Upside Down CAPM: Part 9 - The mystery of long term returns

Timothy Taylor has a post up about long term returns.

There is this:

In real terms, the "safe" rate doesn't look all that safe.

Indeed, if you look at the "risky" assets like housing and corporate stock, but focus on moving averages over any given ten-year period rather than annual returns, the returns on the "risky" assets actually look rather stable.

May I suggest the upside down CAPM model?  "Risky" assets earn a relatively stable *expected* return, which is whipsawed by real shocks to cash flows.  Over longer time frames, the shocks tend to wash out, and the expected return approximates the realized return.  (Mainly here I'm talking about equities.) "Riskless" assets have an expected return that is more volatile, and reflects a discount from the stable expected return on at-risk capital, which shifts with sentiment and on-the-ground reality.  They have more stable short term cash flows, but long term returns that can fluctuate.

There is basically a risk arbitrage between volatile cash flows and the expected return on stable cash flows.

He discusses the r>g issue.  Upside down CAPM says that (at-risk) r is relatively stable.  When g is higher, then r and g tend to converge, and risk-free r rises with g and converges with at-risk r.  If we're worried about r>g, upside down CAPM says to increase g.  Mostly, that can be achieved with something like NGDP level targeting that minimizes nominal income volatility, reducing the discount that must be taken to avoid it.  I predict that under NGDP level targeting, debt levels would decline, real long term interest rates would rise, and average income growth would rise.

Upside Down CAPM: Part 8 - Deficit Spending isn't stimulative or inflationary

Modern Monetary Theory (MMT) - not to be confused with market monetarism (MM) - has been a popular topic lately.  I have some thoughts on the matter, which I will lay out here.  I ask for generosity from the reader, and for corrections in the comments if I declare something here that is demonstrably wrong.  I don't have a deep understanding of MMT, and this isn't meant to be a critique of it, but the main issues that seem to form the core of MMT thought are related to some ideas that have been floating around in my head that probably aren't good for much more than embarrassing me, but I want to air them out.

As I have mentioned in some previous "Upside Down CAPM" posts, I think it is best to think of safe debt as a service provided from the borrower to the lender.  The service of delayed consumption - low risk saving.  This is the primary motivation for the aggregate use of debt in developed economies.

Considering this, I think it is best to think of public debt as a service the federal government is particularly capable of providing.  Since it can provide the safest form of deferred consumption, it gets to "sell" it at the highest price (bonds with the lowest yields).  This is wholly separate from the question of budgets and spending.  So, it is best to think of government deficits as two separate acts.  First, the act of taxing and spending.  Second, a debt transaction.

So, in this framework, all spending is funded by taxes.  Whether it is stimulative, inflationary, etc., stems from the spending itself, funded through taxes.  When that happens, capital (in both real and nominal terms) is transferred from private to public hands, affecting aggregate decisions about investment, spending, etc.

Now, if the government decides to engage in deficit financing, there is a second act.  This is purely nominal.  When it sells Treasuries, it simply creates offsetting accounts - an asset account in the private domain and a liability account in the public domain.  The creation of these accounts is purely nominal.  No real capital shifts as a result of this accounting.

In the aggregate, this is no different than imposing a tax.  Within the private sector, it is a decision to delay the distribution of that tax.  But, in the aggregate, the real capital was removed from the private sector when the spending was triggered.  If the government taxes a different individual in the future to pay back the bondholder or just defaults on the bond, the first order effect is the same.  The accounts are simply erased, and just as when the Treasury bond was issued, there is no aggregate effect on the use of real capital.

Ricardian equivalence is usually referenced here as a source of stimulus or lack thereof.  The idea is that the creation of those accounts affects the private sector's notion of its own wealth.  If it fully internalizes the cost of future taxes, then the issuance of the bonds isn't stimulative.  If it doesn't, then the bonds are stimulative, because they trigger new spending from this perceived wealth.

