Income, wealth and liquidity

National income is an official measure of the flow of new goods and services produced in a country during a year. A country’s wealth is the value of the stock of assets created over a period, and which last into the future, and beyond a single year. Income is converted into wealth when assets are purchased. For example, a new house built and sold in a given year forms part of that year’s national income, but it also becomes part of national wealth, as the house will last for many years.

Types of wealth

Wealth is held in many forms, including:

Personal wealth

Personal wealth includes physical assets such as houses, land, motor cars, computers and antiques, savings from previous income, share holdings, and cash in the bank.

Corporate wealth

Corporate wealth includes physical assets such as buildings, equipment, machinery, and a wide variety of financial assets. Financial assets include holdings of bonds and shares in other firms, cash in the bank, foreign currencies, repayments on loans due from debtors, and the value of unsold stocks.

Businesses tend to differentiate current assets, which exist for one year or less, and long-term assets, which last several years.

Wealth effects

A wealth effect refers to changes in household or corporate spending that can occur as a response to changes in the value of wealth. Wealth effects can be positive and negative. They are most commonly associated with changes in house prices, share and bond prices.

Annual household net worth 2002 - 2010

While the average level of household wealth in the UK has risen over time, it is volatile, and the house price crashes of 1990 - 1993, and 2008 - 2009, led to a steep falls in wealth levels. Household spending is affected by changes in household wealth through a process called equity withdrawal, and changes in confidence levels.

Liquid and illiquid assets

Wealth can also be looked at in terms of liquidity, which is the ease with which an asset can be converted into cash. Cash is considered to be perfectly liquid, whereas fixed assets like machinery and premises are extremely illiquid.

The macro-economic system needs considerable liquidity to facilitate the circular flow of income. The recent credit crunch, like previous economic disturbances, was triggered by sudden changes in the availability of liquidity. As banks, firms and households look to reduce their risks they often reallocate their wealth from illiquid forms to liquid forms. However, as they increase and protect their own liquidity, less liquidity is made available to others.

In a sense, people hoard liquidity which perversely reduces liquidity in the whole macro-economic system.  For example, banks may call in loans or make fewer loans, and in turn, firms may hold fewer stocks and prefer to hold cash.  To compound matters,  anxious households may save more of their income, and hold more cash, which reduces spending on consumer goods, and further reduces liquidity.

See also: The financial crisis and quantitative easing