In an email, Thomas Palley says, "Here's my first policy op-ed of 2007. ... It was inspired by your posting of Ricardo Caballero's paper (thanks!), which I noticed produced much confused discussion." He'd like to hear what you think of his attempt to clear the air:
World Asset Prices: What’s Really Going on?, by Thomas Palley: World asset prices have been booming for the last five years, with many bourses setting new record highs. Along with record real estate values, this has created fears of a global asset price bubble. Now, MIT’s Ricardo Caballero has come up with the proposition that prices are rationally up because of a global shortage of financial assets, and there is little reason to worry. Close inspection reveals his analysis to be unpersuasive on both the facts and the merits, and it also carries dangerous policy implications.
On one level the observation of an asset shortage is trivially obvious. Econ 101 demand and supply analysis teaches that prices rise when there are shortages. The novelty enters when it comes to explaining the cause of the shortage. According to Caballero, countries have gotten their investment markets together, and entrepreneurs now need collateral to back financing for new investments. Ergo, a global collateral shortage that has driven up asset prices. In this environment, a price bubble is actually the optimal market response because higher asset prices create collateral that expands economic activity, and the gains from this expansion outweigh the costs of subsequent asset price deflation.
This is clever stuff that will undoubtedly earn high praise among economists whose axiomatic reasoning renders everything the market does as optimal. The problem is that it is pure axiomatic reasoning with little regard for the real world. First, the collateral shortage hypothesis does not explain asset inflation in the U.S. Europe, and Japan, as these economies have long had established functioning investment markets. Second, the real world has actually experienced an explosion in asset supply. The past twenty-five years witnessed a worldwide process of privatization that had governments sell off huge chunks of the global economy. Today, this process continues with China off-loading banks and regularly bringing new initial public offerings (IPOs) to market. The 1990s also saw the Internet boom with its flood of IPOs. Moreover, this has been a period of significant government deficits, with governments selling huge quantities of bonds. Lastly, there has been massive expansion of credit markets involving issuance of private sector debt, and one person’s financial liability is another’s financial asset.
If you only have a hammer, everything tends to look like a nail. That applies to explaining the economics of boom – bust cycles, for which collateral has become the hammer of the herd (yes, the economics of herd behavior applies to economists themselves). For those who are more discerning, here are eight other factors explaining the boom in world asset prices, each of which seems more plausible and consistent with the facts than the collateral shortage hypothesis.
Factor #1: increased income inequality. Over the last two decades global income inequality has exploded, both within and between countries. Moreover, the increase has been particularly acute in the U.S., and a recent study by Becker and Gordon documents how the top ten percent of earners have collared half of U.S. productivity growth over the last thirty years. This has returned U.S. income and wealth distribution to pre-1929 inequality levels. For asset prices, the important feature is that very high-income families have a very high propensity to save, which has increased demand for financial assets.
Factor #2: increased profit shares. Over the last two decades there has been a significant shift in the profit share. The U.S. after-tax profit share is at its highest level in 75 years, while the share of profits in Europe and Japan is near twenty-five year highs. That has contributed to an increase in the fundamental value underlying equities.
Factor #3: taxation policy. Not only has the economy favored profits and high-income groups, so too has tax policy. Thus, between 1978 and 1999 top marginal tax rates fell significantly in every OECD country for which statistics are available. In the U.S. the top rate fell from 70 to 39.6 percent. In the U.K. it fell from 83 to 40 percent. This has further increased incomes of high-income families, increasing their demand for financial assets. Corporate tax rates have also fallen, and a KPMG study documents that between 1993 and 2006 the average rate of corporation tax in 86 countries declined 29 percent. This has further increased the underlying value of equities.
Factor #4: export-led growth. It is now widely recognized that China and much of East Asia have adopted export-led growth, a key ingredient of which is undervalued exchange rates. To keep their exchange rates under-valued, East Asian governments have been accumulating U.S. and European bonds, resulting in lower interest rates that have in turn fostered higher equity and real estate prices.
Factor #5: lower central bank interest rates. In addition to the effects of export-led growth, the weak state of demand in the global economy has prompted central banks to push interest rates lower. In Japan, the threat of deflation has kept official interest rates close to zero for a decade. In the last U.S. recession the Federal Reserve pushed interest rates to one percent, held them there for an extended period, and then only raised rates incrementally over a two-year period. Moreover, even now at the peak of the business cycle, interest rates remain historically low because of fears of underlying demand fragility. Similarly, in Europe interest rates have been at historically low levels for the past five years. These low interest rates have in turn supported higher asset prices. However, if an economic downturn takes hold, weak goods demand could yet end up trumping this central bank interest rate effect.
Factor #6: credit market innovations. The last twenty years have also witnessed tremendous credit market innovation. In the corporate sector, the 1980s saw the introduction of junk bonds, and such financing is now the favored vehicle of leveraged buyouts that bid up asset prices. Additionally, the emergence of private-equity funds allows the super-rich to pool their funds and leverage them. In 2006, John Mack, CEO of Morgan Stanley, was paid $40 million. Leverage that ten times, and with one year’s pay Mr. Mack can buy a company worth $400 million that took a century of work by thousands to build. This reveals how factors affecting asset prices interact synergistically.
Household credit markets have also changed as evidenced by home equity loans and the advent of interest-only mortgages. These innovations have liquefied homes and increased the volume of money chasing real estate assets.
Factor #7: demographic trends. Another widely recognized development is the aging of the baby boom generation, which is now in the second half of its work life. That places baby boomers in their period of heaviest saving for retirement, which has increased asset demand. Additionally, public policy in the U.S. and elsewhere has encouraged replacing defined benefit pensions with defined contribution pensions (think 401(k) plans). This too has increased financial asset demand since companies need not fully fund defined benefit plans, whereas defined contribution plans are fully funded.
Factor #8: mania. Finally, world asset prices may be up because of good old-fashioned investor mania. Such manias have a long history from the 17th century Dutch tulip bubble, to the 18th century South Sea Company bubble, to the crash of 1929. Human beings, with their proclivity to greed and taste for gambling, remain largely unchanged. That means manias remain a live possibility, and they are easily fostered by yuppie dinner-table talk of house prices and Wall Street’s promotion of equities.
The “supply-side” collateral shortage hypothesis and asset “demand-side” hypothesis have radically different public policy implications. The former views asset price bubbles as largely benevolent, reflecting the market’s attempt to solve collateral shortages. Policy may even wish to encourage bubbles by further lowering interest rates, thereby increasing asset values and collateral.
The latter sees things very differently. The rise in asset prices reflects significant adverse trends regarding rising income inequality and shifts in income distribution to profits. It also reflects the distorting effect of excessive export-led growth and weak global demand that have driven low interest rates. Furthermore, asset price inflation aggravates income inequality since it is tantamount to a terms-of-trade improvement for the wealthy, whose assets are now worth more. Consequently, workers must give over more to acquire retirement assets, and they are also vulnerable to price declines. Lastly, asset price inflation creates a form of economic lock-in since attempts to alter income distribution or taxes can undermine asset prices, potentially causing financial crisis. This is particularly so if asset purchases have been credit financed.
Finally, the collateral shortage hypothesis camouflages a regressive political economy. Nobel laureate Joseph Stiglitz’s work on credit rationing shows how economies can be constrained by lack of collateral that limits access to credit. This is a real problem in developing countries where wealth inequality means that most have no collateral, inhibiting their entrepreneurial possibilities. The asset boom - collateral shortage hypothesis implicitly puts this insight in the service of developing country elites who own most of the wealth, encouraging policies that further raise the value of their assets. Look for this idea to soon show up at the IMF and World Bank.