The Asset Divide

Below is a recent article explaining the growing wealth inequality based on asset ownership and control. This shouldn’t even be phrased as a question as our easy credit policies, massive RE debt leverage, and favored housing policy has created an almost insurmountable wealth divide between the asset-rich and the asset-poor. Who and what policies do we think those left behind are going to be voting for? Non-gender bathrooms? See also Thomas Edsall’s article in the NYT.

Is Housing Inequality the Main Driver of Economic Inequality?

Richard Florida

A growing body of research suggests that inequality in the value of Americans’ homes is a major factor—perhaps the key factor—in the country’s economic divides.

Economic inequality is one of the most significant issues facing cities and entire nations today. But a mounting body of research suggests that housing inequality may well be the biggest contributor to our economic divides.

Thomas Piketty’s influential book, Capital in the Twenty-First Century, put economic inequality—and specifically, wealth inequality—front and center in the global conversation. But research by Matthew Rognlie found that housing inequality (that is, how much more expensive some houses are than others) is the key factor in rising wealth.

Rognlie’s research documented that the share of wealth or capital income derived from housing has grown significantly since around 1950, and substantially more than for other forms of capital. In other words, those uber-expensive penthouses, luxury townhomes, and other real estate holdings in superstar cities like London and New York amount to a “physical manifestation” of Piketty’s insights into wealth inequality, as Felix Salmon so aptly puts it.

More recent research on this topic by urban economists David Albouy and Mike Zabek documents the surge in housing inequality in the United States. Their study, published as a National Bureau of Economic Research working paper, charts the rise in housing inequality across the U.S. from the onset of the Great Depression in 1930 through the great suburban boom of the 1950s, 1960s, and 1970s, to the more recent back-to-the-city movement, the 2008 economic crash, and the subsequent recovery, up to 2012. They use data from the U.S. Census on both homeowners and renters.

Over the period studied, the share of owner-occupied housing rose from less than half (45 percent) to nearly two-thirds (65 percent), although it has leveled off somewhat since then. The median cost of a home tripled in real dollar terms, according to their analysis. Housing now represents a huge share of America’s total consumption, comprising roughly 40 percent of the U.S. total capital stock, and two-thirds of the wealth held by the middle class.

What Albouy and Zabek find is a clear U-shaped pattern in housing inequality (measured in terms of housing values) over this 80-year period. Housing inequality was high in 1930 at the onset of the Depression. It then declined, alongside income inequality, during the Great Compression and suburban boom of the 1950s and 1960s. It started to creep back up again after the 1970s. There was a huge spike by the 1990s, followed by a leveling off in 2000, and then another significant spike by 2012, in the wake of the recovery from the economic crisis of 2008 and the accelerating back-to-the-city movement.

By 2012, the level of housing inequality in the U.S. looked much the same as it did in the ’30s. Now as then, the most expensive 20 percent of owner-occupied homes account for more than half of total U.S. housing value.

Data by Albouy et al. Design by Madison McVeigh/CityLab

Rents show a different pattern. Rent inequality—or the gap between the cost of rent for some relative than others—was high in the 1930s, then declined dramatically until around 1960. Starting in about 1980, it began to increase gradually, but much less than housing inequality (based on owner-occupied homes) or income inequality. And much of this small rise in rental inequality seems to stem from expensive rental units in very expensive cities.

The study suggests this less severe pattern of rent inequality may be the result of measures like rent control and other affordable housing programs to assist lower-income renters, especially in expensive cities such as New York and San Francisco.

That said, there also is an additional and potentially large wealth gap between owners and renters. Homeowners are able to basically lock in their housing costs after purchasing their home, and benefit from the appreciation of their properties thereafter. Renters, on the other hand, see rents increase in line with the market, and sometimes faster. This threatens their ability to maintain shelter, while they accumulate no equity in the place where they live.

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But what lies behind this surge in housing inequality? Does it stem from the large housing-price differences between superstar cities and the rest, or does it stem from inequality within cities and metro areas—for instance, high-priced urban areas and suburban areas compared to less advantaged neighborhoods?

The Albouy and Zabek study considers three possible explanations: The change over time from smaller to larger housing units; geographic or spatial inequality between cities and metro areas; and economic segregation between rich and poor within metro areas.

Even as houses have grown bigger and bigger, with McMansions replacing bungalows and Cape Cods in many cities and suburbs since the 1930s (as the size of households shrunk), the study says that, at best, 30 percent of the rise in housing inequality can be pegged to changes in the size of houses themselves.

Ultimately, the study concludes that the rise in both housing wealth and housing inequality stems mainly from the increase in the value of land. In other research, Albouy found that the value of America’s urban land was $25 trillion in 2010, roughly double the nation’s 2016 GDP.

But here’s the kicker: The main catalyst of housing inequality, according to the study, comes from the growing gap within cities and metro areas, not between them. The graph below shows the differences in housing inequality between “commuting zones”—geographic areas that share a labor market—over time. In it, you can see that inequality varies sharply within commuting zones (marked “CZ”) while it remains more or less constant between them.

In other words, the spatial inequality within metros is what drives housing inequality. Factors like safety, schools, and access to employment and local amenities lead individual actors to value one neighborhood over the next.

Data by Albouy et al. Design by Madison McVeigh/CityLab

All this forms a fundamental contradiction in the housing market. Housing is at once a basic mode of shelter and a form of investment. As this basic necessity has been transformed over time into a financial instrument and source of wealth, not only has housing inequality increased, but housing inequality has become a major contributor to—if not the major overall factor in—wealth inequality. When you consider the fact that what is a necessity for everyone has been turned into a financial instrument for a select few, this is no surprise.

The rise in housing inequality brings us face to face with a central paradox of today’s increasingly urbanized form of capitalism. The clustering of talent, industry, investment, and other economic assets in small parts of cities and metropolitan areas is at once the main engine of economic growth and the biggest driver of inequality. The ability to buy and own housing, much more than income or any other source of wealth, is a significant factor in the growing divides between the economy’s winners and losers.

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Why Ownership Matters

TheOwnershipSociety

A little over a decade ago, in 2004 to be exact, the subject of ownership in democratic capitalist society was raised as a national political issue. Attribution goes to President George W. Bush, as he was campaigning for a second term, when he stated, “…if you own something, you have a vital stake in the future of our country. The more ownership there is in America, the more vitality there is in America, and the more people have a vital stake in the future of this country.” He called his vision The Ownership Society and it became the theme of his campaign. Naturally, his political opponents pounced on the idea, deriding it as the You’re-On-Your-Own Society, with the catchy acronym of “YO-YO.”

At the time I found the original statement to be more profound than was probably intended by its conservative proponents. My doubts were confirmed when the focus soon narrowed to the Holy Grail of residential home ownership, which was experiencing a boom due to policies favored by both parties that powered a historic bubble based on cheap credit and lowered lending standards. In the final capitulation to politics, the ownership agenda was reduced to, and attacked as, a naked partisan strategy to privatize entitlements, primarily to carve away support for liberal Democratic proponents of the social welfare state.

However, I don’t see ownership as a partisan issue, or even an ideological one, despite the fact that our political class certainly does. Instead, I see it as a theoretical and empirical issue that goes far beyond policy or politics to encompass economics, psychology, moral philosophy, and evolution.

For reasons that will become apparent, I will define this discussion to the ownership of financial capital. The ownership and control of capital assets is essential in the age of capital for two main reasons: first, it enables people to diversify against the risks of change; and two, the establishment of ownership rights is how the market and our legal system determine the distribution of returns to those aforementioned risks. Thus, ownership rights serve to determine the distribution of both a priori risks of, and a posteriori returns to, uncertain change.

Managing Risk

The best way to illustrate these two assertions is with the analogy of a roulette game. Imagine that several players with equal stakes gather around the roulette table. They wager their ownership stakes according to different risk preferences, some playing single numbers (highly risky) down to those who play black or red, odd or even (less risky). After each turn of the wheel the winners receive pay-offs or absorb losses in proportion to the odds ratios, or risks, of their strategies. In other words, if one played a single number or a row of numbers that hit while another played a red or black, the first would receive a much larger pay-off because she would have taken a much higher risk of loss. What we see if we examine the odds ratios of all the different plays on the roulette table is that the risk-adjusted rates of return of all strategies are essentially equal (and favor the casino ever so slightly). If the return/risk ratios are all the same, the only way to increase one’s return is to increase one’s risks and manage them successfully. This risk-return trade-off is the foundation of finance theory.

Behavioral studies show that we are uniformly loss averse. Since we cannot know the future, uncertainty and the risk of loss is inherent to our existence (although every tomorrow also offers hope for new opportunities). The best way to insure against losses due to unpredictable risks is through diversified pooling. We do this when we buy auto or homeowners insurance. These insurance pools are in fact diversified portfolios of capital assets. Likewise, ‘saving for a rainy day’ is a form of self-insurance. Due to the asymmetric information of insurance, certain problems arise that we call moral hazard and adverse selection. Moral hazard is when the beneficiary of the insurance changes risk-taking behavior because they are insured. This is like someone who drives recklessly because they have insurance to cover the cost of an accident. However, if the insurance issuer knew the person was going to change their risk behavior it would demand higher premiums. Adverse selection is when good risks opt out of an insurance pool with bad risks, causing the risk pool to become more risky and require ever higher premiums until the pool breaks down. Because we know our own risk-taking behavior better than anyone else, both of these insurance problems result from asymmetric information.

We can see that self-insurance doesn’t not suffer from asymmetric information because we are essentially insuring ourselves, so the incentive to drive recklessly is irrational. For this reason, self-insurance incurs no agency costs and is by far more efficient than insurance pooling. But to self-insure, i.e. save for a rainy day, we must accumulate assets to diversify in a portfolio. Thus, asset ownership is essential.

A second analogy—the scientific principle of natural selection and species adaptation—reinforces the importance of risk diversification. Nature constantly adapts to unpredictable change and the imperatives for survival by promoting diversification. Biodiversity is nature’s way of achieving a sustainable ecological balance and we can imagine human societies are certainly subject to the same survival imperatives.

Sharing the Rewards

If we not only want to protect ourselves from unpredictable risks of loss but also want to share in the returns to capitalist success, we must accumulate capital assets through ownership, put them at risk, and manage those risks successfully. Establishing the policies and complementary institutions, both private and public, to facilitate this process is actually the primary policy challenge of a free democratic society. In this sense, George Bush and his critics were both right: One must take an ownership stake in America to reap her benefits, and in so doing, one assumes the risk of loss and the obligation to manage that risk successfully.

Critics of this view might ask why capitalist profits are not more justly distributed through the payment of input costs, such as labor. The problem is exactly that: labor is an input cost that must be minimized under the profit incentive in order for the enterprise to succeed in a competitive environment. With access to a world supply of labor, the dynamics of capitalism exert constant downward pressure on wages. Laborists have long sought to use countervailing political power to constrain capital, but this strategy conflicts with the globalization of free trade among sovereign nations. In an open global economy with mobile capital and immobile labor, capital has strategic dominance over labor in simple game theoretic terms. Capital can move instantaneously, withdraw, or lie dormant indefinitely.

Labor’s argument is also undermined by the fact that if workers take no explicit residual risk in the enterprise, they have no defensible ownership claim to a share in the residual profits of success. Fixed labor contracts, in effect, assign risk and thus profits to owners in return for lower, and, hopefully, more secure and stable compensation. But under fixed labor contracts, firm losses are largely, and unjustly, borne by the unemployed, who are not fairly compensated for these hidden risks in good times.

For these reasons, I believe it is a misguided political strategy to pit labor against capital in an adversarial relationship. The solution is for labor to participate in capitalist enterprise as owners as well as workers. Risk then is more broadly shared across all stakeholders rather than borne by the weakest members of the labor force.

Equally important is the policy demand to share the returns of capitalism more broadly. There has been growing public criticism of market capitalism due to cronyism and widening economic inequality. A quick analysis of the distribution of wealth and income will confirm that much of this inequality can be attributed to the benefits accruing to those who own and control financial capital. Corporate elites get rich off stock options as part of their compensation packages. Employees of successful tech start-ups become fabulously wealthy due to their equity participation, not salaries. More important, financial markets concentrate the rewards to success, especially through the use of debt leverage. Federal Reserve financial repression that keeps interest rates near zero has rewarded borrowers and asset holders while penalizing savers and workers. Enhancing labor skills through education can only mitigate these trends to a point. In capitalism today, it is essential to own and control financial capital.

Financing Adaptation and Innovation

The analogy to nature’s biodiversity suggested above is more consequential than may appear. Diversification helps species survive, but it does this by enhancing the ability to adapt successfully. Natural adaptation is synonymous with human discovery and innovation. There is a branch of social psychology that focuses on the science of human creativity and innovation and draws from the lessons of natural adaptation. In a seminal article in 1960, the psychologist Donald Campbell argued that creative thought depends on a two-fold procedure he called blind variation and selective retention (BVSR). Blind variation refers to undirected change, much like unpredictable mutation in genetics. Selective retention refers to the replication of successful change. His argument suggests that creative innovation frequently relies on novelty and surprise, as well as utility.

