World Asset Prices: What’s Really Going on?

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.

4 Responses to “World Asset Prices: What’s Really Going on?”

  1. Bill Parks Says:

    Really excellent analysis. I’d like to send you some ideas of mine that might be of interest to you. Because I’m still working, though retired, I don’t have any way to get these ideas out. They are an extension of the ideas proposed by Warren Buffet to manage our trade deficit.

    ATTACKING OUR PERSISTENT TRADE IMBALANCES
    Bill Parks

    INTRODUCTION TO THE PROBLEM

    According to many economists the present trade deficit is unsustainable. And unlike the federal budget deficit for which there are known remedies, there is no assured answer to combat the growing trade deficit. Most economists pin their hopes on a change in exchange rates to solve the problem. While it seems to be correct that there is a level of dollar depreciation that will cure the trade deficit, it unlikely that there is a level that could reasonably be obtained without massive domestic dislocations.

    The globalization of even relatively small business has created a world market for many products that never had such a market in the past.

    For instance, I recently checked on the delivered cost of a Chinese product and the cost for a comparable domestically available product made in the U.S.A. The cost differences are huge. The domestic product (for no particular reason we will call them Widgets) is available for about $100.00. The product made in China is available including tariff and transportation charges for about $31.50. Will any economist advocate this much depreciation of the dollar?

    And while revaluing the Yuan will make some difference in the relative trade position, it is only likely to make goods from India, Malaysia, Thailand, Viet Nam and Indonesia relatively more desirable. Imports from these Asian sources are growing at 18% per year. The above comparison is not unusual. In industry after industry, the differences are comparable.

    Businesses naturally gravitate towards the products that have the greatest differential between imported and domestic prices. Likewise, products for which there is the greatest advantage in export prices over another country’s domestic prices are the products exported. Trade deficits occur when there are more product values available to import than to export. While it can be pointed out that imports are profitable up to where their cost is just equal to domestic production costs. However, Of course, anyone familiar with trade would point out that there are many products for which a much smaller differential exists between domestic and overseas costs. Economists can easily show that importers will continue to increase their imports up the point that landed costs of imports are just equal to the costs of products available from domestic producers.
    However, Widgets are not an extreme case of cost differences. Many other more extreme ones can be shown to exist.

    Unfortunately, even extreme devaluation of the dollar is not guaranteed to right the trade imbalance. For instance, if the dollar were devalued by fifty percent, surely a very drastic move, the widgets would be available in the United States for approximately $63.00. If Widget demand didn’t decrease, then the trade deficit on Widgets would double and the United States would be even worse off from a deficit standpoint.

    The economist would naturally ask how could the price double and yet the demand not be reduced. One has only to look at the profits of many U.S. companies to see where the very high margins available from imports are going. Public companies, captive to Wall Street expectations, are more likely to pass on any price increases and thus further fuel inflation.

    As can be seen above, the idea that production now in China will come back to the United States with any reasonable dollar depreciation, though theoretically appealing is not likely to have and practical significance. A most important part of trade is knowledge. In 1959 a steel strike continued for 116 days. After exhausting domestic supplies even at outrageous prices, purchasing agents across the country looked for steel to meet their needs from any source and for almost any price. Desperate, they turned to steel mills and suppliers from around the world. What they found were high quality products available from European and Asian suppliers that were not only reasonably priced, but of equal or better quality to that had been available domestically. And the prices, absent the 1959 shortages, were substantially below domestic prices. The largest steel warehouses or steel service centers as they preferred to be known, were linked with the major domestic suppliers. Before the strike the few warehouse importers were outcasts from the domestic industry and few purchasing agents would buy from them or directly from overseas producers. Afterwards their products and service were part of the consideration of many more purchasing agents. At that time the fate of the domestic industry was sealed. For the next 40 years congress and the president were being solicited to pass more and more legislation that would save the domestic industry from “unfair competition or “dumping”. At the same time the increasing use of the mini-mills with their electric furnaces to process scrap were taking a greater and greater part of the domestic market. The knowledge of foreign steel producers’ capabilities was the genie that once unleashed could not be returned to the bottle.

