The market can stay irrational longer than you can stay solvent

Brad DeLong has a great post on the puzzle of low US interest rates (made more puzzling by the sharp decline over the past week or two). It seems obvious that this can’t last, but entirely unclear when it will come to an end. The reasons he and I (and more relevantly George Soros and Warren Buffett) aren’t betting on, and therefore accelerating, the end are argued pretty well, I think.

I’ll add my own contribution to the discussion over the fold. It’s a comparison of views of the economy based on flows of goods and services and those based on asset prices. On the former (traditional) view, the signs of impending disaster are everywhere. On the latter view, it’s sunny skies as far as the eye can see.

The capital gains economy

Australians have always had a penchant for speculation in real estate, and this has been reflected in periodic housing booms and busts. There is, however, no historical parallel for the extent to which the Australian economy is currently dominated by the pursuit of capital gains. The same is true of other English-speaking countries, notably the United States and United Kingdom. Depending on how capital gains are interpreted, the steady growth in output and consumption over the past 14 years may be seen either as an unsustainable bubble or as a sign of even better things to come.

The economic statistics on which analysis of the economy is based are, in general, computed as part of a system of national accounting based on production, and on a concept of income as the share of production flowing to owners of factors of production (labour, land and capital). In this framework, changes in the stock of capital assets arise from investment, net of depreciation. It follows that capital gains are transitory asset price movements, of little economic significance. Hence, rapid growth driven by consumption out of capital gains appears as an unsustainable bubble.

The alternative assumption begins with balance sheets in which assets and liabilities are valued at current market prices. Income, net of consumption, can be derived as the change in net worth over a given period. In this framework, capital gains represent the primary form of income. Production is relevant only to the extent that it increases capital values, after allowing for capital gains.

In the standard, production-based system of national accounts, the main statistics providing support for the view of the economy as a bubble are those relating to household savings and the balance of payments. According to the Australian Bureau of Statistics, Australia has had negative household savings since … The primary mechanism of negative saving has been the withdrawal of equity from housing. Faced with an increase in the market value of their homes, Australian households have increased their borrowing through home equity loans or have traded up to more attractive homes by taking on additional debt. Since the ABS does not treat capital gains as income, these transactions result in negative saving in the national accounts.

A focus on balance sheets yields a very different perspective, arguably closer to the viewpoint of the typical household. From the household’s viewpoint, a home equity loan drawing on capital gains is merely a partial offset against an increase in wealth. As long as the household’s net wealth is increasing, it appears from this perspective that saving is positive. The way to make this consistent with the income account is to treat capital gains as a component of income.

If capital gains are treated as part of income, the decline in aggregate household savings appears much less significant. Despite negative savings in the traditional sense, households have experienced rising wealth thanks to capital gains.

Changes in the treatment of capital gains have more subtle implications for the interpretation of the trade and current accounts deficits. The ABS national accounts show that the decline in household savings has been matched by rapid growth in the trade and current account deficits. In 2003-4 the balance of trade in goods and services was a deficit of 3.1 per cent of GDP. The current account deficit, which includes income payments on foreign-owned assets in Australia (net of payments to Australians from overseas assets) is approaching 7 per cent of GDP. Both figures are at the upper end of historical experience, in the range that has historically been associated with impending crisis. Yet concern over the deficits has been muted, to say the least.

To understand the issues, it is useful to look at some accounting identities. The budget balance and the external balance, combined with the consumption and investment of the private sector are combined the national income identity

Income = Consumption + Investment + Govt spending + Exports – Imports

This is an accounting identity, true by virtue of the definitions of the terms, and not because of any particular economic theory. This identity can be rearranged in various ways. In particular, the current account deficit (Imports – Exports ) is equal to the difference between total investment and the sum of private saving (after-tax income less consumption) and government saving (taxes less government spending). This arrangement leads to an interpretation in which inadequate public and private saving drives current account deficits, leading to unsustainable growth in debt. The fact that lenders do not immediately demand higher interest rates in the face of such unsustainable growth is seen as an indication of capital market failure, or of moral hazard created by the likelihood of an IMF bailout.

