Clause 61: The Pushback Blog

Because ideas have consequences

Consumption, Investment and Speculation

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With the recent Nobel Prize announcement, previous interviews with co-laureate Robert Shiller have been recycled, such as the interview from February 2013 where he challenges the received wisdom of a home as an investment.

When is an activity an investment, and when is it not? And if it is not an investment, what is it? Although Shiller makes valid points, the answers are not entirely clear-cut.


It is obvious from talking to people that the differences among consumption, investment and speculation are not well understood. So our starting point has to be clarifications of what each of these are.

Current Accounts

Start with the current activities of any person or group. The entity is producing and consuming wealth in order to stay in existence.


People need food, clothing and shelter in order to live. These are forms of wealth that, to varying degrees, we use up in the course of living. Food has the shortest lifetime; we eat it and it is gone. Clothing lasts a little longer, but it has very little residual value.

Periodically, there is public discussion around the assertion that “70% of Gross Domestic Product (GDP) comes from personal consumption.” As Robert Higgs points out, it is easy to make an unwarranted leap from that assertion to a meaning. There is no agreed-upon norm of what proportion of the economy personal consumption ought to be.

The assertion itself is open to question, as Michael Mandel explained in 2009. A percentage is a ratio, and as is usual with statistics based on ratios, the denominator is where the slipperiness is. More about this shortly.


Few people discuss surplus, but it is the secret sauce of prosperity. Surplus is production less consumption. In order to have anything left over to store up and get richer, one has to be producing more than one consumes; this is called capital formation.

The surplus produced by a business is called retained earnings. Typically, accountants back into retained earnings; it is what is left on the balance sheet after liabilities and equity, which are sources of funds, are subtracted from total assets, which are uses of funds.

In order to have any wealth to work with above the subsistence level, somebody has to either be running a surplus now or have formed and preserved capital from a prior surplus. Borrowing in order to invest presupposes that the lender has capital as a result of a prior surplus, or there would be nothing to lend. If a couple buying a house had enough money saved to pay cash for it, they would not need a mortgage. This is usually not the case. The source of the wealth for the mortgage must have accumulated the capital in order to lend.

The problem with GDP is that it really doesn’t measure production at all, but spending. We look at what was spent and assume that the wealth must have been produced in order to be spent. However, there is mounting evidence in the form of international capital flows in support of the argument that this assumption is being violated for the United States.


A store of wealth which can be used to fund other wealth-producing activities is called capital stock. Modern economic activity depends on the existence of capital stocks that can finance other activities. I will begin by discussing these in terms of a for-profit business, and then switch to examine what changes when applying the terms to the activities of an individual person.

Paddy Hirsch has created the Whiteboard series on; it is a well-developed series that explains complicated topics in economics, business and finance (although with some biases). His discussion of lending is typical of how the topic is typically presented: from the perspective of the bank. While the bank’s perspective is important, the demand for capital is even more important, and is essential to understanding the nature of business activity.

When you start a business, your payables are due now but your income will arrive mañana, maybe. Your suppliers and employees don’t want to wait until you get paid before they get paid. The rent and electric bill are due immediately whether you have money in the till or not. You, the business person, have to front the money and bear the risk of ownership. Thus, you start out in a cash flow bind. Capital provides the funding to pay the bills now and see the business through until the income arrives later. As such, capital is a factor of production and is entitled to its share of income, which is called interest and dividends.


A lender makes capital available at relatively low risk for a fixed return, the interest on the debt. Lenders typically expect to not have their principal at risk, and loaned money has a senior legal claim to invested money. The lender relinquishes some upside in return for this.


Investors provide capital in return for an ownership interest. Investors do expect to have their principal at risk, but they also expect greater returns. At least in theory, the management of the business has significant accountability to the investors. This is less so in a publicly traded company, which is another topic of discussion. An investor with a significant position in a private company will have a presence on the board of directors and will have transparency into the operations of the business.


