#29. Capital, income and the next crash

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.

11 thoughts on “#29. Capital, income and the next crash

  1. Tim,
    It wasn’t quite clear as to whether you meant that the buying of 5%/10% inceased value by £20bn rather than buying them up with £20bn?
    Otherwise the rational and arguement seem sound ;so why do others not see this ?
    best
    peter

  2. Peter

    I meant using £20bn to buy them.

    Say a big company has a value of $100bn. A buyer of $5bn comes into the market (and, moreover, it is known to everyone that this buyer is there, i.e. they know there is upwards pressure on the price). In this situation, no-one is keen to sell, so a buyer of 5% of the company’s outstanding shares will chase the stock price up by quite a long way, even though he’s buying only a modest proportion of the total “market value”.

  3. Fabulous clarity, as ever, thank you Dr Morgan!

    Having recognised that interest rates cannot rise by any worthwhile amount in the forseeable future, and that financial asset valuations are fiction, how might this play out?

    We can all see any number of possible triggers for a crash: Japan becoming insolvent, China suffering an uncontrolled commercial & regional government debt meltdown, US dropping back into recession, further Eurozone debt problems, the UK looks very exposed with its lack of growth and trade deficit, we have an assortment of wars that might spiral (even more) out of control, and more besides.

    Is it not probable that the financial repression policies of central bankers can be extended almost indefinitely, and that the adjustment becomes an adjustment of expected earnings multiples and yields? I’d see that as a selective form of inflation, reflecting the injection of cash into asset markets instead of the economy. And I then wonder how can these overblown markets crash, given that (as you observe in your comments on marginal pricing) there isn’t anywhere obvious for all of the money to go? As cash it is losing value all the time (and subject to seizure by governments bailing out insolvent banks). Bonds and equities are fairly closely tied by the perceived risk of the corporates to which they apply. No economy seems to qualify as a safe haven now.

    Are we not now looking simply at the new normal, which is a “normality” of an extended period of negative real growth, negative real interest rates, and lower real incomes, with continued money printing whenever it looks as though interest rates are starting to creep up?

    • Thanks Dr Morgan for another interesting piece.

      It struck me on reading around the internet this week the stark contrast between your views and those of most of the political establishment following Modern monetary theory.

      http://petermartin2001.wordpress.com/

      So much of what I have read here seems to be the orthodox view of the establishment. In general the MMT school seems to be relaxed about money printing and debt (it’s just a government IOU that never has to be repaid ) and that having a trade deficit of 5% doesn’t really matter.
      I also suspect they are quite relaxed about the distortion and bubble effects in the capital markets you have described.

    • Kenneth:

      This isn’t the place to come to for a consensus view! My views are unorthodox and sometimes unpopular, but I would say that (a) my forecasts have been pretty good, and (b) I always try to use logic, and explain my conclusions so you can follow my reasoning and agree or disagree.

      The establishment (if I can use that term) wants to avoid frightening anyone, and the economic consensus moves like a herd. As for being relaxed about bubbles, history doesn’t exactly vindicate that stance!

    • Thanks Dr Morgan,

      I have to say I strongly agree with your views and am quite alarmed by the sheep like nature of politicians and those in the media commentating on economic events. How often has the meaning of ‘debt’ and ‘deficit’ been mangled by the BBC.
      This ‘experiment’ in QE seems to be based on a pretty shaky theory ie ‘creating something from nothing’. How can some of the dangerous elements of MMT be defeated and replaced before the economy implodes ?.

      Lies and spin seem to be the order of the day. For example the Coalition seem very proud of their record in creating ‘new’ jobs – some 1.8 million since 2010.

      However digging beneath the surface reveals that spending on working tax credits has gone up from 23 billion to 29 billion over this period. So it looks like these ‘new ‘ jobs (many of which go to migrants) are being heavily subsidised by the taxpayer. So more hand car washes etc.

      We are indeed ruled by a bunch of ‘college kids’. Professional politicians who have no real world experience in many cases other than inside political bubbles. What we are seeing is those at the top putting their own short term career prospects ahead of the long term interests of the economy in my view.

    • Thanks Badger. I think you describe the “new normal” very well.

      But our system is predicated on perpetual growth – it’s the only way debts can ever be repaid, welfare obligations ever be met or the needs of a growing population satisfied. The economy, as presently structured, cannot really cope with an ex-growth status.

      Just taking the UK as a (minor but local) example – how long can we cope with falling real wages, nil returns to savers, therefore no incentive to capital formation, and real govt revenues not rising despite “recovery”? It may be the new normal but I think it’s a time-limited one as well.

      My broader view, as you know, is that the ending of cheap energy took growth out of the economy about 10 or 12 years ago, and that we’ve manipulating the financial economy ever since then to disguise the weaknesses of the real (energy) economy.

  4. Tim,
    Perhaps a marginal injection of new money into the capital markets can be viewed as a reversal of a price elasticity concept – a market impact of new additional $1 of demand (supply-demand imbalance) translating into the price change. What do you think?

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