Saturday, 22 March 2014

Economic myths: Asset prices and interest rates

The traditional explanation is for example here at marginal revolution:

There has been a lot of discussion recently of Fed policy, tapering, and asset price “bubbles.”

One point to bear in mind is that when interest rates are low even rationally determined asset prices may fluctuate wildly. Consider, the simplest Gordon model of asset prices in which future dividends are expected to be $100 forever, then the asset price is $100/r where r is the interest rate.

If r is .1, for example, then the stock will be worth $1,000. At an interest rate of 10% the price of an asset that pays $100 forever is just $1,000 because the future is heavily discounted. If the interest rate were to fall to 9%, the asset price would rise to $1,111.11 ($100/.09).

The asset is worth more at a lower interest rate because the future counts for more but not that much more since the far future is still discounted to near zero.


Yes there is a lot of truth in that, even though on closer inspection it is credit availability (i.e. QE) which influences 'asset' prices as much as interest rates.

But this is backwards logic; it is not the value of the actual asset which changes, it is the net present value of the future income to be derived therefrom. So using the word "asset" (or indeed "capital") to describe shares, land, government bonds etc is highly misleading.

If we think about real assets, like tools, machinery, vehicles, buildings, software, an advertising campaign to build up goodwill etc, the calculation is the other way round:

The businessman knows what it costs to buy such assets and has to make some sort of forecast of how much extra income he can derive from that real investment. Those are the two known/estimated figures. He then divides the expected return by the cost and that is the return on capital aka interest rate.

Income ÷ cost = rate of return

Faced with limited funds and a range of possibilities, he will choose the combination of projects with the highest expected overall return. The market rate of interest (in the financial sense) is dictated by whatever is the lowest rate of return; if the least promising project which is worth doing gives an expected return of 5% and the one after that only yields 4%, then the businessman will put his money in the bank for 4.5% interest; other businessmen will then borrow that money for 4.5% if they can find a project which returns more than that (ignoring the bank's spread); they are pre-spending future income and turning it into capital today.

And now for the arse backwards calculation applied to future income streams:

Income ÷ interest rate = asset price

The value of your tools, machinery, vehicles etc. does not change very much if interest rates change; and neither does the amount of income you can earn from them. Every business will try and get the most out of what they've got; so in the long run this will all level off and even out and we'll end up with business doing whatever is most profitable/creates most wealth. If expected return on capital increases, then investment in the most profitable kinds of capital increases to soak up that extra income etc.

Quite the opposite with financial assets which are in truth no such thing.

… it gets worse; if total expected earned income from real capital increases, there's a surge in demand for smartphones or apps or something, then in the medium term, the amount which businesses invest in producing new smartphones or apps goes up so more businesses are sharing more income; the real rate of return is stable.

So there's only any point in buying a future income stream if it is fairly fixed and nobody can compete it away, i.e. if there is a reasonable monopoly element i.e. rent included.

So if demand for smartphones or apps increases, the cost/value of your real assets stays the same and your share of the total income stays the same. But if rents increase then the net present value of land must also increase. The rents cannot be competed away, by definition, rents are that element of income which cannot be competed away; the part which can be competed away already has been.

[Of course smartphones and apps are protected by patents and other IP rights, which raise barriers to entry so the income from the patents and IP rights is to some extent rent, separate topic.]

… and worse. If the real economy is moribund, then businesses can't identify many profitable projects and the real return on capital falls, businesses are ore likely to put their spare cash in the bank, so credit availability increases and interest rates fall, so the net present value of rents i.e. land prices increase yet again.

So I know it is a bit clunky substituting the phrase "Capitalised value of future monopoly income streams" instead of "assets" in the context of land, government bonds, shares and IP rights, but it would be much more accurate.

9 comments:

The Stigler said...

"Of course smartphones and apps are protected by patents and other IP rights, which raise barriers to entry so the income from the patents and IP rights is to some extent rent, separate topic."

I know a little about the app market and there's not much that's patented in there (audio and video stuff uses some patents for compression). There is some trademarked stuff, like if you want to make a Pacman game, you need to get it licensed. Other than that, you've got copyright on the code and characters.