People often describe themselves as investors where they are really speculators. A person who takes an equity position in a business, not because he understands how the business makes money, but because a stranger on an airplane told him to, is really a speculator.

Upper-class people whose social norms discourage them from direct involvement in business affairs are often speculators and targets of swindlers. An example was provided in an en passant remark in the third series of Downton Abbey. The Earl was casting about for a source of income to keep the estate going, and he hit upon: “I hear of schemes every day that will double whatever’s put into them. There’s a chap in America — Charles Ponzi!” The reviewer in Television Without Pity described this as “super-cheap,” but I think it captures the propensity for such people to fall for speculative schemes without being overly preachy about it.

Speculation is inherently risky by nature. The speculator embraces risks that are not even visible to him in the expectation that a greater fool will come along. Public policy tolerates speculators, who magnify market movements, because they absorb risk.


Where does this leave the holder of common stock in a publicly traded company? Well, it depends on the purpose. A day trader is a speculator, pure and simple; there is not enough time for him to understand the business activities of the companies in which he is taking a position. His motivation is to take advantage of an opportunity that exists based on his expectation of what others will pay him for his stock in the immediate future.

A person who wants to be an investor rather than a speculator would have to know something about the business of the company whose stock she is buying in order to make an effective business judgment about it. She would be able to read the financials and understand the entire package line by line, including the notes. She would often still encounter challenges obtaining transparency into the business; this leads into corporate governance issues that are beyond the scope of this post.

The issues are further muddied because we commonly describe activities such as stock purchasing as “investments” when they may be in reality highly speculative. We discuss investments as if the mere fact that stock was purchased establishes that the purchaser is investing. We also misapply the term to describe speculation in metals. Then we take the same terminology and apply it in a parallel way to real estate.

The Non-Business Perspective

The foregoing definitions are from the perspective of a commercial business which produces wealth and is a going concern as long as it is financially solvent. How do these definitions apply to living persons, whose existence is not contingent on financial results?

Think about paying cash for a new car, with a service life of 5 years. A business that purchased a vehicle as part of its operations would expense part of the value of the car every year, matching this expense against the revenue generated by using the car in each year. The cash out the door at purchase would show up in the statement of cash flows in year one, but the car would be carried on the balance sheet as a depreciating asset.

An individual person is usually on cash-basis accounting. Nevertheless, the person who uses the car to commute to work is able to match some of the depreciating value of the car to income produced by its use in every year. At least part of the value of the car paid for up-front would then represent an investment, because it is amortized over a period of years to participate in income-producing activities. It also provides value in logistical functions such as getting to the grocery store. The owner of the car runs down the value of the vehicle, not in a malicious or destructive way, but by using it over its service life.

One could argue that a $20,000 car can perform these functions just as well as can an $80,000 car. If we were to use the $20,000 car as the baseline, a person who paid $80,000 cash up-front for a luxury car would be making a $20,000 investment and consuming the remaining $60,000. This is not a value judgment; the person choosing the luxury car has reasons that are perfectly valid to her, and I do not propose to criticize them. The important point is to recognize that not all of the expenditure in purchasing a long-lived asset is necessarily investment. I am not saying, “investment good, consumption bad.”

We can extend the metaphor by imagining a person paying $100,000 cash for a limited-production collector car, in the hope that the car will be worth more in the future. This would be speculative behavior; the value of the car in the future will be determined not by the use of the car by the owner but by the future demand for the car and the survival of other cars of its kind. The purchaser may represent that he is making an investment here, but it is really mere speculation.

Real Estate

I chose the car example both because it is easy to visualize and because it ties back into Shiller’s argument. What about “investing” in real estate?

Components of the Real Estate Purchase

When you buy a single-family house, you get the house and the land. The structure is, as Shiller says, a depreciating asset — it has a longer life than a car, but it depreciates nevertheless. For example, the expected service life of a well-constructed asphalt shingle roof is 15-20 years, although wind and hail can damage it and reduce the life.

