How rising asset prices increase inequality

The release of French economist Thomas Piketty’s best-seller “Capital in the Twenty-First Century” has posed once more the question of what causes inequality. One key culprit from Piketty’s findings is the changing valuation of financial assets.

Imagine that you hold a financial asset, a company share worth $1,000. And suppose I believe the market is going to rise and I offer you $2,000 for that share. The market price for this share will now have increased from $1,000 to $2,000. This transaction will also increase the net worth of those who hold these shares by the amount that the share has increased in value — in our example, $1,000 — multiplied by the number of these shares in existence.

If we imagine that there are 5,000 of these shares in existence, this will increase the net worth of the holders of these shares by $5 million. Since rich people hold a disproportionate number of shares, my bid will have increased inequality in the economy because the net worth of the rich will rise in relation to the net worth of the poor.

The dynamics that this grossly simplified example highlights are highly relevant to the real world. In the real world when asset prices rise, this leads to the net worth of the rich rising in relation to the net worth of the poor. These assets can be anything from shares to housing to land. If the rich own more of these assets than the poor, then any increase in their value will lead to increased inequality in the economy.

This is precisely what the data show. James Galbraith and J. Travis Hale, two economists specializing in the study of inequality, measured changes in income disparity between counties in the U.S. in their paper “The Evolution of Economic Inequality in the United States, 1969–2012” and compared them with the movements in the stock market in the same period and found that, lo and behold, the two were well correlated over 35 years and almost exactly correlated from 1992 to 2004.

The recent correlation is so striking that is has led Galbraith to state that “it’s actually redundant to measure income inequality in the U.S. You can watch it go by on cable TV, on the stock ticker.”

This leads to an entirely different narrative about what the financial sector is and what it does. In mainstream economic theory, the financial sector is seen as basically a market for money. Investors who want this money to build factories make bids with those that hold the money — namely, savers — and pay them interest. But the findings of Galbraith and Piketty call this narrative into question.

Rather, it appears that when what economists call the FIRE sector (finance, insurance and real estate) becomes too bloated, it turns into a mechanism through which wealth is redistributed through changes in asset prices. With wages stagnant, the rise in prices of financial assets gives the wealthier members of society a source of income to purchase more goods and services. While this gives rise to an economy that is completely dependent on rising asset prices and is thus highly unstable, it allows the economy to grow to some extent.

The economics mainstream has been very slow to pick up on these trends. But people mobilizing in the streets have not. The Occupy Wall Street movement recognized quite quickly that the financial sector was inherently tied up with the massive disparities in income distribution. Indeed, it is not hard to form this view if you walk down Wall Street or through the City of London.

Thankfully, Piketty’s book has put the question of inequality, its sources and potential policy solutions back on the table. But the economics profession might well fall back on the hoary theories that they have been clinging to for years. Mainstream economists are apt to give us explanations of inequality that paint it as inevitable, an unfortunate byproduct of our access to amazing technologies like the modern computer and the Internet. An informed citizenry should be very cautious about these sorts of stories. In this instance, what you see with your own two eyes is far more likely to be the truth of the matter.