Rahul Deodhar's Blog, page 28

Identifying Asset bubbles

Recently, Scott Sumner and Arnold Kling blogged about asset bubbles. Scott Sumner post is about bubble deniers and how cognitive bias affects our assessment of about predicting bubbles. Arnold Kling takes one central point out of the Sumner argument - how to define a bubble. I think he views Prof. Sumner's post narrowly but his own definition is fabulous. That got me thinking about predicting asset bubbles. Let me explain it. The underlying principle Mr. Kling uses is this:

Asset profitability = rental rate + appreciation - interest cost

The logic is, so long as the asset profitability is positive at given price, the price is justified and hence not in a bubble territory. Let me distill the equation a bit more. I am simplifying here but, rental rate represents income from asset, appreciation represents rate of price appreciation and interest cost represents cost of capital. We also need to remember that that the equation deal in expectations. So asset profitability is expected asset profitability, rental rate is expected rental rate and so on. Further, to be consistent with units, we have to use rates (first derivatives) everywhere. Thus we have,

Asset Profitability = rental rate + Rate of appreciation - weighted average cost of capital (or WACC)

Hence, the limiting condition for asset profitability is,

Rental rate + Rate of Appreciation > WACC

Mr. Kling suggests that prices are in bubble territory when

Rate of Appreciation > WACC (given Rental rate > = 0)

Interpreting the asset bubble condition

Please examine the equation for bubble condition. There is no variable called price. Is it a surprise that the equation, as distilled does not involve absolute prices  or price income ratio or other related variable at all? Well the equation leads us to very important conclusions.



First, we understand the influence of interest rate on asset bubbles. We understand why raising interest rate pricks bubbles. It increases the RHS of the bubble condition. Now raising interest rate or cost of debt by 1% will increase cost of equity by more than 1%. Thus WACC will increase in relative proportion. We must note that WACC is very difficult to determine at a macro level - for the entire market. WACC also increases when risk perception of the environment increases thus popping bubbles. That may be the reason why extraneous events that affect the risk perception for capital pops bubbles and cools asset prices.



Second, asset prices move within a spectrum. Do note the way equation is derived. It shows us how asset price rise, initiated by fundamentals, moves into bubble territory. At one end of the spectrum are assets that depreciate - like machinery. The decision to buy them depends on how much rental rate (or income from that assets) exceeds the WACC. If the rental rate covers the depreciation(1) then assets become profitable. At the other end of the spectrum are assets where Rate of Appreciation is greater than WACC. I expect price of every asset moves within such a spectrum, from the rental rate covering for WACC and depreciation on lower side to the bubble zone where rate of appreciation exceeds WACC.



Third, asset bubbles can be identified by relative prices. The equation helps us understand if the prices we pay are bubble prices or genuine prices for our point of view. We cannot determine if the market as a whole is in a bubble territory or not. To know if markets as whole are in bubble we again go back to two principles. First is the notion that it is difficult for a market participant to estimate market WACC. Second represents the ability to stack assets in order of hierarchy based on rental rate. For any given WACC we can determine relative price hierarchy and thus estimate if rate of appreciation is higher than WACC.





Note:

(1) Here we must understand the difference between financial definition of depreciation and effective depreciation that includes maintenance and upkeep costs. Firms use factory maintenance programs to reduce the effective rate of depreciation.






My book "Subverting Capitalism & Democracy" is available on Amazon 

How lower Interest Rate create Malinvestments?

Hayek argues about lose monetary policy resulting in malinvestments. But it is important to know how.In essence, there are three components to the argument.

First, interest rate represent the hurdle or minimum threshold return a business must produce. The return on capital is measure of the strength of business model and execution skill of the firm. The higher the return more capable the firm, stronger its business model, better its execution. (Note: does not indicate causality but simply co-existence).

Second, credit flows to those with history. Bankers or creditors in general, prefer to lend to large firms because of reputation, size and volume of credit that can quickly be deployed. In a low interest rate environment, bankers will prefer to loan a project of a large firm with ROCE of 5% rather than lend to 30 small firms with ROCE of 15%. This behaviour stifles the flow of credit to vibrant smaller enterprises, thus restricting new innovations. Because of this low-cost finance availability, it is possible that large corporates create unjustified barriers to entry (for example, dealer credit) to prevent new entrants. Further, it also creates anemic large projects that not only falter at the first sign of trouble, but also impose amplified collateral damage to the banking and credit system as a whole.



Based on my experience, the investment relevance - interest rate curve is a bell-shaped curve. If interest rates are too low then they result in malinvestments. If they are too high they strangle the economy. In between is a sweet spot policy makers should aim for.