    And the idea that there is any reasonable level at which our trade deficit will stop growing is unfortunately not based on reality. As more and more domestic plants close, the smaller sub-suppliers also close and the infrastructure deteriorates. Conversely, in China and many other countries, sub-suppliers and other infrastructure as well as direct suppliers are growing apace. It is amazing to see how factories and their supports including housing are growing at a frantic pace all over Asia. Yes, there is widely predicted to be a bust to follow the China’s boom, but the economics are so compelling any bubble burst is likely to be followed by further growth.

    Today, though knowledge is ubiquitous, relationships are still important. We receive solicitations from Asian factories at least weekly and unlike the Nigerian scams these have real substance and there are probably many reputable and competent firms among them. Mostly, however, we depend on referrals and friends of friends to source specific needs. These networks, having once been built will be available for many years, no matter what should happen to the value of the dollar. Privately held firms such as ours can afford to take a long view and simply will not respond dollar devaluation in the ways that economic theory says we should.

    If economists are correct that the present trade deficit is unsustainable, what will be the situation if the trade deficit continues its relentless rise to say 10% of GNP and that this deficit continues for 15 years? What will be the position of the United States at the end of that time? If, as seems likely, depreciating the dollar won’t cure the problem, what are the alternatives?

    Protectionism, whether in support of steel or textiles may be good politics, but whether or not it is good economics, it is likely to be overturned by the World Trade Organization. Thus it may be time for some original thinking on the subject.

    A POSSIBLE SOLUTION

    Fortunately, Warren Buffett and Carol Loomis have given us a roadmap for easing into a way to slow down and then reverse our ballooning trade deficit. One paragraph of the article shows both the reason and the direction for his plan. “The time to halt this trading of assets for consumables is now, and I have a plan to suggest for getting it done. My remedy may sound gimmicky, and in truth it is a tariff called by another name. But this is a tariff that retains most free-market virtues, neither protecting specific industries nor punishing specific countries nor encouraging trade wars. This plan would increase our exports and might well lead to increase overall world trade. And it would balance our books without there being a significant decline in the value of the dollar, which I believe is otherwise almost certain to occur.

    We would achieve this balance by issuing what I will call Import Certificates (ICs) to all U.S. exporters in an amount equal to the dollar value of their exports. Each exporter would, in turn, sell the ICs to parties - either exporters abroad or importers here - wanting to get goods into the U.S. To import $1 million of goods, for example, an importer would need ICs that were the byproduct of $1 million of exports. The inevitable result: trade balance.”

    The heart of Mr. Buffet’s and your proposal is this:

    · For each dollar of goods and services exported, the government would give an exporter a certificate that could be traded on the open market.

    · Importers, on the other hand, would have to purchase a certificate for every dollar of goods and services they import. Outsourced jobs count as “services” and also require import certificates.

    Because imports now exceed exports by about two to one, implementing this plan too abruptly would be like throwing a car into reverse at 60 miles an hour. But by implementing the Buffett plan in stages, our trade imbalance and related jobs problems could gradually be reduced and eventually completely remedied.

    Suppose the United States started by allowing importers to import $2.00 of goods for every $1.00 export certificate they purchase. (Assuming this approximates the present U.S. import-export ratio.) For a year or two, import certificate prices would be nominal. However, as the ratio decreases, certificate prices would be increased.

    Suppose further that by the year 2010 the import/export certificate-cost ratio has been reduced to allow $1.75 of imports for every dollar exported. Assume also that export certificates are selling for $.20. Exporters would then actually be reducing their costs by $.20 on the dollar. This represents a huge potential benefit to every exporter and the export market as a whole.

    By the same token, if importers were required to buy a certificate ($.20) for every $1.75 in imports, that would raise import costs by over 11%. While some importers would still want to import, many others would have a strong incentive to buy U.S. goods and services.

    Buffett’s plan entails the expectation that future importing costs and exporting benefits will both be increased under this plan, motivating businesses to modify their strategy and look for ways to increase exports and decrease imports.

    The simplicity and elegance of the plan may not overcome special interests, but it should go a long way towards illuminating the role they play in manipulating our trade policy.

    Success for this plan would hinge on removing special incentives, quotas and tariffs so that the free market can function and industries that are closest to being competitive in the world market receive help and those industries that presently import even though the domestic industry is close to competitive in the world market would be encouraged to purchase domestically.

    Job outsourcing trends depend on the differences between US and foreign wages. Here again is a fruitful area for the Import Certificates to encourage the export of services and discourage the outsourcing of jobs.