These app stores actually don't make much money. Game development in general has the same problem for developers as being a rock star or an actor. It looks really sexy and if you strike it big, you make a fortune. But most game developers don't. And you only hear about the hits.

Lola said...

Indeed. Strictly speaking there are only four true 'assets' on the planet - shares, bonds, property and cash. Why? Because they all have a cash yield - aka 'rent'. And their prices are a function of current interest rates (the 'risk free rate'), the discounted cash flow of the future income stream(as you say), and 'good' or 'bad' money (that is the Misean 'unwarranted expansion of money and credit).
Overall, why should not 'savers' live off these 'rents'?

Mark Wadsworth said...

TS, what I meant is once you've made your app, it is automatically copyrighted, so if it is one of a thousand which is a hit, you get some protection.

L, "Overall, why should not 'savers' live off these 'rents'?"

No, savers are supposed to live off their savings.

The purpose of "saving" being to spread your consumption evenly over your lifetime, despite having fluctuating earnings. So taking everybody as a whole, the value of your savings = the value of everybody else's dissavings.

Lola said...

MW. They do indeed live off their savings. But in the process they will have some payment for the time their savings are on deposit (and I incluxe in on deposit owning stocks and bonds and property). Which is fine. And the late lamented annuity was exactly that - a return of your 'capital' with interest. And that is what most pensioners do.

The Stigler said...

"TS, what I meant is once you've made your app, it is automatically copyrighted, so if it is one of a thousand which is a hit, you get some protection. "

True, but that's not really a barrier in the way that patents are. Someone has created a game - it doesn't stop me from creating a game.

Mark Wadsworth said...

L, yes, as far as savings/dissavings goes, we have to have 'interest rates' to balance out people's propensities to either bring forward or defer consumption, thus arriving at some overall maximised value of consumption.

Remember: an individual obtains maximum benefit from his lifetime's consumption if he spreads it as evenly as possible, even if that total consumption is exactly the same, or even slightly less than if he spent every penny he earned immediately.

TS, I chose smartphones and apps just as an example of "something new which lots of businesses are investing in" just as an example, and then it occurred to me that this activity, just like most others, does have some element of govt. protection, barriers to entry and hence rental income.

In other words, there is always a grey area between 'earned' and 'unearned' income, but the exercise is still useful in distinguishing between

a) 'capital' or 'earned income' (the cost/value of which does not fluctuate with interest rates), and

b) those 'assets' whose price does fluctuate with interest rates, which are clearly not 'capital'.

For example, when company A takes over business B, company A will impose a non-compete clause on the former owners of business B. That is a rental payment to B and in future is rental income for A.

But you could argue that B has built up goodwill out of his own efforts and at his own cost, so that is only a fair return for B's historic efforts.

So that's a grey area.

The Stigler said...

Mark,

TS, I chose smartphones and apps just as an example of "something new which lots of businesses are investing in" just as an example, and then it occurred to me that this activity, just like most others, does have some element of govt. protection, barriers to entry and hence rental income.

In other words, there is always a grey area between 'earned' and 'unearned' income, but the exercise is still useful in distinguishing between


The main protection is around work created. As I said, you can't go making copying Pacman, or making a version of Pacman without contacting the owners. But it doesn't act as a barrier to entry into the games market, only as a barrier to passing off other people's work.

At their best, intellectual property laws do things that ensure we get more intellectual property. But there is rent-seeking, like lobby groups that keep trying to retrospectively extend copyright, when it really should be much shorter.

Mark Wadsworth said...

TS, yes of course. It's a tricky balancing act.

If the period for copyright protection is too short, it discourages people from creating new IP; if it is too long, it also discourages people from creating new IP - why bother if you can harvest the old stuff?

So there is an optimum duration, and I have no idea what it is - I just know that there is one.

But it's a good example nonetheless - if copyright were extended by another 50 years, then the value of old copyrights due to expire would go up a lot, a windfall gain for the original authors. That is clearly rental income.

Dinero said...

Sounds OK in theory But power companies have a high figure for the dividend divided by the price even with the security of proftis,

any comment