When Illusions of Wealth Shape the Economy: Understanding Pseudo-Wealth, Macroeconomic Volatility, and Social Welfare

Yves here. This readable article demonstrates that pseudo-wealh, as in “pseudo assets”\not representing tangible economic resources, notably crypto, harm the collective good. Mind you, this discussion comes to that conclusion without mentioning the elephant in the room, that the use cases for crypto are tax evasion, money laundering, and payments for criminal activity.

Before fans complain that crypto is being unfairly criticized (which as John Mearsheimer would say, is not a serious argument), other studies by heavyweight sources, including the IMF, have found that financial speculation generally is a negative for growth. The IMF and others have found that the bigger the asset management sector becomes, the more that it is to the detriment of the rest of the economy. Brain drain is one reason; employees in the asset management industry are twice as likely as those in tech to become billionaires as those in tech. Yet officials have promoted this trend. For instance, the SEC has been fixated with lowering transaction costs, when there is no evidence that this much liquidity is helpful to anyone other than speculators.

By Martin Guzman, Professor, School of International and Public Affairs Columbia University; Professor of Money, Credit, and Banking National University of La Plata, and Joseph Stiglitz, University Professor Columbia University. Originally published at VoxEU

Pseudo-wealth is a perception of wealth that is not backed by real economic resources. When people have widely different beliefs, they create ‘wealth’ through betting. This column describes how this perceived wealth can rapidly inflate or deflate without changing real economic fundamentals, leading to volatility in spending and potential economic instability. It raises the question whether societies should promote markets that enhance the capacity of individuals to trade based on their own beliefs or intervene to protect societal welfare.

In a family of canonical macroeconomic models, fluctuations in consumption are explained by changes in real fundamentals – technology, factor productivities, resource endowments, or external shocks. But in the real world, we often observe sharp shifts in aggregate spending even when these fundamentals remain stable. Why do such spending swings occur if the underlying physical state of the economy – its human capital, infrastructure, and natural resources – hasn’t changed?

The relevance of this question increases in the current digital era and in the midst of critical global debates about the role of collective action. From soaring cryptocurrency valuations to the rise of meme coins and online betting markets, societies are grappling with forms of perceived wealth that are increasingly untethered from productive assets. These new markets often generate strong beliefs of value among participants – even when that value has no connection to the economy’s underlying productive capacity. How should we understand the economic and social value of these forms of ‘wealth’? And what happens when that value evaporates as quickly as it was created?

In our theory of pseudo-wealth (Guzman and Stiglitz 2021a), we offer a new explanation for these phenomena. This is not wealth in the traditional sense – backed by tangible or productive assets – but rather a perception of wealth that emerges when there are differences in expectations. And outside of special circumstances where there is common knowledge, there will always be differences in beliefs. ¹ The consequences of those differences in beliefs depend on the structure of financial markets. Pseudo-wealth, the difference between aggregate sum of the net wealth that individuals believe they have and the actual wealth of the economy, can inflate and deflate without any corresponding change in actual resources. And when it does, it can lead to real consequences: increased volatility in consumption and misallocated resources over time that have consequences for societal welfare.

The Anatomy of Pseudo-Wealth

Consider two people with different beliefs about the future who can bet over a rare event or, to simplify, the price realisation of an asset. One expects the asset price to rise; the other expects it to fall. If these individuals trade based on their beliefs, one will bet on a positive outcome and the other on a negative one. In equilibrium, the market for such bets will appear to create wealth for both: each believes they are going to win. Yet, from society’s point of view, no new physical asset has been created.

This illusion of wealth – generated by markets that allow trading on divergent beliefs – creates what we call pseudo-wealth. It is perceived wealth based not on new productive capacity, but on expected gains from bets. While each individual may feel wealthier, and while such bets may, from the perspective of standard welfare economics based on ex ante expected utility and ignoring any macroeconomic interactions, be Pareto improving, society as a whole has not added to its stock of real wealth.

A Hidden Source of Volatility

The introduction of pseudo-wealth into macroeconomic dynamics offers a novel explanation for spending fluctuations. When the dispersion of beliefs in the economy changes – for example, due to a shift in investor sentiment – so does the total amount of pseudo-wealth. Of course, if people feel richer, they spend more. Hence, the theory of pseudo-wealth observes that even if there is no change in average sentiment, if there is an increase in the dispersion of beliefs, there will be more betting and hence more pseudo-wealth; and the resolution of those bets will give rise to volatility.

