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. The focus is on Australia, but most of the arguments are equally applicable to the US. 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.