Components of Prosperity

A recent book about financial markets said “real estate prices collapsed, credit dried up and house building stopped.” That’s not a description of 2008 or 2009. It refers to 1792, during the administration of George Washington. More recently, stock markets dropped sharply, banks curtailed lending and unemployment rose to double digits. That was 1974.

Live long enough and you begin to appreciate what remains constant through cycles of history. More than 40 years ago as a student at Berkeley and then at Wharton, I developed a formula for prosperity that applies in any economic cycle:

P = Ft (HC + SC + RA)

It says that prosperity equals the effect of financial technologies acting as a multiplier on the total value of human capital, social capital, and the real assets – cash, receivables, land, buildings, etc. – typically found on balance sheets. Social capital includes educational, cultural, religious and medical institutions and such intangibles as the rule of law and enforceable property rights. Human capital – the largest, most-important asset – is the skills, training and productivity of people.

My academic research in the 1960s had shown that investment in a diversified portfolio of high-yield bonds produced a better return – even through the Great Depression – than investment-grade debt. These non-investment-grade securities were also superior investments than loans to individuals, to real estate or to governments. This became increasingly clear as financial technology was developed and expanded in the 1970s and ’80s using such tools as collateralized loan and bond obligations. It’s important to distinguish these innovations – which are backed by the substantial value in operating businesses and have stood the test of time – from securities with less underlying value. An example of the latter would be mortgage- related instruments in a marketplace where both borrowers and lenders are excessively leveraged. Consider some of the differences: