Stocks Tumble as Asset Deflation Threatens Debts -

One of the puzzles for in this recent market rout is that jobs numbers in December were so favorable and yet stocks acted like the world was sliding into the abyss. What is wrong with this picture?

At the root of the problem is that two major groups of asset investors — Chinese and oil-fueled Arabs and others — are suffering major income declines and these declines restrict their ability to hold up asset prices worldwide.

The problem becomes a crisis in the half of the economy that economics classes most neglect. Capitalist economies have two major parts: the productive economy and the asset stock. Economics is almost entirely focused on the first to the neglect of the second. This crisis, like many others in world history, is less about what is happening in the productive economy, but more about asset markets.

Assets are things that are held for their exchange value rather than for their consumption utility or productive uses. Depending on who is owning them and what they are doing with them, assets may include things that do have productive uses or consumption utility. Commodities, for example, gold, oil, pork bellies, coffee, and copper all have utility in production or consumption, yet some investors also buy them for their asset value, expecting their price to rise. Financial assets like stocks, bonds, derivatives, bills, and currencies all are pure assets without direct utility as consumption and production items. Generally the biggest class of assets is real estate.

Since most assets (other than commodities) are not manufactured in the real economy, their prices are restrained near the economic cost of production by the possible influx of new output when prices rise. Of course effective monopolies or cartels may prevent this, as recently in scandalous cases of outlandish pharmaceutical prices, but at least it is a possibility whenever there is potential for market competition.

For assets like land and financial products that do not have a production cost that could potentially restrain the price, the main determinant of price is the supply of credit available to potential purchasers. If investors are easily able to borrow to fund new purchases of stocks or real estate, for example, then the price may spiral upward, at least until credit tightens. Credit-fueled demand can create, for some time, a self-fulfilling prophecy of rising prices fueled by expanding credit, the credit being secured by the rising asset values. It is a virtuous circle.

However, when owners of, say, oil assets lose massive income from the precipitous drop in oil prices, they still need to cover debts incurred when oil prices were high and thereby provided ample collateral for leverage using tempting low-cost credit. Typically, liquid resources are insufficient, so oil barons must sell other assets to pay debts no longer serviceable from oil income alone. The same happens to wealthy Chinese export and real estate interests when their prime income sources begin to decline.

Originally published at The Street on January 15, 2016 – Stocks Tumble as Asset Deflation Threatens Debts