What does this mean in the context of technological innovation and discovery? It means that many creative discoveries in the sciences and the humanities result from unintended consequences and not deliberate, intentional efforts. In other words, discoveries often come out of the blue; creativity is magical in that it cannot be so much cajoled by deliberate effort as just being allowed to happen under the right conditions. A creative artist knows this well from experience. This research has implications for how we can stimulate economic innovation by sowing the seeds of risk-taking capital far and wide in order to reap the benefits of creativity and discovery. It also suggests the limits of directed risk-taking through the public sector or through the bottlenecks of private venture capital. The next new big thing (or just very successful small thing) is more likely to come out of a garage or kitchen and not be financed by either the state or the financial sector. More likely it will be financed by personal relationships referred to as angel financing. Broadening the accumulation and ownership of financial capital helps to broaden the reach of angel investment to fund unorthodox risk-taking.

Agency

There is an ubiquitous weakness inherent to economic systems of specialization and exchange, alluded to above in the insurance case, that is referred to as the “agency problem.” When a principal hires an agent, such as a sales agent or a manager, there is always a potential conflict of interest between the principal and the agent, which can end up being quite costly to the principal. This agency problem was recognized by Adam Smith and more recently by those who study industrial organization and the public corporation. Managers often have material interests that diverge from the principal owners, i.e., shareholders and other stakeholders of the corporation.

This agency problem can never be perfectly eliminated (except through small sole proprietorships), but economic efficiency demands that the costs be minimized by aligning the interests of all stakeholders. This has been at the root of the use of stock options and profit participation in compensation. It’s called having “skin in the game, ” but too frequently the game is played with somebody else’s skin. The abuse of stock options merely points out the pitfalls of misunderstanding the nature of ownership and control. Equity financed with other peoples’ money is not a good way to eliminate conflicts of interest and minimize risk behavior. A recent article in The Economist points to the relative success of family-owned private firms that minimize agency costs. But for the large corporation to grow through needed access to outside capital, minimizing agency costs requires transparency and close monitoring of owners’ interests. This will require the checks and balances of competing agents, such as an independent board that represents various stakeholders’ interests to management. I would suggest that this offers a positive role for organized labor—to represent their worker/shareholders so that their interests align with public shareholders in ownership and control.

Property Rights, Morality, and the Law

Because English common law was established to protect property, ownership is the linchpin of our contracts legal system: we assign losses or gains in transactions according to the legal ownership of tangible assets. We even have a maxim that says, “ownership is nine-tenths of the law.” The relevant principle is equity, in every meaningful legal, moral, and accounting sense of the word. The moral implication of the finance law of risk and reward should be apparent: those who bear the equity risk of the enterprise assume the losses of failure or reap the gains of success. The importance of equity claims can also be illustrated through accounting principles: on the income statement, input costs such as labor reduce profits that accrue to equity; on the balance sheet, labor contracts are a liability that reduce residual equity of the firm. A labor union that seeks excessive wage rents by controlling the supply of labor is actually using politics to exploit rents from the owners of capital. But if workers participate in equity, they merely shift claims from the cost to the profit side of the income statement and from the liability to the asset side of the balance sheet, all the while aligning their interests with the overall success of the enterprise. As implied, with their own “skin in the game,” they also share more of the risk.

Lastly, the legal statutes for business equity are consistent with the criminal code that states that the innocent shall not pay for the crimes of the guilty. In this light we can see that political cronyism that privatizes gains but shifts losses to taxpayers is not only an abrogation of ownership rights, it is a violation of the moral spirit of the law.

In summation, I have argued that capitalist ownership matters for the following reasons:
1. Accumulation of capital assets for self-insurance, minimizing risk through asset diversification, and reducing the need for after-tax entitlement transfers;
2. Sharing the benefits of capitalist success by broadening participation in the market economy. These benefits feed back into future consumption and investment demand while reducing the inequality generated by finance;
3. Broadening the sources of finance capital, helping to fund adaptation and innovation;
4. Reducing agency costs by aligning interests of stakeholders in capitalist risk-taking enterprise;
5. Reaffirming the moral and legal basis of equity and the law of risk and return through transparency and accountability.

These five reasons illustrate why ownership and control is an essential component of a free society. The ultimate challenge to an organic entity, whether a species or a civilization, is to adapt successfully to constant change. In economic terms, we need to harness the forces of change and adaptation for the long-run sustainability of the economy and security of society. There certainly are other social systems that attempt the same by eschewing private ownership and imposing top-down control, such as authoritarianism, national socialism or fascism, and communism. But none of these systems are able to assert the primacy of individual freedom and security that we hold inextricably entwined. To empower ownership is to advance freedom, to facilitate risk management under uncertainty, to spur adaptation and innovation, to affirm equity and justice, and ultimately, to foster peace and prosperity.

On the other hand, without ownership, we get feudalism:

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