    In some ca. Please help me get in contact with one of your trade, finance or business advisors. I want very much to discuss the merits of Buffet’s plan with government officials in a position to make a difference. I am willing to lend my years of experience to unraveling the complications of designing new and sound trade policy.

    to create a balance in One product is available for about what will happen Although the United States budget deficit may represent a lack of will and almost everyone understands that raising taxes, cutting spending or some combination of the two is all that is needed to stop the deficit or even return to a surplus there seems to be no consensus on what to do or even if there are any possible solutions. Given that one deficit for which there are known remedies lacks any movement to solution it is no wonder that there are few ideas and no consensus on how to solve the problem. Or even agreeing that there is a problem. Whether having a trade deficit that is 10% of GNP is possible, much less desirable, does not seem to be part of the debate on the current trade deficit. Perhaps if we were to have a forecast that the trade deficit would average say 10% over the next 20 years and then ask how would we deal with it the gravity of the situation would become clearer.

    It is clear that over the next 20 years having a persistent deficit of over 10% of GNP is probably not possible. Just as scientists give much higher dosages of potential carcinogens to animals to test their potential danger, so we should ask whether such a not even logical. And that is assuming s a lack of Unlike the government deficit that could be solved with lower spending and higher taxes, the U.S. trade deficit has no visible solution. Once companies find the suppliers they can trust to provide economical and quality products there is no reasonable way to and provide quality products
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    The Chinese strategy of holding down the value of the yuan until they learn to do everything is brilliant. The Japanese did the same thing thirty years ago and the result was that today we talk on Panasonic phones, drive Toyota cars and watch TV on Sony televisions. Yes, the Japanese had a series of recessions and stopped growing didn’t grow

    In 1959 the steel industry went through a traumatic strike. The strike lasted for over 100 days and by its end steel consumers in many industries had started buying steel from wherever they could find it from around the world. While they didn’t expect it, buyers found superior quality at very competitive prices. When knowledge like that became widely available it was only a matter of time before domestic steel producers would come under unrelenting pressure. Various anti-dumping laws were put in to help the industry, but the long-term fate of domestic steel was sealed by the 1959 strike and the taste for foreign steel that was generated by that interruption of domestic supply.

    Did you ever wonder why the shirt you bought was often made in a country you had never heard of? The textile and apparel industries have been protected for many years by the so called “voluntary quotas” that the United States has imposed on country after country to protect domestic suppliers. When the quota for one country was filled, producers found additional countries in which to site factories and ramped up production until the United States negotiated another treaty to limit imports from that country. However, in 2005 the World Trade Organization rules prohibited the use of textile quotas. Since one supplier is preferred over multiple suppliers in many countries China became the big winner and imports from China jumped.

    As China and other countries have ramped up not only their production but also their capabilities, imports have increased at an accelerated rate. Now that source and product knowledge is so widespread among purchasers in the United States there is no foreseeable limit to the future trade deficit. For many products costs of a product sourced from China or another Asian country are approximately 1/3 of the same product sourced domestically.

    In other products the differences are much less. To think that any realignment of currencies will cause domestic producers to be competitive is simply unrealistic. Just as theorists created the voluntary quota or “visa” system that allowed many factory owners to retire and just sell their quotas. I remember being told at one time that a sweater that cost $12.00 consisted of a $7.00 cost of production and $5.00 for the visa. That money went to the foreign national that owned the visa instead of having the U.S. auction off the visas that could have been added to the U.S. Treasury.

    Whether a revised visa program could work at this point is academic because international agreements no longer allow it.

    There is no reasonable method that would work to stem the huge trade imbalances that will only get worse.

    New thinking is needed and fortunately, Warren Buffett in a Fortune article (2003) suggested a way to solve the problem. I have taken the liberty of extending Mr. Buffett’s ideas to provide a complete and logical solution not only for the United States, but arguably for any country that is suffering from trade imbalances.

    The n article in

    while U.S importers paid prices that reflected the visa cost and perhaps the result of too many people who have never earned a competitive dollar telling practitioners how the world works. versus a domestic producer are approximately reasonable limit to the the knowledge of to Giant companies kept moving capacity to additional countries as they added to the amount they were allowed to import. adding countries have serthat would ultimately result in widespread bankruptcies and a much smaller steel industry.

