Saturday, May 12, 2007

Asset Price Inflation is Not a Good Thing for Most People

What's not to love about rising asset prices? The Fed has oft argued that to the extent they do not cause an increase consumer prices, lofty home values and stock markets do not lead to inflation. Thus, central banks only aim to stop consumer price inflation, not asset price inflation/appreciation. Given that central banks operate in democracies, this is a politically wise move. However, asset price inflation is not benign and is indeed inflationary. The Buttonwood column of this week's Economist, gives a few examples of why this is true.

The victims of rising asset prices:

Rising home prices are great for "middle-class people who started climbing the property ladder 20 years ago. But they make life difficult for young people wanting to buy their first home and for those trying to create affordable housing for low paid, but vital, workers, such as nurses."

For young people starting out in places such as DC, CA, NY/NJ, & Boston, this necessarily means that they have to load up on debt in order to afford an over-valued house. Presumably they will save even less because a large portion of their income goes to pay the mortgage.

High asset prices Now imply lower Future returns:

"The second problem is that, when asset prices are high and yields are low, future returns are likely to be subdued. It thus takes a lot more effort to generate a given lump sum for retirement."

Given today's rich valuations in nearly every single asset class I can think of, perhaps "past performance will not be indicative of future results." Indeed, the best performing asset class for the next ten years is most likely not even on the radar of the ordinary investor in the developed world.

Conclusion: high asset prices are exacerbating the looming retirement crisis

As defined benefit pension plans go the way of the dodo, the rich world will be split into four categories of retirees:

  1. Already wealthy people
  2. Government workers whose retirement is funded by taxpayers

"Have Nots"

  1. Private sector workers who did not save enough
  2. Poor people who rely on government for their subsistence

"The more numerous losers may demand higher taxes to penalize the lucky winners. What the market hath given, investors may find a future government taketh away."

In one way or another, this almost certain to be the outcome in the United States. The first step could be to take away Social Security and Medicare benefits from the "haves." The tax code could be modified to penalize people who have "too much" socked away in tax-advantaged accounts. Or perhaps people with passive incomes might have to start paying some form of payroll taxes.

So if this looming retirement crisis is worsened by asset price inflation, then why doesn't the Fed do something to stop it? Two reasons I can think of. First, there would be blood in the streets if the housing market declined markedly. Same thing if the Fed set out to crash stock & bond markets. The second reason is that, as a nation, we have way, way too much debt. Lower asset prices is deflationary -- there is nothing worse to a heavily indebted person (or government) than deflation. To the contrary, inflation is a gift for debtors because it shrinks the "real" value of the debt and interest payments.

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