The Global Liberty Community
Issue Debt and Have Children!
What if current low interest rates and consequently high asset prices are because of both supply and demand problems? Specifically demand and supply in the market for loanable funds. To quickly define terms, supply of loanable funds is what non-economists call saving/investing. Demand of loanable funds is borrowing. The price of loanable funds is interest, and as we can see there are a variety of loanable funds markets conforming to different needs of both investors and borrowers.
The price for loanable funds in the developed western world is extraordinarily low and has been for some time. That isn’t news. What’s still perplexing is why interest rates continue to be so low. Certainly the Fed and the ECB and other central banks pursuing low interest rate policies can have something to do with it, but that only explains short-term rates. Long-term rates are abnormally low, and they have gone even lower as the Fed has raised the fed funds target rate.
Well, some very interesting research from the Fraser Institute has given some legs to another hypothesis that you may or may not have heard: demographics. If this hypothesis is accurate, it has much different long-term implications than anything the central banks are doing with interest rates.
Briefly, the idea is that young people & young businesses need more financial capital than they have or can generate, so they borrow. Old people & old businesses, excuse me “mature,” have more financial capital than they need and so lend it. In a growing economy, young outnumber old meaning there’s more demand for loanable funds than there is supply and thus interest rates are positive – and sometimes very high. Of course, within the funds market there are risk factors and so on that subdivide the market, but here we’re talking about the big single factor driving all rates down.
The demographic shift that is taking place in Canada, the U.S., western Europe, and indeed most developed countries, is what happened to Japan – birth rates are way down, and people are living way longer, giving rise to a greater proportion of old to young. In addition to many other implications, this means interest rates are way down because there are ever more lenders and ever fewer borrowers – including businesses.
By the way, these demographic forces are long-term but I believe they are currently being exacerbated by the lack of real investment from the business community in developed economies. There are a variety of reasons for this, but the effect is that all that cash on firms’ balance sheets is being used to fund stock buybacks and not real investment. The shrinkage of outstanding stock leads to less demand for loanable funds and increases downward pressure on interest rates.
Now, all that said, what are the implications for asset pricing, valuation, and investing? Glad you asked! The demographics issue has implications for growth, but that is beside the point of this post. I will return to that issue in the future. Here I want to focus on the required return (interest rate) aspect of asset prices.
When we’re thinking about expected returns on assets, like bonds or stocks, we’re thinking about two things: the risk involved, and the price of the risk. Interest rates are about the price of risk. The risk we can take as a given here. When baseline interest rates are down because of some bigger factor (demographics here) then the price of all risks gets driven down. So instead of returns of 8% on stocks in general, we’re looking at 6%. Depending on the taste of risk (or risk tolerance if you will) that may not be high enough for some people. Others may be so risk intolerant that they will take whatever the lowest risk returns happen to be, thereby actually destroying real wealth since risk-free rates are below inflation. At any rate, interest rates in all categories of risk are driven down, even assuming risk spreads don’t change.
What happens when interest rates are driven down? Asset prices rise. Coupled with a shortage of assets to invest in, we get an even bigger increase in asset prices. I don’t consider this to be a bubble at all; it’s simply a reflection of economic reality. Extending the argument, asset prices that have risen because of these factors are unlikely to crash deeply. More likely, we’ll get more of what we’ve been getting: slow growth and asset prices moving sideways.
The implications for valuation are simple: looking forward, your WACC or discount rate, whatever you’re using, is probably going to be low by historical standards. But, at the same time, your growth rate might be lower too, so cap rates (return – growth) might be similar to historical experience. I’ll think through growth rates in a future post.
The Cranky Finance Prof Spouts Off
This is a mixed bag of economics, finance, and political philosophy.
Join The Discussion
4 CommentsThoughts? Comments?
Please login or register to post a comment.
Martin Brock June 27, 2016 , 1:56 pm Vote0
The demographic transition has something (maybe a lot) to do with economic trends, and many people seem to prefer other explanations. This transition has interested me for decades (following research by Ben Wattenberg in the 80s and Philip Longman and others in the 90s and later), and I started a blog on its financial effects in 2008 but never took it very far. The payroll tax surplus was peaking then, and I argued that similar peaks were occurring in other financial balances.
But we can’t lay everything at the feet of demographics. Political factors reinforce the demographic trend. An unprecedented proportion of the population expects to retire, and they’re bidding up entitlement to rents, but they’re also seeking more political rents, not only bidding on existing rents.