Again a focus on balance sheets yields a more favorable interpretation. Here the analysis starts from the assumption that low rates of interest on international borrowing and inflows of equity capital imply that global markets rationally place a high value on financial and physical assets in the borrower country, which presumably reflects an expectation of high growth in the future. Given the likelihood of high growth, it makes sense to increase current consumption.

Which approach is correct? In large measure, this depends on the view that is taken of the determination of asset prices. In macroeconomic analysis, and particularly analysis influenced by Keynesianism, asset price fluctuations are associated with macroeconomic shocks. Most macroeconomists would not deny that there exist some long-run equilibrium values for interest rates and asset prices. In the short run, however, the assumption is that both interest rates and asset values are determined by the interaction of monetary policy and the ‘animal spirits’ of investors.

History is full of examples where asset prices have fluctuated widely and where the sentiments of lenders have changed radically. Similarly, in the short and medium term, interest rates can vary for reasons unrelated to the long-run substitutability of current and future consumption. When the availability of credit changes rapidly, painful adjustments are required. History suggests that more of the pain is borne by borrowers than by lenders. It follows that, even if high levels of household or international indebtedness can be financed it present, excessive levels of debt are dangerous.

Since every economic situation is different, there is no precise rule for determining how much debt is too much, or how much borrowing means that debt is growing dangerously rapidly. Two approaches are worth considering.

The first approach is to derive rules of thumb from historical experience. As noted above, a common rule of thumb is that a current account deficit in excess of 5 per cent of GDP is a sign of danger. Other ratios, such as the ratio of debt service to export income are worth considering. Tony Makin of Griffith University has argued that the crucial requirement is that domestic net saving should be positive. On this basis, the sustainable CAD for Australia is between 7 and 8 per cent. Australia’s deficit was well within the limit suggested by Makin until recently, but is now approaching the limit, as is the United states.

An alternative approach is to consider possible steady-state positions and to model the adjustment processes required to reach such steady states. If feasible adjustment paths require rapid shifts in the near future, it is reasonable to conclude that these shifts will be painful and that policy action to anticipate and smooth them is likely to be desirable.

By contrast, an asset-based approach suggests that analysis of this kind is a waste of time. Standard models in finance theory are based on the assumption that asset prices represent the best available market estimate of the value of the flow of future income or services that will be generated by an asset, discounted at a market-determined, risk-adjusted rate of discount.

In this view, an increase in asset prices must reflect either an increase in expectations of future income flows, or a reduction in interest rates. The boom in share prices in the United States in the 1990s was generally attributed to expectations of higher earnings. The most extravagant of these expectations centred on Internet-based dotcom enterprises, and were fairly conclusively refuted by the collapse of most of these enterprises. Now that the main focus of asset price growth has shifted to housing, changes in expectations are of less importance. There is no particular reason to expect that the value of services provided by existing houses will increase in the future. Strong income growth may increase the scarcity value of wel-located residential land, but the boom in Australia has been so widespread as to cast doubt on this view

Low real and nominal interest rates have provided a more durable basis for increases in asset prices. In the simplest case of an asset that will generate a fixed flow of services, of constant real value, indefinitely into the future, the equilibrium asset value is inversely proportional to the real interest rate. More generally, a decline in real interest rates implies an increase in asset prices.

The big problem for finance-theoretic explanations of the recent boom in asset prices is that there is no convincing market-based explanation for the decline in real interest rates. Since the interest rate is the price at which present consumption can be traded for future consumption, a lower market interest rate arises either if consumers become more patient, increasing the demand for future consumption, or if expectations of future growth decline, reducing the expected supply.