Third, interest rate regime sets the benchmark for risk. Every investor, particularly those like mutual funds or pension funds, has a minimum expected return. This return is adjusted in keeping with planned expenses, payout of costs already incurred, adjustment for inflation etc. This minimum expected return is not a fancy number we expect to see, but rather a minimum threshold to ensure you cover your costs.



To hit this minimum return, investors now need to take more risks. In other words, we have modified the risk calibration. Each modification creates a portfolio churn, sometimes increasing the risk within the portfolio, sometimes reducing the risks as signaled by the interest rate regime changes. This is a form of mal-investment.



However, lower interest rates do help longer gestation vibrant projects. Infrastructure (or rather appropriate infrastructure) comes under this classification. Thus, a low interest rate environment can be used to create a longer term strategic advantage. Clearly, such process must involve stricter policy oversight and control.






My book "Subverting Capitalism & Democracy" is available on Amazon

When to support Asset Prices and at what level?

Back in 2007-09, during the peak of the crisis, world central bankers and regulators initiated strong actions to support asset prices. Some of the ideas continue to seep into the current bailout and stimulus strategy. However, to my mind, supporting asset prices is not a right strategy as it depends on the level at which supports are extended. Let us look at dynamics of asset prices to understand if their actions were warranted or not.

The asset price support strategy is in effect a response to bursting of asset bubble. There are two central considerations about supporting asset prices. First, should we support asset prices at all. Second, if we had to support, at what prices level should we support?

Why support asset prices at all?

The logic for sustaining asset price level rests on the fact that negative asset prices hurt a lot more than declining incomes. This is particularly true if the assets have claims on income (because of debt funding of assets). The collapse in claims result in cascading effects on the economy resulting in asset price deflation spiral.



For example, if a person or household earning $1000 per month with a conservative mortgage payment of $500 loses employment, then it immediately goes under prompting a loss to the bank. As the bank tries to recover its money by asset sales, the value of asset declines if many people lose their jobs and houses simultaneously. The situation is converse of a bank run. In a bank run, the liabilities of the bank get called in while assets are locked up. In this case, assets start getting marked down thus increasing the risk of liabilities being called in. Hence it renders banks undercapitalized. An undercapitalized bank freezes the entire money flow channels as it desperately tries to hold on to all the money it can.

At what prices should we support asset prices?Given that there are situations wherein asset prices may need support, the question comes at what price can support be justified? To answer this question we must understand asset prices in more detail.



Asset prices have an income equivalence. In other words, every price point of an asset corresponds to an income level of the population. For example, if a person can spend only $100 on a car, then that will form the ultimate ceiling on the cost of making a car. Similarly, if an income producing asset can produce $100 worth of income (present value discounted appropriately), then that forms the ceiling of the asset price. For houses the income of future buyer will form the ceiling price of the house. This principle is captured as affordability ratio. About 100 years of data indicate that typically the house price is 5-7 times the current annual household income of the buyer. Conversely, when we support asset prices at a certain level, we should be sure of incomes rising to near affordable limits in short span of time (no longer than 6 months). This makes sure that prices can be sustained by the buyers through their own work and contribution.



Support for asset prices, particularly housing, should come at affordable prices and not at artificially high prices created during bubble times. I would also venture that the support for asset prices should be established at a point just below the affordable price so that tax payers' (those bailing out or helping support the prices) interests are protected.






My book "Subverting Capitalism & Democracy" is available on Amazon

Income bubble or asset bubble?

What is the objective of QE2? Is it holding asset prices higher or is it pulling incomes higher? In other words, is the purpose of QE2 to create asset bubble or income bubble? In any situation, I prefer income bubble to asset bubble. I always thought it was ridiculously straight-forward. But may be the US FED and authorities do not understand it. Or may be I don't get it. So let me put the arguments out.

Rising asset prices do not give as much benefit as rising income. 

To gain advantage out of rising asset prices you need to monetize the assets. The monetization is advantageous if you replace the higher value asset with other asset. Replacing asset value with consumption is wrong. Any financial analyst worth his salt will explain that it impairs the balance sheet. Further, using asset values to create more debt is absolutely mindless. 

If asset prices have to be artificially inflated, it means there was mal-investment in the first place. If asset prices are held up, it gives the signal to the market to create more assets. This is exactly opposite of the signal we intend to give to markets.



When policy makers want to support asset prices they create a price floor. This only allows the prices to increase. They expect higher asset prices to translate into higher consumption expenditure (through wealth effects) and thereafter into higher incomes (through consumption led growth). It seems to be a round-about way of achieving growth. 

Contrast to that, working with incomes is better. 

Rising incomes create surplus disposable cash. Thus,  income creates direct support for asset prices. Let me highlight the support is direct. Now, working with income relates more to working on unemployment (or ensuring full employment) than issuing income diktats. Keynes understood this mechanism and hence advocated full employment. Full employment is able to efficiently translate income growth towards best skills. 

