Shares of stock are no more than sheets of paper or more likely, computer entries, and do not directly contribute to the productive ca- pacity of the economy. Instead, financial assets contribute to the productive capacity of the economy indirectly, because they allow for separation of the ownership and management of the firm and facilitate the transfer of funds to enterprises with attractive investment opportunities. Financial assets certainly contribute to the wealth of the individuals or firms holding them. This is because financial assets are claims to the income generated by real assets or claims on income from the government.

When the real assets used by a firm ultimately generate income, the income is allo- cated to investors according to their ownership of the financial assets, or securities, issued by the firm. Bondholders, for example, are entitled to a flow of income based on the interest rate and par value of the bond. Equityholders or stockholders are entitled to any residual income after bondholders and other creditors are paid. In this way the values of financial assets are derived from and depend on the values of the underlying real assets of the firm.

Real assets produce goods and services, whereas financial assets define the allocation of income or wealth among investors. Individuals can choose between consuming their current endowments of wealth today and investing for the future. When they invest for the fu- ture, they may choose to hold financial assets. The money a firm receives when it issues securities (sells them to investors) is used to purchase real assets. Ultimately, then, the returns on a financial asset come from the income produced by the real assets that are financed by the issuance of the security. In this way, it is useful to view financial assets as the means by which individuals hold their claims on real assets in well-developed economies. Most of us cannot personally own auto plants (a real asset), but we can hold shares of General Motors or Ford (a financial asset), which provide us with income derived from the production of automobiles.

Real and financial assets are distinguished operationally by the balance sheets of indi- viduals and firms in the economy. Whereas real assets appear only on the asset side of the balance sheet, financial assets always appear on both sides of balance sheets. Your finan- cial claim on a firm is an asset, but the firms issuance of that claim is the firms liability. When we aggregate over all balance sheets, financial assets will cancel out, leaving only the sum of real assets as the net wealth of the aggregate economy.

Another way of distinguishing between financial and real assets is to note that financial assets are created and destroyed in the ordinary course of doing business. For example, when a loan is paid off, both the creditors claim (a financial asset) and the debtors obligation (a financial liability) cease to exist. In contrast, real assets are destroyed only by accident or by wearing out over time.

The distinction between real and financial assets is apparent when we compare the composition of national wealth in the United States, presented in Table 1.1, with the financial assets and liabilities of U.S. households shown in Table 1.2. National wealth consists of structures, equipment, inventories of goods, and land. (A major omission in Table 1.1 is the

I. Introduction 1. The Investment

Environment

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