These fluctuations are not just noise: they translate into tangible effects on macroeconomic stability. Since pseudo-wealth is not anchored to real productive assets, it is inherently fragile. Shocks to beliefs, or just the resolution of the event over which the betting occurs – a reduction in uncertainty which would normally be thought of as having a positive welfare benefit – can cause abrupt reversals in spending patterns. And there may be no close relationship between the volatility of pseudo-wealth or that of any of the underlying real fundamentals in the economy. Volatility in pseudo-wealth leads, in turn, to volatility in consumption (Guzman and Stiglitz 2021a), leading to intertemporal consumption misallocation: households spend too much in one period and too little in another with respect to what they would have chosen under consistent beliefs.

The Paradox of Completing Markets

The economics literature has shown the fragility of the perfect markets theory, which establishes the extreme conditions under which free markets produce Pareto efficient and stable outcomes, meaning that there is no value in collective action, which justifies market fundamentalism (Grossman and Stiglitz 1980, Stiglitz and Weiss 1981, Shapiro and Stiglitz 1984, Guzman and Stiglitz 2020, among many others).

Following the famous Arrow-Debreu theorems of welfare economics, standard economic theory suggests that completing markets – by allowing more states of the world to be insurable through contingent claims – improves welfare. But our theory shows that when markets are completed by enabling bets based on heterogeneous beliefs, they may increase individual and aggregate risk instead of reducing it, raising unsettling questions for social welfare analysis.

In our theory of pseudo-wealth, we show that while the classic First Welfare Theorem still holds, as welfare is evaluated based on each individual’s ex ante beliefs, this leads to a troubling conclusion: ex post welfare falls as markets become more complete. In other words, individuals make choices that seem optimal from their subjective perspectives but which result in objectively worse outcomes once the true state of the world is realised.

From a policymaker’s standpoint, this presents a quandary. If expanding financial markets allows for more betting on divergent beliefs, the result may be not improved welfare, but greater volatility. ²

A Normative Puzzle

The existence of pseudo-wealth introduces a fundamental tension in welfare economics. If markets facilitate trading based on individuals’ heterogeneous beliefs – leaving aside the issue of how those beliefs are formed – standard theory says outcomes are Pareto optimal. Yet when the set of societal beliefs is inconsistent, these outcomes can lead to worse societal outcomes, at least as viewed through the alternative lens of actual outcomes.

We argue that a planner who adopts a consistent set of beliefs (as, for instance, the reasonable beliefs defined in Brunnermeier et al. 2014 as convex combinations of individual beliefs), rather than deferring to each individual’s private expectations, would judge most betting equilibria as inefficient. This suggests that market structures facilitating pseudo-wealth creation may not be welfare-enhancing ex post, even if from the viewpoint of individual beliefs they are welfare-enhancing ex ante, and that some regulatory interventions could improve aggregate outcomes.

Reframing the Policy Debate

The theory of pseudo-wealth sheds light on why some financial ‘innovations’ – as those that expand betting on future states – may do more harm than good. One policy implication is the need to scrutinise financial innovations that increase pseudo-wealth and its volatility without enhancing productive capacity.

Recent economic events provide vivid illustrations of the dynamics described in this framework. The rapid rise and collapse of crypto assets and meme stocks further underscore how markets built on divergent beliefs can inflate pseudo-wealth, fuelling spending that becomes unsustainable when expectations or the environment shift.

It also provides a partial rational theoretical explanation for Kindleberger’s (1978) suggestion that innovations often are associated with greater volatility. Inevitably, there are large uncertainties associated with such innovations: What will be their ultimate impact? How quickly will the innovations disseminate through the economy? Will there be follow-on innovations which will make today’s leaders obsolete? These uncertainties give rise to large dispersions in beliefs, giving rise in turn to the creation of pseudo-wealth beyond the value of the wealth itself created by the innovation; and over time, as we learn more and more about the innovation, the dispersion of beliefs and the magnitude of pseudo-wealth declines. Even if society, in the aggregate, were right on target in its valuation of the benefits of the innovation, pseudo-wealth will increase more than by that amount initially, to be followed later on by a contraction in pseudo-wealth. Of course, for the welfare analysis, it is important to distinguish the innovations that create real value from those that do not.

Ultimately, the theory of pseudo-wealth provokes us to reconsider how we evaluate the value of growing betting markets – whether for crypto assets, meme coins, or financial bets – that can produce large shifts in perceived wealth without increasing real prosperity.

More broadly, our analysis raises a profound normative question: Should societies promote markets that enhance the capacity of individuals to trade illusions, based on their own beliefs – even when inconsistent – or should they intervene to protect the collective interest when belief-driven choices create systemic risks with no gain for the real economy? This is another modern incarnation of the longstanding tension between libertarianism and collective action. Libertarianism places blind faith in individual autonomy and voluntary exchange, but pseudo-wealth shows that such freedom can lead to outcomes that are inefficient and harmful when viewed ex post and from the perspective of society as a whole. In an age where perception can create and destroy trillions in value overnight, reconciling these philosophical tensions is critical for building more resilient and equitable economies.

See original post for references