By James H. Nolt
Economic systems include two interrelated components. Economists focus on the production-consumption component, but largely neglect the debt and asset component, especially in textbook macroeconomics. Yet economic crises are often caused when effects from the asset side spill over into the production-consumption side. The two are intimately related.
Media and pundits often use the short hand “Main Street” to refer to the production-consumption economy and the “Wall Street” tag for the asset economy, but there is some problem in the popular conceptions of these.
The first is that “Wall Street” or the asset economy is not some remote element of “New York culture” or the “Eastern Establishment” or any other geographically specific locale. The asset economy is everywhere because its principal element is not financial securities like stocks and bonds, but real estate. Most of the middle class has a piece of it, though typically a fairly small and often mortgaged piece. Real estate has always been the most widely distributed asset from previous centuries, when farmers predominated, to modern suburbia.
What financial and real assets have in common is that they are units for storing wealth and they may produce income: real estate may produce rent (though not if owner occupied), stocks may produce dividends, and bonds typically pay an interest rate called the coupon rate. All assets may gain in market value, which is known as capital gains. They may also decline in value. The total percentage increase in the value of an asset over time, combining both any income from it plus any capital appreciation, is called its yield. The yield may be negative if the value of the asset is dropping at a higher percentage rate than the income it pays.
The production-consumption economy considers income and other flow variables; the asset economy focuses on wealth and therefore stock variables. Flows are like a river. Their volume must be measured in units that include a quantity (of, say, dollars) and a unit of time, such as a year. Stocks are like a lake. Their size can be measured at a snapshot or instant of time solely in a unit of money.
As the best-selling book, Capital in the Twenty-First Century, by Thomas Piketty illustrates, throughout history wealth, rather than income, tends to be more skewed in favor of the rich. While income is unequal, wealth distribution is even more so. This is easy to understand if you remember that there are many people who work for a living and rent a home, but own almost nothing. They have income, but virtually no wealth.
Therefore, even more than the production-consumption economy and its income flows, the asset economy is a game run by and for the rich. As I mentioned, the main part of the asset economy that does trickle down to the middle class is home ownership. This is the main intersection between the asset world and the production-consumption circuit.
Macroeconomic textbooks focus almost entirely on the flows of the production-consumption economy, with the exception of a few important dissidents like Piketty. It is no wonder then that even the twists and turns of the business cycle, let alone major economic crises, are mysterious and largely inexplicable from within macroeconomics. These are phenomena deeply implicated in the strategic interactions among private powers than animate the asset economy.
Most important to understand, since it is so pervasive, is the real estate system. Real estate (the land itself plus any previously produced improvements or structures built upon it) is not a currently produced product. It exists in its present form largely as a result of previous human effort, but the land itself is not part of the production-consumption circuit. It is like a painting by Van Gogh. It may have considerable value, but it cannot be manufactured in ever-expanding quantities at a fixed cost.
As wealth becomes more concentrated, it becomes easier for the very rich to bid up the prices of whatever parcels of land catch their fancy. (This also applies to real assets such as diamonds or financial assets such as stocks.) Since assets like land are valuable, they can also be used as collateral for loans, allowing the owners to leverage their capital and buy ever more land at prices that continue to spiral upward as long as credit is available to fund the increasingly expensive assets. Of course, the same asset then acts as collateral for the loan.
Since land is not produced, as I said last week, there is no natural upward limit to its price. Unlike manufacturing, there is no process by which more of it can manufactured to bring more to market and thus restrain the price. Expanding credit can raise prices. Only contracting credit can lower them. Therefore, fluctuations of asset values, including real estate, are largely a function of the expansion and contraction of credit. This effect typically overwhelms influences from the less dramatic expansions and contractions of the production-consumption economy.
The asset economy is also typically more volatile and unstable than the production-consumption economy. Its storms of boom and crash become more severe as wealth is increasingly concentrated at the top, since that expands the sheer mass of asset values and the claims of their owners on greater and greater shares of the production-consumption economy.
Increased inequality of wealth, such as has occurred during recent decades, thus naturally increases the predominance of the asset economy over the real economy, or, in common argot, the dominance of Wall Street over Main Street. The only real remedy is not regulation or tinkering at the margin, but significant redistribution of wealth back toward the vast majority of middle class and poor people.
Next week I will further explore how the current economic crisis in China is becoming the third leg of the rolling global financial crisis that started with subprime mortgages in the U.S. during 2007-2008, hit the eurozone with the Greek debt crisis of 2010, and now is embroiling China. This phase of it will once again reverberate around the world for reasons that are linked to the globalization of an elite-driven asset economy that often seems remote in the view from Main Street, but is actually all too close for comfort.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Wikimedia Commons]