Asset Prices and the Measurement of Wealth and Saving

Abstract

The paper defines concepts of real wealth and saving which take into account the intertemporal index number problem that results from changing interest rates. Unlike conventional measures of real wealth, which are based on the market value of assets and ignore the index number problem, the new measure correctly reflects the changes in the welfare of households over time. An empirically operational approximation to the theoretical measure is provided and applied to US data. A major empirical finding is that US real financial wealth increased strongly in the 1980s, much more than is revealed by the market value of assets.

Economists seem to be convinced that there exist better measures of real GDP than the Big-Mac-Index. In this paper I argue that the same is true for real wealth, and I develop a measure that accounts for the intertemporal index number problem. I will show, both in theory and in an empirical application that the new measure can significantly deviate from conventional wealth series. Such an improved measure of real wealth is important in several respects. First, it is a better welfare indicator. If the market value of assets increases because interest rates have fallen, are households richer, not just in a nominal, but in a real sense? Real wealth as I define it answers this question. It has the property that an increase in its value indicates an improvement in the economic situation of a household. I will show that this is not true for the currently used wealth measures.

Second, real wealth plays an important role in the measurement of saving. Several authors have pointed out that conventional measures of national saving, based on the National Accounts, are insufficient. They reflect investment in physical capital¹ only, and even here they are incomplete, since they use some more or less arbitrary accounting principles for asset valuation, and exclude changes in the value of existing capital. Bradford (1989, 1990, 1991) has forcefully argued that the change in the market value of assets is a better measure of saving than those derived from the National Accounts. The same view is expressed, e.g., in Barro (1989, p.50). One can criticise these claims on two grounds (cf. the comment of Stiglitz, 1991, on Bradford). First, one may argue that asset prices contain valuation bubbles2, and changes in asset prices thus not always reflect changes in real wealth (reasonably defined). The fact that the proposed measure of national saving is very volatile, and even negative in some years, may be interpreted as pointing in this direction. The second critique concerns the inherent index number problem, caused by changes in interest rates. The latter problem is solved if saving is defined not as the change in market values, but as the change in real wealth as defined in the present paper. On the first criticism, the present paper has nothing to say. I proceed under the strict neoclassical assumptions of rational expectations and asset valuation by fundamentals, which I consider as a useful starting point of the analysis. An interesting question, which I will analyse theoretically as well as empirically, is whether the savings measure based on real wealth is less volatile than the measure based on the market value of assets.

Third, the new measure of real wealth has potential implications for the definition of the income tax base. In many European countries, as well as in the US, the”ideal" base of income taxation is considered to be the Schanz-Haig-Simons concept of income (cf., for example, Goode, 1990, p.62). This includes the change in the market value of assets, adjusted, of course, for ination. The appeal of this concept is not derived from formal models of optimal taxation, it is rather based on more traditional considerations of fairness and ability to pay. Tax theorists often complain that the practical implementation of the income tax does not account for inflationary changes in asset values. This paper shows that accounting for inflation in the usual sense is still insufficient. In addition, it is necessary to account for revaluations of assets that reflect changes in the intertemporal price structure, without changing the real wealth position of households. In the spirit of Schanz-Haig-Simons, only changes in real wealth as defined in this paper should be included in the income tax base.

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