria Street, London SW1E 5JL. For US institutional investors: securities offered through Ruffer LLC, Member FINRA. Read the disclaimer

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