Obviously, Australian and US households have not become more patient. Rather they have reacted to low interest rates by increasing consumption, as would be expected if the reduction in interest rates was exogenous. Hence, if a market-forces explanation is to be sought, it must be located in the willingness of foreigners to lend money to the English-speaking world at low rates of interest. In some versions of the asset-based explanation, this willingness to lend reflects the attractions of investment in dynamic, rapidly growing economies. However, this explanation would imply that capital inflows should primarily involve investments in equity, rather than public or private debt.

An alternative hypothesis, more consistent with the evidence, is that lending is being driven by Asian governments and central banks, in what has been called a new Bretton Woods system. The motive for lending is not the attractiveness of the returns on offer but the desire to finance growth in exports to the United States and other countries with large current-account deficits. Since this interpretation relies on the willingess of foreign governments to incur continuing financial losses in order to subsidise consumers in English-speaking countries, it raises concerns for proponents of an asset-based model who rely on arguments about market optimality. Nevertheless, proponents of the ‘new Bretton Woods’ hypothesis are generally relaxed about large current account deficits.

To sum up, acceptance of strong versions of the efficient markets hypothesis leads to the conclusion that economic analysis should be focused on asset values rather than on income flows. Observations of current income flows are informative only about the present, whereas asset values capture all relevant information about current and future income flows. An increase in asset values implies an increase in the present value of future income and therefore in the optimal level of consumption.

On the traditional, income-based view, by contrast, asset-based arguments are misleading and dangerous. By the time sentiment shifts in asset markets, the opportunity for an orderly adjustment will already have been lost.

One way or another we should know before long. The asset values we are observing make sense only if a substantial acceleration in the rate of economic growth is imminent. And without such an acceleration, the arithmetic of compound interest will produce a blowout in the current account deficit, necessitating a sharp, and probably painful, adjustment process. Over the next few years, we will find out which of these stories is correct.

25 thoughts on “The market can stay irrational longer than you can stay solvent

  1. And I have just taken out a home loan. I have been trying to figure out if the big crunch (whether it is soft or hard) that the US is heading into is going to take us down with it. I take the above post to mean if the strong market hypothesis is incorrect then we’re up the creek without a paddle as badly as they are. Well I know I don’t believe in the strong market hypothesis and I suspect JQ doesn’t either. I should have had more faith in my own conclusions about what was coming and kept renting.

    Oh crap.

  2. This is all interesting stuff, regarding the last decade, but not so relevant to the last couple of years. At least as far as Australia is concerned, asset prices haven’t been rising for the last couple of years. Stocks have gone up but house prices have gone down and being of a larger value I presume their movements would predominate in any assessment of ‘asset prices’ generally. Yet our CAD has been rising.

  3. To keep things simple, if I buy a house for cash and the seller sold it for a profit, then I am simply swapping my savings for his house. There is no net gain from the transaction. He has my savings and I have his house. There is no value added, no gross domestic product, only inflation. The way its done makes sense to me.

  4. Undoubtedly assets have become more important as a part of the average person’s balance sheet.

    In the late 90’s in the US this led to a virtuous circle where higher stock and housing prices led to higher current consumption which led to higher economic growth and higher asset prices.

    What concenrs me though is what happens when an exogenous shock like, say. higher oil prices, disrupts that process and sends it into reverse.

  5. Obviously, in Australia, we all have house values in the back of our minds when we consider asset values. Houses/dwellings are odd sorts of assets, in that the NPV of an income stream generated by a dwelling is only meaningful if we consider rent the dwelling might earn, or (conversely) the rent we would have paid if we hadn’t bought a dwelling. But rent is just that, rent; it isn’t a marketable product or service of the sort which might be produced by other sorts of assets – eg. a factory. Increases in house values are therefore not the same as increases in the values of other sorts of assets. It is possible therefore that disaggregation of asset price rises might give some clues as to the sort of process involved. If it turns out that the predominant asset price rises are in the housing sector, we might conclude that the “targeted inflation” process I referred to in my comment of 10/4/05 under the “Weekend Reflections” post of 8/4/05 might be considered.