Thus, the objective of bailout or economic revival policy should be full employment and not a certain level of asset prices.




My book "Subverting Capitalism & Democracy" is available on Amazon

Behaviour of Indian Equity Markets

In the recent time Indian equity market are showing four distinct behaviour clusters. These zones are independent in the sense that their behavior does not seem to correlate with news or other stimuli. If that were the case, it would not be worth commenting on. However, this behaviour  is important to note this as it affects the trading strategy.

The trading happens in four peculiar disjoint zones. 

First zone represents the newly started pre-market operations. The price movements in this segment are very difficult to predict and the pre-market prices do not reflect in any way the likely direction markets may take post open. I avoid using the prices set in this phase totally.

The second zone represents the market open to about mid-day wherein European markets open. However, the timing match with European markets is not exact. The second zone lasts till about 1.30 -2 pm India time. 

Post this till close at 2.30 -3 pm represents the third zone. The performance in this zone is drastically different from performance in the second zone. Note, it is not necessarily opposite, just different. The markets may expand on second zone performance or simply reverse it.

The final zone is the last 30mins to 1 hour of trade. This zone appears occasionally. But can make or break your day trades.

QE2 polarizing Haves and Have-nots

The policy of supporting asset prices at artificially high levels through easy money policy is popularly referred to as QE2. This policy is widening the difference between Haves and Have-nots. 

Preventing new net Asset ownershipAsset Price support helps those who owns assets, while denying those who do not own assets an opportunity to ever own any asset. If you own some asset, you can convert it into others. If you do it skillfully by selling your asset at its peak price and buying other assets at their lowest prices, then you get richer. In other words, we are all asset managers.

What happens if we do not own any asset to start with? Well, earlier, your hard work, your labour value was an asset. But today that won't get you far. You need to start with an asset if you want to get close to median income. And that is where credits or loans come in. At a very basic level, you can get a students loan and improve your labour value and convert it into a labour category that markets value. This is the central utility of credit to our economy.

The Income-asset price connectionUsually asset price - income cycle works other way around. Higher median incomes drive asset prices up. The converse is not always true. In other words, higher asset prices need not drive median incomes. Note the use of word "median"income.



Here it is important to explain that at a gross level the asset price-income cycle is reversible. It means if we use total national income and asset prices across all assets in our cycle then we get a reversible cycle.



However, the moment we consider median incomes the reversibility breaks down. With each iteration, the income of the rich increases while those of the poor reduces. The median income reduces as we push through with these cycle.



Ben Bernanke is operating at a gross level but real economy will recover only when median incomes start stabilizing. Thus the Fed's policies of QE-X won't achieve anything unless Fed starts looking at median income levels. I hope they get it sooner than later.






My book "Subverting Capitalism & Democracy" is available on Amazon

Higher Food Prices and Poverty

Dani Rodrik asks if higher food prices mean higher poverty or does it mean higher income for the poor. He points to several articles and essays on this topic (refer notes below).





The issue is complicated. Just as we have expense basket we also have income basket. Agriculture appears in income basket of low-income HH. An increase in food prices, at least those forming part of income basket, should ideally help these low-income HH. However, the reality is different for most countries.



Often, most of price rise is effected at middleman levels (know for sure about India). The reason is typically inadequate market infrastructure for farm goods. Thus in countries where agri-product markets are well evolved, higher food prices tend to seep to the low income HH whereas in other areas they don't. (Some logical assumptions included).



Further, if a certain section of the low-income population is suffering drastically because of food price increases then it is difficult to justify the increase. Urban poor almost always suffer because of any food price increase. However, if urban poor can return to rural areas then it is possible to tweak their income basket to their advantage. This obviously depends on how volatile the price rise is.



The point is, whether the net impact of increasing food prices is beneficial depends on various factors. First, it depends on the profile of income basket and how much of income basket is increasing. Second, it also depends on how effective are agri product markets. Thirdly, it also depends on polarization of income baskets within lower income class.

Notes:



Dani Rodrick 2007 post - Food prices and poverty

Dani Rodrick 2008 post - Food prices and poverty confusion or obfuscation

Johan F.M. Swinnen - The right price of food

Maggie McMillan - Does OECD support for agriculture increase poverty in developing countries?

World Bank Implications of higher global food prices for poverty in low-income countries

World Bank Distributional effects of WTO agricultural reforms in rich and poor countries



My book "Subverting Capitalism & Democracy" is available on Amazon

The idea of taxes

Scott Sumer discusses taxes TheMoneyIllusion » Income: A meaningless, misleading, and pernicious concept. There have been responses by Bob Murphy, Richard Thaler and others all linked in his recent post titled Comment on Murphy and Thaler. I wish to draw attention to a more fundamental issues.