Also, notice the introduction of the term “well-constructed.” The investor has to make sure that the roof really is well-constructed, possibly by personal supervision, either by the owner or a delegate. The speculator doesn’t care much beyond outward appearance; her only interest is what she can get someone to pay for the house.

Not only does the house wear out, but it ages in other ways. Interior décor goes out of style and requires updating or the house looks “dated” and the market value is impaired.

One would expect land to appreciate in value, because we can’t make more land (fills in coastal cities can’t keep up) and we are constantly making more people who want to live on it. However, several factors influence this. Land can be less desirable because it is less productive than neighboring land, or because it is in an area where demand is lower. When the conditions of a neighborhood (South Bronx) or the economic of a region (Detroit metro) deteriorate, demand for land there will go down. Thus, even land is not certain to appreciate in value over time.

I will exclude from this discussion townhouses and condominiums, which carry minimal or no land with the deed. These do not change the discussion except to increase the emphasis on the structure, which is the depreciating asset.

Home Ownership Considered

The headline is naturally sensationalized to get your attention: “Robert Shiller Destroys The Idea Of Investing In A Home.” Does he really? We need to understand the benefits and costs of home ownership.

Personal Benefits of Home Ownership

There are several benefits that a home owner obtains from owning his residence:

  • Control: You can do what you want with the house. Subject to local ordnances and association restrictions, you can hang items, paint and even move walls if you see fit. You can redo the kitchen, choose the appliances and arrange the storage to suit yourself.
  • Permanence: You do not have the uncertainty of leases, changes in landlord/management and deterioration of service. You can count on living there as long as you want to and you can pay the mortgage.
  • Privacy: Many people who would be renting apartments can qualify for a single-family house with greater separation from the neighbors.
  • Credibility: Outside of areas that are predominantly populated with renters, such as Manhattan, a homeowner has credibility as a citizen that a renter does not.
  • Tax shelter: Both mortgage interest and real estate taxes are deductible on Schedule A. This helps reduce the operating cost of owning compared with renting.

Notice that most of these are intangible benefits. It would be next to impossible to rigorously assign financial values to them.

Social Benefits of Home Ownership

Watch the movie It’s a Wonderful Life [trailer]. It was directed by Frank Capra, who had made the Why We Fight series to explain the necessity of American involvement in World War II. Capra really knew how to drive his point home. It’s a Wonderful Life is a paean to home ownership. He even gives the viewer a look at the alternative universe where most people don’t own their own homes: the town has become a pit, with dime-a-dance joints, pawn shops and prostitutes.

Frank Capra was not alone in the belief that a community of owners would be a better place to live than a community of renters. It has been tacit policy for decades to subsidize owners through tax relief and by the creation of quasi-government entities to influence home financing and socialize financing risk. These latter entities are commonly known as Fannie Mae and Freddy Mac.

We believed that a nation of homeowners would build stronger communities than would a nation of renters, because property owners would have a stake in their community. To an extent this is true, although there is not an exact correlation; it is possible to find locales with high levels of owner occupation that are not all that desirable.

When the owners start speculating on real estate, there can be problems because the owners overextend themselves and don’t have anything left to allocate for the upkeep of the community. However, without the community, the asset value of the property itself is at risk. Jack Knuepfer, who was chairman of the Board of Commissioners of DuPage County, Illinois from 1978-1990, summarized the problem this way in a 1990 interview:

It`s difficult keeping up with growth because when people move to a new house, they generally put every nickel that they have into it and maybe a nickel that they don`t have. And then, all of a sudden, they find out they have to pay for highways and schools and everything else, and that`s sometimes the straw that breaks the camel`s back. They want the lifestyle but would like someone else to pay for it.

At that time, you could drive around DuPage County at night and look at the see-through houses: the owners had made themselves so house-poor that they couldn’t afford window treatments, so you could see from the road clear through the house if the lights were on.

