HOW “EXTEND AND PRETEND” IS BUILDING THE BIGGEST BUBBLE OF THE LOT
One of the most striking anomalies of the current age is the mismatch between buoyant capital markets and stagnant economies – by any pre-crisis benchmark, both bonds and equities look extremely expensive in relation to the underlying realities of government finances and economic performance.
You could, of course, simply conclude that capital markets are heading for a very nasty correction, and you’d be quite right. But what we really need to understand is the relationship between capital values and incomes. Around the world, you see, income is just as scarce as capital value is, supposedly, robust.
The lack of income is strikingly visible almost anywhere you look. In Britain, average wages are growing by just 0.3% with official inflation standing at 1.9%. What this means is that wage-earners are getting poorer in real terms, just as they have been in every year since 2007.
Wage earners aren’t alone in this. Savers’ returns have been pulverized by low interest rates, which may have cost savers as much as £400bn in lost income when measured against pre-crash benchmarks. The same phenomenon has cut a swathe through employer-funded pension provision whilst decimating the income available from annuities. Even the state pension has trailed the surging cost of essentials, and much the same can be said of most benefits.
This squeeze on income is apparent in national aggregates, too. Even in Britain – where growth in GDP appears comparatively strong – an increase in economic output of maybe £80bn this year is likely to be dwarfed by the accumulation of perhaps £250bn in additional debt.
Why, then, are capital markets so out-of-kilter with incomes? There are two related answers to this question.
First, capital values are marginally priced.
Second, this marginal pricing facilitates manipulation by authorities playing the global game of “extend and pretend”.
Let me explain what I mean by “marginal pricing”. Where incomes are concerned, we can measure them in their entirety. If you earn £25,000 this year, then £25,000 is what will show up in your bank account. If your investments earn you £1,000, then £1,000 is what you’ll get. Much the same applies to national income measured as GDP, even if this is boosted by some accounting oddities which may inflate the reported number by perhaps 15%. Essentially, £1.6 trillion of GDP means that something close to this number – perhaps £1.4 trillion – will show up in people’s pockets.
Capital values don’t work like this. If you multiply the average house price by the number of houses in the country, you’ll come up with a number which is impressive – and utterly meaningless. Obviously, the vast majority of those buying houses are the same people who are selling them. Neither Britain nor America nor any other country could sell its entire stock of houses – who, apart from their current owners, could buy them?
The same applies in all other asset markets. The impressive number of trillions that the equity market is supposed to be “worth” could never be realised, any more than we could monetize the entire enormous, but purely theoretical, value of the bond markets.
Capital market values, then, are a game that we play with ourselves. In the normal course of events, a small proportion of the total (say 5% or 10%) is bought and sold, and the price at which this fraction changes hands is used to value the totality.
Invert this formula and you have a multiplier effect. Put £20bn into a market of which 5% changes hands and you’ve stoked up the theoretical value of the whole pie by £400bn, or £20bn multiplied by the inverse (20x) of 5%.
From this you can see how very easy it is to ramp up any kind of asset market, be it the UK property market (by subsidising buyers) or the US bond market (by using newly-created money to pump in as much as $80bn each month). Governments and central banks cannot (without catastrophic consequences) create $10 trillion of new money, but they can inflate the bond and equity markets by $10 trillion very easily indeed by injecting just a small fraction of this amount.
As I’m sure you know, the authorities worldwide are playing a game of “extend and pretend”, and have been doing so ever since 2008. Globally, we are so indebted that we simply could not afford to see interest rates rise. In Britain, for example, where aggregate debt is around 500% of GDP, even a 2% rise in rates would bite 10% out of GDP. Of course, some of that money would go back into GDP via higher returns to savers, but the net effect of higher rates would nevertheless be devastating.
This problem isn’t uniquely British – the Eurozone, the United States and China are in the same holed-below-the-waterline boat, and let’s not even begin to apply such multiples to Japan.
Interest rates, of course, are a function of the income of a bond (sometimes called the coupon) divided by the capital value. A bond priced at £100 paying you £10 a year has a current yield of 10%, but you can push that yield down to 5% if you can push the price up from £100 to £200.
Bond yields are the market’s way of setting interest rates, so the authorities can keep rates low if they exploit the “marginal pricing” of asset markets to inflate capital values. Put in £1, inflate the aggregate value by £20, and hey presto – lower interest rates.
Now you might think that, ultimately, it’s income, not theoretical capital value, which puts bread on the table, and you’d be quite right. As we’ve seen, however, all forms of income – real wages, saver returns, pensions and so on – are under pressure.
You might also realise that the real, “embedded” value of an investment is the sum of the income stream that you’ll get from it in the future. Again, you’d be right.
Essentially, then, the authorities are to be congratulated for their success in keeping the game of “extend and pretend” going for so long.
They are to be commended, too, for their future place in the history books – as the architects of the biggest crash in financial history.