With asset prices plunging, I hear cash is piling up on the sidelines as investors flee the market. These words conjure up the image of a weary blackjack player who has chosen to cash in his chips and sit out the game. Unlike a blackjack table where cash moves among players and the house, market trades move cash from sideline to sideline, not into or out of markets (other than for occasional share offerings or repurchases by companies). Despite the vague feeling that there are no buyers in this market, every dollar “taken out of the market” by a panicked seller is offset by an equal dollar “put into the market” by a buyer. There is essentially no net change of cash on the sidelines even in a falling market. Yet the seductive appeal of this money illusion might be a cornerstone of the current financial crisis and the bubbles that preceded it.

Let’s deconstruct how the money illusion can insidiously fuel asset inflation. Imagine a town of 100 similar homes that are priced at $100,000 and the next marginal buyer pays $150,000 for a house. The typical mark-to-market appraisal mechanism would value all 100 homes around this price. A single $150,000 transaction “produces” $5 million in collective home equity. Stocks are similarly appraised, especially since common shares are interchangeably equal. If a marginal buyer pays $15 for 10,000 shares of stock that recently traded at $10 with 1 million shares outstanding, then the collective brokerage account balance appreciates by $5 million. In each case, a relatively small amount of cash moves from sideline to sideline as a corresponding seller assumes the cash position, but the overall effect on asset inflation is substantially larger.

These examples highlight how mark-to-market asset appraisal methodology can exponentially decouple accounting wealth from the underlying cash wealth of a system. Cash movement is zero-sum in every transaction but can produce asset markup through price discovery. The mark-to-market appraisal mechanism further applies this multiplier effect to all similar units. When credit institutions lend against the “marked up” home or stock equity, the multiplier effect itself multiplies through the financial system. A relatively small $150,000 marginal transaction catalyzes an apparent $5 million gain in collateral for borrowing, and so on, fomenting asset bubbles. When the caprice of price discovery turns, mark-to-market appraisal can work in reverse and drive down prices in a feed-forward manner, as we are witnessing now.

The systemic distortion created by mark-to-market appraisals begs the question as to whether an unrealized price gain of an asset should be treated as a real asset. On one hand, it seems hard to fault any specific bank that lends against the appreciated equity of a particular unit of stock or home since that asset could be liquidated near the most recent transaction price if it were to be the next unit sold. On the other hand, it is hard to justify 100 banks all lending against the collective appreciated equity since they cannot all simultaneously be the marginal seller.

An alternative way to appraise assets that confers more pricing stability and dampens feed-forward bubbles and busts might be to use cost-based appraisal until a price change becomes realized. Interestingly, for capital gains tax assessment purposes, the unrealized gain is not treated as a real asset. When a house or stock appreciates, the marked-up value is not eligible to be taxed for capital gains. Indeed the asset is held at its cost basis for purposes of capital gains assessment until the gain becomes realized through a marginal transaction.

Inevitably, questions will arise about fairness. However, it is important to point out that we already live in an inconsistent world where the same unrealized gain is treated differently for financial purposes than for tax purposes. Homeowners want to eat their cake (have their assets be appraised at cost for capital gains tax purposes) and eat it too (appraised at mark-to-market price for financial purposes). Can you imagine the uproar if homeowners were asked to pay capital gains on mark-to-market appreciation of home equity? Yet homeowners would be equally indignant if they were prevented from borrowing against mark-to-market appreciation of home equity and their assets were valued at cost until sold. On a cost basis, our fictional town of 100 similar homes would then be affected in a different way. The marginal sale of a home for $150,000 would not affect the appraisal value of other 99 homes, and would only add $150,000 to the collective wealth calculator.

Valid criticism regarding fairness and the resulting economic inefficiencies aside, the trade-off in socioeconomic benefits cannot be underestimated. Forcing credit institutions to drop mark-to-market appraisal of assets and adopt a cost-based appraisal methodology, similar to that used for capital gains assessment, would significantly dampen the money multiplier effect and mitigate the amplitude of feed-forward asset bubbles and busts. Asset prices would be less volatile and better track underlying fundamental wealth. Lower asset price volatility reduces the risk of episodic economic and social upheaval. Thus, the risks of adopting cost-based asset appraisal might be high, but as we are experiencing today, the risks of not adopting it are a lot higher.

Joon Yun is president, Palo Alto Investors LLC, Palo Alto, Calif.