Thursday, June 25, 2015

Higher asset prices are not a Wall Street giveaway.

The value of a financial asset is the present value of future cash flows.  That value can generally be simplified to (1) current cash flows, (2) the growth rate of future cash flows, and (3) the discount rate applied to future cash flows.

I have been arguing that, for corporate assets, at least (of which equities are our proxy), the discount rate tends to be fairly stable over time, and most of the cyclical and secular changes in equity values are from changes in cash flows.

There seems to be a widespread belief in the idea that balance sheet expansion at the Fed has injected cash into asset markets, and has been a "bailout" of financial interests.  This is usually paired with the idea that the alternative would be some sort of fiscal injection or Federal transfer. In effect, the idea is that fiscal injections would increase consumption (ergo, current cash flows) while monetary injections increase asset prices instead of consumption (ergo, decrease the discount rate).

What if I am wrong about the relatively stable discount rate, and monetary injections are just inflating asset prices (reducing the discount rate)?  This is still not a "giveaway" to Wall Street.  Asset prices resulting from changing discount rates are simply a transfer from new owners to current owners.  Cash flows have not changed.  In the end, after all cash flows have been received, the only difference will have been that an owner that sold at t=0 would have received a one-time transfer from the new owner.  So, to the extent that this transfer leads to consumption from asset holders, there would be no net wealth effect, all things considered.  There would only be a transfer of consumption from the future to the present.

Now, I don't believe this is the primary result of monetary injections.  It certainly wasn't the case in the one undisputed period of loose monetary policy - the 1970s.  Both monetary and fiscal injections increase current corporate cash flows.  We can argue about which is the best policy and which types of injections do the best job of maximizing future growth while mitigating short term dislocations.

But, without getting into all of that, I am just pointing out that if any policy is a Wall Street giveaway, the interpretation of events that does not describe a Wall Street giveaway is the one where monetary injections "artificially lift asset prices" above the "fundamentals".

This is how some people characterize the housing boom of the 2000s.  I agree that there was a wealth effect during that period (although I disagree that it was artificial or based on a deviation from pricing fundamentals).  But, notice how in that scenario, where middle class households are the protagonists in the narrative, the narrative treats the wealth effect as a transfer through time, that had to be matched with reduced consumption in the bust.  But, when the narrative has "Wall Street" as the protagonist, the wealth effect is treated as a giveaway, or a bailout.

We like to populate our narratives with dupes and villains - "smart money" and "dumb money".  I think these sort of preordained narrative biases become self-fulfilling, leaving many with an attitude that there is some greatly over-estimated cabal of financial power mongers who have a "heads I win, tails you lose" stranglehold on the economy.  The erosion of trust this sort of narrative building creates leads to so much poor public policy, such as the supply constrictions I have been discussing in housing.


If discount rates are stable, then Wall Street gains from the other interpretations of cyclical policies are mainly the result of broad-based expansion of spending across the economy and higher expectations of future broad-based expansion.  Looking at profits + interest income + proprietors' income, total returns to corporate and non-corporate capital only have cyclical fluctuations of 2% or less, and haven't moved outside of a band of 4% since WW II.  In other words, even if all of the fluctuations in capital income were a product of some pro-Wall Street cyclical policy, it could only amount to a total capital price appreciation of about 10% between valuation bottoms and tops.

In fact, even that small amount of fluctuation is almost entirely the product of corporate profits recovering from the dislocation created by the contraction.  Once this dislocation is reversed, long term levels of capital income appear to be a very stable product of complex social inputs.

I have been commenting on the unusually high corporate earnings, relative to valuations, in the 1970s.  In the first graph here, we can see total capital income share bottoming out in 1970, after the long period of cyclical stability in the 1960s, and growing until it peaks in 1984.  But, even here, we are looking at an increase in share of GDI to capital of only 4% over a period of 15 years.  And, this was during a period of very low equity valuations.  The secular growth in capital income share during that period was more likely a product of slowing growth expectations associated with pro-consumption policies, a poor capital environment, and some amount of misattribution of the inflation premium portion of interest income.  (The inflation premium of nominal interest payments on corporate debt causes interest income to be overstated and profit to be understated.  On mortgage debt and consumer debt, the inflation premium overstates interest income and understates real savings for households.  But, the overstatement of interest income due to mortgage and consumer debt should tend to amount to less than 2% of GDI, with relatively little fluctuation over time.)

There is simply no modern era evidence of massive relative income grabs by capital.  It is probably impossible, or at least highly unlikely, for that sort of income transfer to take place in a modern liberal society.  Except for the exceptional burden equity holders accept of absorbing negative cyclical shocks, long term growth in capital income is a reflection of the rising tide of abundance.  We are the 100%.


  1. Your statement that higher asset prices are not a "giveaway" to wall street is only supported if buyers and sellers meet without intermediaries. If you had brokers who traditionally took payment related to the nominal value of the assets that they managed then it would be a large transfer of wealth to those brokers to double the nominal value of assets. (it would also be great PR for those firms to advertise the returns their clients got and would focus more activity in the sector that they are experts in, a stock market boom should in general be great for "wall street").

    1. That's a fair point, baconbacon. I would only say that the scale is much different - billions of dollars instead of tens of trillions. But it would be enough to encourage rent seeking. The same can be said of real estate brokers - in fact, probably more so, since real estate transaction costs are so much higher.

  2. TravisV here.

    You might be interested in this new paper Tyler Cowen linked to:

    1. Thanks Travis. Digging into that paper is on my to do list.