  6. The thing is the way terms like “Building Society” have become synonyms for “Housing Societies”, with a change in emphasis from the addition of new stock to the management of existing stock. There was a huge social change too, with the original societies representing a way for people to promote themselves into a political class incrementally. That was actually a much sounder outcome than simply diluting the franchise; efforts should have been directed at more promotion, not changing the basis of the vote. What happened actually led to apartheid, displacing a detribalising promotional process that had been underway.

  7. We live in a capitalist economy.

    To say “that capital gains are transitory asset price movements, of little economic significance, would be to understate one of the basic building blocks of our economy.

    Capital is invested to get a return, either a capital gain and/or income- this is the foundation of our economy. If this did not occur our economy would collapse- as happened in the Soviet Union.

    The balance sheet is just a snapshot in time of how that investment of capital is going. Many variables can have a bearing on the balance sheet. Income and expenditure (cash flows) capitalisation (debt and equity flows).

    These variables change according to the prevailing economic climate; incomes can turn to losses; capital can be raise in the form of debt or equity, returned as well as rise and fall in value in line with assets.

    To focus on one aspect with out taking into account all the other variables would not be considered prudent financial management. Nor would it be good financial management to treat something as income when it is not realised. Whether it is a capital gain, debt financed consumption or some other obscure financial arrangement.

    What is important is that we have a clear picture of what is going on so that we manage effectively. Our national debt to equity level held at conservative at $1 debt to $3 equity and our debt-servicing ratio improved from 19% to 10% over the ten years to 2001.



    These are the primary two ratios used by lenders to evaluate debt. By these measures we were travelling well in 2001. Income levels and asset prices can change quickly- careful lenders conduct annual reviews.

    A prudent review would also look at the increased net foreign debt because: “Some of Australia’s foreign debt has financed the acquisition of capital goods and other assets that can be used to generate future income and support future consumption; some debt has financed current consumptionâ€?.

    Debt to finance current consumption over the longer term is living beyond our means. If it has recently increased, coupled with deterioration in the two ratios mentioned above, then we should be concerned.

  8. Three econometricians go hunting, and spot a large deer. The first econometrician fires, but his shot goes three feet wide to the left. The second econometrician fires, but also misses, by three feet to the right. The third econometrician starts jumping up and down, shouting “We got it! We got it!”

    Comliments of Jane Galt

  9. IG, the point about the older system was that it was about to give women and darkies the vote – so they fixed it. Had things continued in an evolutionary way, the “lower clases” would never have got the vote – but it would have become the empty set, with all people moving out of the stultification of a class framework.

  10. “Australians have always had a penchant for speculation in real estate, and this has been reflected in periodic housing booms and busts. There is, however, no historical parallel for the extent to which the Australian economy is currently dominated by the pursuit of capital gains.”
    This assertion is totally incorrect. Several periods when high levels specualative activity occurred are the South Sea Bubble and the Great Railway Boom in the US during the 19th Century. Speculation by intent is a gamble to achieve capital appreciation, so therefore to say our most recent boom in terms of scope etc. is witout precedent is inaccurate to say the least.

    I really don’t understand why economists spend so much time looking at the symptoms rather than the malaise.
    The reason we have speculative excesses in the economy is because of credit expansion caused by
    1. interests rates that are set too low, and
    2. fractional banking, which allows banks to lend more through the multiplier effect of their reserves.

    We only have to look at the money supply to see the damage the RBA has caused to this economy since 1996. Money supply (m3) I believe has grown by 80% since then.

    Of course you can’t be sure where the borrowed money will end up. In our case it went into real estate speculation. The US experiencing the same thing saw money flow into the stock markets.
    It really isn’t that complicated.

  11. dc, the point was clearly with reference to Australian experience.