    To: cloomis@fortune.com
    Subject: Your article with Warren Buffett and a proposal for implementation
    Dear Ms. Loomis

    For years I’ve noticed that you author particularly important Fortune articles that I’d definitely want my students to read were I still teaching. However, I retired from teaching 10 years ago because my little side business was getting out of hand.

    I’ve been an importer and exporter for over 25 years and a professor of business since the early 1960s. I’m well aware that, while my company is growing, we’re also contributing to a steady loss of jobs for American workers.

    Conventional solutions simply are not working and you and Mr. Buffett have an elegant and non distorting solution. I’ve taken the liberty of fleshing out his proposal for you.

    The heart of Mr. Buffet’s and your proposal is this:

    · For each dollar of goods and services exported, the government would give an exporter a certificate that could be traded on the open market.

    · Importers, on the other hand, would have to purchase a certificate for every dollar of goods and services they import. Jobs that are outsourced would count as “services” require import certificates as well.

    Because imports now exceed exports by about two to one, implementing this plan too abruptly would be like throwing a car into reverse at 60 miles an hour. But by implementing your plan in stages, our trade imbalance and related jobs problems could gradually be reduced and eventually completely remedied.

    Suppose the United States started by allowing importers to import $2.00 of goods for every $1.00 export certificate they purchase. (This approximates the present U.S. import-export ratio.) For a year or two, import certificate prices would be nominal. However, as the ratio decreases, certificate prices would be increased.

    Suppose further that by the year 2010 the import/export certificate-cost ratio has been reduced to allow $1.75 of imports for every dollar exported. Assume also that export certificates are selling for $.20. Exporters would then actually be reducing their costs by $.20 on the dollar. This represents a huge potential benefit to every exporter and the export market as a whole

    By the same token, if importers were required to buy a certificate ($.20) for every $1.75 in imports, that would raise import costs by over 11%. While some importers would still want to import, many others would have a strong incentive to buy U.S. goods and services.

    Your plan entails the expectation that future importing costs and exporting benefits will both be increased under this plan, motivating businesspeople like myself to modify their strategy and look for ways to increase exports and decrease imports.

    Here at last is an implementation plan for Ricardo’s comparative advantage! The simplicity and elegance of the plan may not overcome special interests, but it should go a long way towards illuminating the role they play in manipulating our trade policy. The job outsourcing trends depend on the differences between US and foreign wages. Please help me get in contact with one of your trade, finance or business advisors. I want very much to discuss the merits of Buffet’s plan with government officials in a position to make a difference. I am willing to lend my years of experience to unraveling the complications of designing new and sound trade policy.

    Thank you very much.

    Sincerely,

    Bill Parks
    President,
    NRS
    2009 S. Main St.
    Moscow, Idaho 83843
    Bill@nrsweb.com
    Retired Professor of Business Strategy
    University of Idaho
    bparks@uidaho.edu

  2. Winslow R. Says:

    “Suppose the United States started by allowing importers to import $2.00 of goods for every $1.00 export certificate they purchase. (This approximates the present U.S. import-export ratio.) For a year or two, import certificate prices would be nominal. However, as the ratio decreases, certificate prices would be increased.”

    How would this be verified?

    As an importer I’d purchase a $100 certificate from an exporter and import a car from my Chinese exporter for $100 then resell it to my dealer location for $100 which in turn would resell to a customer for $10,000. We could create an infinite number of transactions to shake off any inspection.

    A similar scheme is used to shift income taxes offshore to Bermuda though in this case taxes would be shifted onshore.

    An exporter could ‘manfacture’ these certificates by selling $1,000,000 plastic flowers to an importer in China for inflated prices.

    Needs some work….

  3. Monique Morrissey Says:

    Tom,
    I found your asset price blog very interesting, but have a quibble about Factor #7. You say the switch from traditional pensions to 401(k)s “has increased financial asset demand since companies need not fully fund defined benefit plans, whereas defined contribution plans are fully funded.” I think the switch to DC plans would have the opposite effect on asset demand, since even an underfunded DB pension can have more funds per worker than a DC plan, due to inadequate contributions, cash outs, low returns, high fees, etc.

    Monique

  4. Honey Says:

    Wow, that’s an deep analysis…

    and it’s true… because, you know, when almost like 1% humans make 96% of income in this world… they are smart to constantly increase prices … though average 9to5 job person will never, ever move that fast with his own salary.

    anyway, that’s a complicated situation… richer are getting richer, and poor poorer…

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