How Does Wealth Disappear?

One of the basic principles in economics is that currency is based, more or less (in our case, less), on the connection with some material good that backs the currency. Now, our dollar is no longer tied to our gold reserves, but it still represents the worth of our goods.

To understand how wealth disappears, we have to understand how wealth is created in the first place. First and foremost, wealth is created through effort. At the very least, the effort is from picking fruit from a tree, or berries from a bush, or hunting an animal, or so on. The worth of the item is based upon need and availability. A cup of water during a flood season isn't worth very much because water abounds everywhere. A cup water to a man dying of thirst in the desert is practically worth his life. But this is simply stating the principles of supply and demand. No one can really question that supply and demand play a role in matters; what is arguable is how much government should tamper with market forces.

Now, wealth is essentially created through effort, as I just said. I can take some raw material, each component fairly cheap because of availability and low demand for just raw components, and turn those pieces into, say, a house. Because of the effort I placed into the house, the worth of the house is more than the worth of the materials individually; worked into the price is the time and talent I've expended. Supposedly, anyone could invest their time and talent to build a house, but in reality, housebuilding is best suited to one who knows how to build houses, especially given the quality of amateurish buildings. That's why my effort adds to the cost of the house.

Now we examine how supply and demand work on the houses I build. Suppose I build one house, and three people want to buy. That means the house increases in value because of the competition. How? I can simply raise the price until two of the three people are no longer willing to buy the house, and then sell it to the one left standing. The thing to note is that this increase in price is somewhat artificial, because it does not necessarily accurately reflect the cost of the materials and the value of my labor. Those two factors are a baseline of worth; the inflated cost is variable and due to other conditions. For example, if two of the three decide they're better off in tents before I inflate my price, then I can no longer inflate the price. With no competition, my one remaining customer can demand that I sell at the base price, or he won't buy at all. Alternatively, I could build two other houses so that all three can buy, and then only be capable of offering a base price. Or I could build more houses than are demanded, which could potentially artificially deflate the actual value of the first house (depending on the cost of the other houses), because the threat is there to go with a cheaper model, and leave the most expensive house unoccupied.

The government can step in and tamper with prices, too. It can mandate that every house be sold for at least some amount. This causes some reverberations in the market, but eventually it settles down. The reverberations come because some houses aren't worth that amount, and won't sell. But soon the new houses built will be built with the minimum price tag in mind, which has two effects. One is that, since cheaper housing is no longer available, there are fewer people looking for houses, and thus fewer new buildings are constructed. With fewer buildings made, the supply goes down. If the demand remains constant, then the value of the cheaper buildings rises, perhaps finally equating with that bare minimum, and the balance is restored. The second is that the base worth of a house is artificially inflated. As I said before, the cheaper houses might eventually rise value as the supply and demand evens out, but other houses will see an increase in value, as well. If this cheap house and this average house sell for the same price, there will be a higher demand for the average house due to quality concerns. Thus its price will rise.

Now suppose that the government changes its mind and removes its regulation that houses must be sold for some amount. Suddenly the price of houses collapses. People can offer cheaper houses for much cheaper than before, and the higher priced houses lose value as people steer towards the cheaper housing. In an instant, thousands of dollars per home just vanish. All manner of wealth just disappears.

This is the sort of thing that happened with the housing market crash. The government effectively mandated a minimum housing cost by making sure a much wider spread of the marketplace could afford housing (via the subprime loans). So if everybody and their cat can receive, say, a $100,000 loan, all houses are now worth at least $100,000, and all the more expensive houses rise in value. This continues in an upward surge for a time, especially as people build more houses to accommodate the influx of people looking for homes. The bubble builds for a while, but eventually--and most people seemed to forget this point--the market balances out again, and the bubble stops increasing. Due to other factors, the economy slowed, people defaulted on loans, and ultimately many banks closed and credit froze. This had the effect of suddenly reversing the $100,000 minimum mandate, and the price of houses dropped. All the wealth that had been there before evaporated.

That's the thing we need to remember in this world of ours. Wealth can not only be created, it can be destroyed. I can pump thousands of dollars into a business that ultimately fails, and that money for the most part may as well have never existed. Now, some may argue that the money I invested at least went to paying the bills, paying employees, and so on, and that even though the business failed, the money still circulated. But that money also went to purchase products that are never sold, or equipment that then lies unused and is sold off at bargain prices. The wealth effectively disappeared.

So how exactly does wealth disappear? It isn't necessarily correct to say that it disappears because it never existed, that it was an artificial wealth that ultimately would be shown to be the phantom it really is. In some cases this is correct. But for the majority of wealth that has disappeared, it disappears because natural drop in demand leads to a drop in worth of items considered.