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.