    More generally, I suggest you adopt a less arrogant tone. If you think you know a lot more economics than I do, I suggest you apply for a chair in one of our leading economics departments. Otherwise, consider that if you read something I’ve written that seems to you to be “inaccurate to say the least”, the odds are that either
    (i) you’ve misread the point; or
    (ii) you’re misinformed on the topic.

    That said, I agree with your general point that interest rates, considered in micreconomic terms as the price of savings, are too low. I’ve said this several times already.

  12. Yes Professor:

    I agree: I need to have a chair in economics before I can question your assertions. Is that right?

    In any event. Let me ask you a question. You say that you have often said that interest rates have been too low. How exactly would you know interest rates are too low or too high for that matter. In a fiat regime, which is paper currency without gold backing how would anyone know when interest rates are at the wrong level?

  13. ‘I agree: I need to have a chair in economics before I can question your assertions. Is that right?”

    No, but you need to adopt a more polite tone if you want me to engage in further discussion with you.

  14. Ok professor agreed.
    Could you please answer these assertions at your convenience please.
    Awaiting with eagerness
    Thanks so much

  15. Fine, dc. The interest rate is a real variable, which is well-defined even in an economy without money, being the price at which future goods are traded for present goods. If we see excessive borrowing by domestic consumers, funded by loans from foreign central banks, it seems reasonable to say that the rate of interest is too low. The question of fiat money is not relevant to this analysis.

  16. dc,
    You say (at comment 11, point 1) that interest rates are too low. You then question PrQ at comment 13 as to how anyone can tell is rates are too low in a fiat regime. There seems to be a disconnect between the two – can you explain?
    Secondly, your concern with ‘fractional’ banking looks like the “Social Credit� theory of Major Clifford Hugh Douglas. Is that the case?

  17. Is money a commodity used to transfer assets, goods and services and interest rates the price of that commodity?

  18. To see what’s wrong with this suggestion, econowit, think of a real commodity money, like gold. It’s clear that the interest rate and the price of gold are two different things,

  19. Brad Delong’s piece is the conventional view on Wall Street, which is long-term rates are low only because the Asians are buying US treasuries and the music will stop when that ends. Well I am not so sure because if that were the case the shape of the yield curve would be much steeper than it is now.

    I am a trader by profession (I’m not sure it is a profession), which means I spend a lot more than than anyone else thinking about markets and what is happening. What I do know is conventional wisdom professed by Wall Street economists is usually wrong. By all accounts the yield curve, whether, Asians are buying the long end or not shhould have steepened by now and it hasn’t. The US CA is not much bigger in terms of % to GDP than a decade and 1/2 ago, which was the time when Japan was the bogey man as China is now.

    As I said the curve should have steepened by now and the reason why I think it hasn’t is because I believe the adjustment has taken place elsewhere.
    I think the adjustment or a large part of it has been taken up by the weakness in the Dollar against all major currencies except those that are not allowed to float freely- the Chinese Yuan being the prime candidate.

    The thing that most people forget is that the Dollar has lost a great deal of value over the last three/ four years against currencies like the Euro where it has fallen over 50% since 2002. This is a huge adjustment by any reckoning. Against the Yen, the Dollar has shed about 8% still a fall but nowhere near the Euro.
    The Dollar index has also fallen dramatically.

    So I think the adjustment has taken place in the currency market rather than interest rates. For this, the US can count its lucky stars because if both the Dollar and bond market had fallen in tandem we would be seeing a horror story develop.

    Thare are two Wall Street maxims worth keeping in mind. A current account deficit becomes a problem only when it becomes a problem. The other one is that many people have gone broke understating the resilience of the US consumer.