Drawbacks of Home Ownership

A house is a very illiquid asset. It ties up a significant amount of personal wealth in an asset that is not quickly or easily converted back into cash. People have been known to overextend themselves and become house-poor; they have the personal wealth, but most of it is tied up in the house.

If the homeowner wants to relocate to another part of the country, the house must be sold. If the local economy is doing badly, the homeowner can be stuck there if he owes more on the secured debt than the house is currently worth.

Don’t Spook the Cattle

Because of the way real estate pricing fluctuates, it has aspects of a Keynesian beauty contest: what matters when you go to sell a house is not what you think it is worth, but what you think other people will think it is worth.

In the face of a perceived deterioration in the surroundings, the value of the property will fall. The deterioration does not have to be real; all that matters is that enough people believe that the neighborhood is falling apart to, in effect, make it so. Even if one homeowner wants to keep his head in these conditions, the fear of sticking around too long while others pull out can be overwhelming.

Blockbusting is a practice where unscrupulous real estate agents take advantage of racial fears and prejudices of homeowners to create a stampede of panic selling. Blockbusting practitioners turned over a substantial portion of the housing in East Cleveland in the late 1960s, leading to the decline of the city. The problem for the city was not the fact that blacks were moving in, but the rate of turnover and the fire-sale prices leading to reduced valuations and a diminished tax base. Moreover, many white residents who fled took their businesses with them, causing further attrition to the economy and finances of the city.

Real Estate as Consumption

Consider a couple who purchase a newly constructed home, move in and live there for the next thirty years. As soon as the home is finished, the meter starts running on the service life of the various components. As they live there over the course of the years, they are in effect consuming the asset. If they did no maintenance or improvements on it, they would reduce it to its salvage value.

By living in the house, they obtain the shelter benefit. They avoid having to pay rent for a place to live. One could argue that they are paying rent to themselves, and that is the origin of imputed rent. Some countries in Europe tax this as income, which is another topic to take up another day.

If this hypothetical couple were to have made a significant down payment, so that they had equity in the house eight o’clock day one, they would have made an investment in the accrual accounting sense: they would have paid up front for an asset (or at least part of one) that they would depreciate through use over subsequent years. However, this is not the same as the general understanding of the term investment.

Real Estate as an Investment

What does investing in real estate look like? How do we tell the difference between investing and speculating?

  • A person who purchases a house to rent it is an investor. The investor seeks an income stream in the form of rents as return on the investment. The investor may engage the services of property managers, tradespersons and various others to manage and maintain the property; this does not modify the situation. The investor doesn’t have to put her own personal sweat into the property in order to be an investor.
  • A person who purchases a house planning to live in it for two years and sell it at a profit is a speculator. He may have projections that, based on past performance of real estate in the area; the future results may not meet these expectations.
  • What about a person who purchases a house needing work, fixes it up and flips it? This falls in a gray area. To the extent that he depends upon his improvements to realize value, he is an investor. To the extent he is counting on future market conditions to be above current market conditions, he is speculating.

To an extent, we need to be able to see inside the soul of the person buying the house to distinguish between investment and speculation.

Closing the Loop

Return now to the interview with Robert Shiller. The title of the article is, “Robert Shiller Destroys The Idea Of Investing In A Home,” but it should really be, “Robert Shiller Destroys the Idea of Speculating in a Home.” Shiller takes the idea of investing in real estate at face value, considers the financials and shows that the home buyer motivated by asset speculation is taking on a lot of risks.

However, the total package as described above is more than just the asset price of the house. For the owner-occupier who wants control over the premises, doesn’t want a landlord or is motivated by the other, less tangible benefits, home ownership still makes sense. Such a person should maintain the house, avoid large renovations justified by the rationale that “it’s an investment” and look for ways to diversify holdings so that there are more liquid assets that can be liquidated if cash is needed.


Written by srojak

October 25, 2013 at 10:51 pm

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