Firstly, we set the tax rates and plan expenditures accordingly. Why can't we do the reverse? I know the wording may not be clear so let me explain to the best of my abilities. Government sets tax rates, looks at collections, plans expenditure that (hopefully) results in more income and hence more taxes. This is a loop of sorts. However, I think we should go the reverse way, every year we should look at important, unavoidable, expenses and then deduce the tax rates from those. In the first case we tend to expand or contract government consumption (for the lack of better word - expenditure may not be appropriate) to fit the tax collections. In the second case we adjust the tax rates to fit with expenditure. It may lead to other issues related with fiscal deficits, productivity and development focus, and others. We will deal with them in a later post.



Second, taxes are less about being complicated right and more about being fair and easy. We have yet to discover a best first principles solution to tax calculation. Any mechanism we use ends up with unfair outcomes for certain portion of population. But if we stick to being fair, people should not have reason to complain. So I agree with you when you say that consumption is a better alternative.



Finally, taxes should not create distortions. Taxes are not means to guide the population and this, as such, should be considered as encroachment on civil liberties. Government has not business nudging people to have more babies, get more insurance, consume more, or invest in tax-havens etc. Alas, I am in a minority on this issue.




My book "Subverting Capitalism & Democracy" is available on Amazon

A logic against QE

Now that extra $600 billion is available to play, world markets are enjoying the party. However, there is a strong logic that suggests QE won't work without other changes. Here is my attempt to explain it:

Let us take a simplistic equation [1],Personal Income = Expenditure = Price * Volume

In this equation, Volume represents volume of various goods we buy. Volume of goods consumed represents our quality of life. Simply put, if we are able to buy 2 computers every year, then our quality of life is better than if we can afford just one. So volume going up is a good thing in general. 

Price represents price of each of those goods. If price goes up and volume remains same or increases, then the price increase is acceptable. However, if price goes up and volume goes down, we have a problem. In economic theory, both phenomenon are defined as inflation. But effect of one is acceptable while other reduces the quality of our lives. We end up with inflation when there is too much money in the system and too few goods.

Now let us come to income. Income for the next year feeds on changes in price and volume in previous year. This is called feedback loop. So in general, if prices or volumes or both rise then incomes will follow.



However, within this generalization we have some specific differences. If volumes rise the chances that employment will increase is higher. If only prices rise and volumes don't (i.e. there is still extra inventory or idle capacity at current employment level) then employment does not rise. To take it a step further, if prices rise (because costs are higher) and volumes fall (as in bad kind of inflation) then employment may actually reduce. 

In current scenario, the income feedback loop is broken and we are pumping money by trillions. Unless we fix the income feedback loop, we are going to have inflation of bad kind. There is a tremendous risk to standard of living. It is surprising that politicians of the world do not understand this simple logic. I am beginning to smell malicious intent here. The only other alternative is incredulous stupidity.



Note:

[1]: I have made many assumption, including no savings or debt. This is to simplify the logic.

Paul Krugman's latest post on Why Inflation targets need to be high wonkish works on similar logic but assumes sufficiently high inflation will fix income loop.

My book "Subverting Capitalism & Democracy" is available on Amazon

Why Koreans still work at 75?

Tyler cowen links to an interesting post about age and employment across countries. The article suggests we rethink the early retirement norm. Here are my comments:

First, retirement should be a personal choice depending on factors such as health, financial comfort etc. It was nudged into a norm through the use of social security. Instead of the lump sum social security, we must rethink the size, frequency and conditionality of social security payouts. We may, for example, decide on step -wise increasing payouts starting at age 55. We may, as another idea, keep the size of payout restricted for those in employment, within the principles of fairness and social justice.

Second, even if we accept the principle behind retirement, the exact age itself must change. The retirement age is a leftover from a effort dominated era. In those times, productivity waned with strength and thus older you got less productive you were. But no longer. We are now a predominantly knowledge economy. And knowledge productivity increases with age. (It also vanishes with new knowledge.)

Third, in the short term, whether adding the retirees to working population helps or not depends on skill profiles. If skill profiles of older workers is different from younger workers then entrepreneurs may devise methods to deploy these skills to economic gain. However, if these skills are similar to those of younger population then demand supply equations will come into play and overall effect will either be lower wages or unemployment. 

Fourth, in the long term, younger workers will get re-skilled (hopefully fairly quickly) and create a skill difference that will help the economy.

Fifth, whatever new form social security takes, it cannot undermine the promises made earlier. Government or any party must be held accountable to the promises they make. The lives of individuals are based on these promises. Had the government not promised social security, people may have saved for themselves instead of spending everything.

In sum, the idea behind social security is laudable. The implementation leaves a lot of scope for improvement.