    This does not mean will won’t get any scares this year as the 200 point fall in the DOW proved last Friday. My feeling is that the underlying strength in the US economy will not erode in 2005 but may see a great deal of financial shakes.
    The big question however is that the Fed’s eagerness to take rates to their “natural level” may cause them to go too far. Greenspan was asked where he thought the “natural level” is, to which he replied that he would only know when rates got there.
    This is a startling admission to make because we sometimes know we have reached peak only when there is a financail panic. If there is a big bust then all bets are off because these markets are going to go to the races.

  20. J. Q

    In that context the money was a promissory note to deliver 1 oz of gold for $35 or something similar.

    Now days it seems to have taken on all the characteristics of a commodity.
    Its value lies solely in the expectation of later use that is backed by governments who utilise inflationary fractional-reserve banking. It is traded on the money markets. I can rent money from different banks at different rates (so I shop around). I know it is not a politically/economically correct way to define it, but from my worldview it is treated as a commodity and the banks keep in it plentiful supply.

  21. Econowit:
    I have been running what I think is a good trade idea. It centres around the fact that the financial world is sloshing around trying to figure out what is going on. What I believe is going on is the first stages of the repudiation of fiat currency. That is money without any backing at all other than what Governments promise. Although we feel safe with this for the moment in truth fiat currency on this wide scale of circulation, that is all over the world is an experiment which began in 1971? when Nixon broke the Gold peg and let the Dollar Float. My bet is that poeple are starting to realise this experimnet may not work, or they are not sure it will.
    I believe ground zero for this failure is the EU which currently has a currency without a home and all the other stuff that is going on. That’s why I sold Euro against Gold. Of course the trade may not work and that’s why I have a stop at 310 Euro to Gold. I am looking for 500 Euro on the trade.

    food for thought.

  22. In one of his last “Letters from America” before he retired and died, Alistair Cook mentioned a billboard advertising gold plated golf clubs. He said that the last time he had seen such extraordinary decadence (not just of the golf clubs, but in general) was during the 1920s.

    I find it terrifying that every market on the planet seems to be in bubble mode. Share markets seem to have gone ga-ga over China and commodities, and the ASX is more exposed to this than US markets. Methinks it will take a lot to knock the steam out of the housing market here. Maybe an equities crash? Yikes.

    Or, is the information and feedback loop better these days than it has been historically? Do people genuinely have a better understanding of value?

    Or have I just been reading too much Max Walsh (who seems to have come out of the bear cave of late).

  23. Regarding low interest rates, it stands to reason that central banks of Japan and China are not likely to purchase higher interest bonds in emerging economies. For one, it wouldn’t create enough demand to justify the move, for another, the reserves are so large it would quickly destabilize those economies. It is better to recieve low interest than throwing it down the drain. One alternative would be to hoard commodities such as oil and metals. Again, the limitation in this move would be inflation, which has been occurring.

    I would like to add, that I believe it was De Gaul who protested American over issuance in 1971 and demanded gold instead of dollars from the United States which prompted Nixon to close the gold window. This begs two questions. What is it about gold that is so special, and why aren’t Asian banks purchasing gold now to protect their reserves.

    In researching the answer to the first question, I found that gold has the highest stocks to flow ratio at about 50-80. This means that it would take 50-80 years at current rates of production to replace existing stocks of gold. No chance of inflation in this scenario. The other quality of gold is that it has a constant rate of marginal utility, something no other commodity possesses. You might ask, if that is true, how do you explain the fluctuating price of gold. When gold is exchanged for fiat currency, the fluctuating price reveals instability in paper, not gold. Subsequent to Nixon’s over issuance, the price of gold went to over $800, and it took interest rates of 16-18% to finally convince investors to dishoard gold and convert their wealth into productive capital. In this viewpoint, interest determines the level at which savers are willing to convert their wealth, which in this case is gold but it could be any commodity, into circulating capital.
    In answering the question, why aren’t Asian banks buying gold?, I would venture, in looking at the gold chart since 2000, that they are. The gold chart looks like a slow, controlled accumulation, in spite of western central bank selling and a lot of negative press.

    Regards, John Beder

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