According to Stockman, firms aren’t only using their current earnings to buy back shares. They’re also using future earnings, i.e. they’re selling bonds to buy back more shares than current earnings alone can buy. If some firms use their earnings this way long enough, why don’t competing firms, less encumbered by debt and reinvesting more, attract resources and customers away from them? Do barriers to market entry prevent this competition?
“Bubble” has no precise meaning in economics. Rising prices suggest rising demand relative to supply, practically by definition, so if “bubble” means anything, it can’t simply mean that prices are rising without demand exceeding supply.
Jeff Oxman June 27, 2016 , 7:57 pm Vote0
Hi Martin,
John Cochrane has also done work on demographic issues, and several others. I personally don’t think demographics would be a problem, or much of one, if (a) there wasn’t so much sand in the economic gears in western countries and (b) it was easier to get global savings moved around, so that young countries could borrow from old countries. But (b) is a no-go because most of the young countries are also significantly unfree countries, like most of Africa.
Stockman is right on the face of it – firms are borrowing to pay cash to shareholders, but the reason is because the cash is mostly not in the U.S. and it’s too costly to repatriate it. Easier to borrow $US against Euro holdings, or even dollar holdings in Europe and lock in low rates.
Certainly plenty of firms are investing in real assets. I question whether or not enough firms are.
See a previous post I did on bubbles. It actually does have a precise meaning – it’s a violation of the transversality condition 🙂
Martin Brock July 2, 2016 , 2:31 am Vote0
We discussed your definition of “bubble” when you posted the previous article, and it still seems contrary to common usage of “bubble”. If quintessential examples of “bubble”, like the price of tulip bulbs in Holland in the 17th century, don’t fit the definition, what good is the definition?
I agree that demographics is more of a problem for the reasons you suggest, but I’m not sure that moving savings around is difficult only because younger countries are less free. “Sand in the gears of older countries” seems another way of saying that older countries aren’t free enough either. Investment in the young seems a problem within the national borders of more developed countries, not only across borders.
We finance college loans in the U.S., but this “investment” itself looks like a bubble to me. We create many more holders of psychology degrees than jobs for them. We have fewer children than our parents and then compound the problem by “investing” in far to many psychology degree holders. We eat much too much of our seed corn and then plant what we don’t eat in infertile soil. Maybe lenders behave “rationally” given all of the political forces constraining their decisions, but again, if this “rationality” contradicts “bubble”, I have a problem with the definition of “bubble”.
The story about U.S. firms, always good stewards of shareholders’ money, borrowing to buy back stock only effectively to repatriate cash earned outside of the U.S. seems suspect to me. “Firms” are abstractions. Corporate officers make these decisions to benefit corporate officers, and boards approve policies driving up share prices even if the increase is only temporary. Why would these factors not bid the firms shares to unsustainable levels? They don’t personally own many shares in reality.
Right. The question is: are firms reinvesting enough to create future earnings sufficient to pay off the bonds they’re selling now, to raise the cash to buy back shares, and to pay off these bonds with enough future earnings left over to sustain the share price they raise as they buy back the shares? If the answer is “no”, they’re inflating a bubble. If we can only know the answer, or the precising timing of a deflation, in retrospect, I suppose it’s still a bubble.
Jeff Oxman July 25, 2016 , 5:23 pm Vote0
Hi Martin, I’m sorry that I didn’t see your reply until now! Let me try to respond.
With respect to defining a bubble, I don’t believe it’s a useful term from a scholarly perspective. But we’ve been over that. I also wouldn’t call the Dutch tulip mania a ‘bubble’ simply because there is no cash flow stream to be expected there, other than the selling price of the bulb. Any price not driven by some expected cash flow stream is basically a bubble, but of course it is purely speculative and subjective. It fits how people colloquially use the term bubble, but again, I think scholars and financial writers need to be more careful than the public in general.
Can you elaborate on your second paragraph? I’m not grasping your point.
Student loans are a very what? nationalized? field of business. I would say compromised, because as you say there wouldn’t be lending at such low rates if it were a defaultable loan. Not sure if that’s a bubble because bubble refers to prices not volume. I would agree that too many loans are issued to people who would not get them if it was a freer market.
On the firms: then it is an empirical question. I can’t see how to untangle the stories a priori.