Thomas Palley's weblog contains an interesting article on the worldwide phenomenon of asset inflation that has characterized the U.S. (and World) economy over the past thirty years and especially the last five years. Palley lists seven factors that explain the bubble: 1) Increased income inequality; 2) Increased profit shares; 3) Taxation policy (favoring the wealthy); 4) Export-led growth; 5) Lower central bank interest rates; 6) Credit market innovations; 7) Demographic trends (baby boomers investing for retirement).

Palley's analysis make sense. When you raise the average person's income, he will usually spend it to raise his standard of living. Not so in the case of the wealthy, who already have a high standard of living. The wealthy invest their additional income, principally in stock and hard assets that are likely to increase in value. They have little incentive to purchase bonds, since interest rates are so low. The predictable result is the bidding up of asset prices. Thus the recent massive tax cuts for the wealthy have had little positive effect on the lower 90% of the American people, while they have maintained high stock values in the face of an increasingly weak economy. The last time this happened was in the 1920s.

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.

To this amateur economist, Palley's analysis bodes ill for most of the world's peoples, with rising inequality leading to increased hopelessness among the overwhelming majority owning no substantial assets which can be collateralized and thus with no access to capital. The growing gulf between the fabulously wealthy 1% and the rest of us who are experiencing more and more economic stress (or worse), increases the likelihood of political and economic instability, with all the pain and suffering that invariably accompany them.

Not a pretty picture. Look around and see for yourself if Pally is on the wrong track.

World Asset Prices: What’s Really Going on?