The Economy Is Again Under the Sway of Asset Prices

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The Waldorf Astoria Hotel in New York is slated to be renovated and have as many as 1,100 hotel rooms removed, with many converted to condominiums. Net wealth in the U.S. now exceeds 500% of national income—an ominous sign for the economy. Photo: Spencer Platt/Getty Images

The past two recessions were ushered in by a collapse in asset prices. The risk of a repeat is growing.

After plunging in the aftermath of Britain’s vote to leave the European Union, U.S. stocks have hit fresh highs. Real estate is quietly doing the same: home prices are just 2% below the peak hit in 2007, while commercial property values have hit records.

The result is that net wealth in the U.S. now tops 500% of national income. Ominously, net wealth has reached that level only twice before: from 1999 to 2000 during the Nasdaq NDAQ 2.74 % bubble, and 2004 to 2008 during the housing boom.

The mere fact that asset prices are high doesn’t mean they are overvalued, or about to crash. But it is a sign of an economy structurally more vulnerable to sudden shifts of sentiment in the financial markets. Central banks have compounded that vulnerability by pumping up growth with low and even negative interest rates that have kept asset markets inflated.

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Those inflated prices make it more treacherous to return interest rates to normal, the task facing the Fed as it meets this week.

Assets didn’t always matter so much. From 1952 to 1996, wealth fluctuated around 400% of national income, according to Gail Fosler, a New York-based economic consultant. Finance was highly regulated and monetary policy mostly worked by dictating how much banks would lend, at what rate.

Then, starting with the bull market of the 1990s, wealth took off. As Ms. Fosler describes it, capital came to overshadow income as the driver of spending on goods and services. As asset values and their accompanying debt grew, business and household fortunes became more closely tied to financial markets.

This was apparent in the explosion of technology shares in the 1990s and the housing boom in the 2000s, both of which were accompanied by a proliferation of new financial instruments, from employee stock options to collateralized debt obligations.

In the current expansion, Ms. Fosler says, exchange-traded funds, which trade baskets of assets, have become a major vehicle for betting on industry sectors, commodities and bonds, providing yet another channel for movements in those markets to ripple out more broadly.

“Changes in the capital economy have always had large effects relative to the income economy but today these effects are huge,” Ms. Fosler writes in a client report. “With the rise in wealth relative to national income has come striking instability.”

A contractor moves roofing material on a home under construction at the Toll Brothers Inc. Cantera at Gale Ranch housing development in San Ramon, Calif. U.S. home prices are just 2% below the peak hit in 2007, while commercial property values have hit records. ENLARGE
A contractor moves roofing material on a home under construction at the Toll Brothers Inc. Cantera at Gale Ranch housing development in San Ramon, Calif. U.S. home prices are just 2% below the peak hit in 2007, while commercial property values have hit records. Photo: David Paul Morris/Bloomberg

A wealth-intensive economy is by definition more at the mercy of asset-price swings. The Fed raised interest rates from 2004 to 2006 to slow the economy and keep inflation under control. It wasn’t those higher interest rates that tanked the economy, but the collapse of housing prices and the financial panic that occurred when the opaque loan pools that financed those homes defaulted.

The latest cycle differs from its predecessors in important ways. Tighter regulation has limited the contribution of leveraged financial instruments to asset inflation—but the contribution of interest rates has grown. The Fed kept them near zero until last December and since then has promised to raise them only gradually. Expectations of even slower tightening after the Brexit vote helped propel stocks to their recent highs. The result: a much more spectacular recovery for assets during this recovery than for the overall economy.

This has consequences for ordinary lives. Wealth inequality has grown even more than income inequality, and it’s more arbitrary. If you join a start-up at the bottom of the market, your stock options make you a millionaire; if you join at the top, your net worth consists of a paycheck. If you had the cash to buy a home in 2011, you are probably sitting on a hefty capital gain. If instead you were turned down for a mortgage, you may still be living with your parents.

The fact that asset prices are so high doesn’t automatically mean a bubble is building. Low interest rates boost the current value of any income-producing asset. Stocks’ historically high price-to-earnings ratios can be justified if rates stay as low as they are now. Similarly, record low mortgage rates mean that even with home prices back to their levels of 2007, the cost of owning isn’t as out of line with renting as it was back then.

But the arithmetic reality is that when valuations are so high, even justifiably so, it takes only a small shift in the appetite for risk, expectations of profits, or interest rates to trigger a major downdraft. The U.S. Treasury’s Office of Financial Research noted this week that stocks have reached today’s valuations “only ahead of the three largest equity market declines in the last century.”

Ms. Fosler has found that in the past, instability emerges when wealth growth slows to below that of income.That has already happened: despite their recent record, stocks aren’t much higher than a year ago. Profits are also down.

It doesn’t mean a recession is coming; but it’s a vulnerability the Fed should keep top of mind.

Greg Ip at greg.ip@wsj.com





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