Wednesday, 11 February 2009

Economic inequality and asset inflation

by Jan Toporowski

In the discussion about the financial crisis, one important factor has been overlooked, namely the distribution of income and wealth. It is obvious that the social consequences of the financial crisis have been made so much more painful by the growing inequalities of income and wealth in the United States and the United Kingdom. But there are also connections between such inequalities and financial instability. These have been highlighted by many critics of financialised capitalism. For example, John Hobson, most famous for his 1902 classic Imperialism A Study, argued that inequalities of wealth and income gave rise to over-saving, and hence economic stagnation. More recently, the late John Kenneth Galbraith noted the connection between tax cuts for the rich and asset inflation.

Asset inflation and income and economic inequalities are intimately linked. Asset inflation means rising values of financial assets and housing. Such inflation allows owners of such assets to write off debts against capital gains, buying an asset with borrowed money, and then repaying that borrowing together with interest and obtaining a profit when the asset is sold. Hence the proliferation of borrowing by households and consumption ultimately financed by debt. When the asset is housing, its inflation is especially pernicious. The housing market then redistributes income and wealth from young people earning less at the start of their careers and indebting themselves hugely in order to get somewhere decent to live, to people enjoying highest earnings at the end of their careers. But housing inflation is also like a pyramid banking scheme because it requires more and more credit to be put into the housing market in order to allow those profiting from house inflation to be able to realise their profits.

Nevertheless, even those entering the system with large debts hope to be able to profit from it. Such has been the dependence of recent governments and society in general on asset inflation that the political consensus is ‘intensely relaxed’ about such regressive redistribution of income. That consensus has encouraged the belief that the best that young people can do to enhance their prospects is to indebt themselves in order to ‘get on the property ladder’, i.e., enrich themselves (or at least improve their housing) through housing inflation.

Those at the bottom of the income distribution inevitably suffer most from rising house prices because, living in the worst housing, they have the least possibility to accommodate their house purchase to their income by buying cheaper, smaller housing. Having little other option but to over-indebt themselves in order to secure their housing, default rates among households in this social group are also most likely to rise with house price inflation. This inequality lies behind the problems in the sub-prime market in the U.S. and the equivalents of that market in the U.K. and elsewhere. Paradoxically, a more equal distribution of income and wealth is more likely to keep the housing market in equilibrium, because any increase in house prices above the rate of increase in income and wealth is more likely to result in a fall in demand for housing. Where income and wealth are already unequally distributed, and house prices rise faster than incomes, a fall in demand from those who can no longer afford a given class of housing is off-set by the increased demand for that class of housing among households that previously could afford better housing. In this way, the redistribution of income and wealth from those with more modest incomes to those with on higher incomes also facilitates asset inflation in the housing market.

Thus asset inflation has increased inequalities of wealth and income and those inequalities have further fed that inflation. Such inflation is therefore a self-reinforcing pathology of financial markets and society, rather than, as the economics establishment tells us, a temporary disequilibrium (a ‘bubble’) in the markets. Financial stability rests not only on sound banking and financial institutions. It also requires a much more equal distribution of income and wealth.

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