But, I think Ricardian equivalence is not particularly relevant.  The private sector, in the aggregate, can't spend those Treasuries.  It might be able to use them as collateral for private borrowing, which then can stimulate spending.  But, then the spending is coming from the growth of the money supply, which is under the control of the central bank.  The central bank will be managing its own targets regardless of deficit management, so any inflationary or stimulative effects from that will be offset in the natural course of monetary policy management.  Whether any spending is facilitated by the existence of treasury bonds, other assets, or simply growth in base money, is not particularly important to the question of whether public spending or borrowing is either stimulative or inflationary.

There is the issue of foreign savers.  In that case, the distinction is that they are outside the domestic tax base, so the consequences of future taxation are more complicated than simply a redistribution within a stable aggregate.  In that case, the first order effect of a default would benefit the domestic balance sheet.  But, still, it seems to me that the margin on which the effect of the debt rests is whether the interest rate is lower than the domestic income growth rate, so that the eventual tax will be paid with fewer dollars, relative to national production.

As long as long term income growth is higher than the rate of interest paid on the bonds, this process is beneficial because of the public ability to profit by selling deferred consumption.  The benefit doesn't come from the deficit itself, but from the government's ability to provide this service better than the next best provider.

In terms of thinking of public spending on the margin, that spending is useful or not useful, regardless of whether it is funded by taxes or bonds.  Practically speaking, some public spending might provide a very high return, and much public spending doesn't provide a return at all.  That's not the point of some spending.  Most of the growth in income isn't the result of public spending at all.  The ability of the government to gain from providing the service of deferred consumption is unrelated to the benefits or lack thereof of public spending.  And, even the ability of this service to lower deadweight loss by shifting taxes to wealthier future taxpayers is only partially related to the spending it funds.  The income growth that reduces that deadweight loss can come from effective public spending.  It could also come from regulatory decisions that aren't related to spending, or it could come from private sector innovations that have little to do with public spending.  If an unknown Mongolian tinkerer invents a perpetual motion machine next year, the entire globe will eventually become much richer as a result, and we will have benefitted for having facilitated deferred consumption purely because of the positive shock created by the Mongolian tinkerer.

The upshot of this is that deficit spending should have little to do with cyclical considerations, except to the extent that an economy with either cyclical fluctuations or secular malaise will be correlated with a high demand for safe assets.  But, it is much better for everyone if there is more demand for making risky investments, in which case, it would be more likely that income growth would be high and Treasury rates would be high, and the budget deficit would naturally be falling because of rising incomes, as it was in the late 1990s.

Whether it is a Keynesian or an MMT framework, the idea that funding spending with bonds versus taxes can be stimulative or inflationary seems questionable to me.  And, the idea that spending, in general, is stimulative or inflationary seems questionable.  The devil is in the details.  Spending should be done because that specific spending is useful, regardless of cyclical matters, and cyclical stimulus should come from monetary policy.  It is probably useful for some developed nations like the US to maintain a significant amount of public debt, but not as a cyclical governor, rather as a public service to risk-averse savers.  But, at the same time, fiscal policy should aim to reduce the risk-aversion that leads to the demand for that service.

Certainly, if something like this is beneficial, it should be done during economic downturns, but there is no reason this should be treated as a cyclical governor.  There is no reason to leave these hundred dollar bills on the floor during economic expansions.  It is just a double-entry accounting entry.  It isn't expansionary in and of itself except to the extent that it lowers deadweight loss, and that is something we should always aim for.  So, hypothetically, the proper level of public debt is the level that maximizes the value of this service, which has mostly to do with the ability to pay the interest from future income.  This is little different than the process a private firm would use to arrive at a target capital base, where generally the level of debt is the level that markets will fund without creating default risk that increases the credit spread that the firm faces.  Obviously, the failure of a nation is much more significant than the failure of a firm, so the limit should be set where default risk is highly unlikely.  Yet, that might be a relatively high level.

Housing: Part 339 - Self-Imposed Stagnation

Here is a graph comparing long term real GDP growth per capita and per worker.  Also, I show the 10 year trailing average annual real total return on the S&P500.

Real GDP per capita had been rising by about 2% for many years.  Real GDP per worker generally rises at about the same rate, but in the 1970s, it dipped down to less than 1%.  This is because the baby boomers were entering the workforce, so the labor force was increasing faster than population was, and we weren't getting as much productivity growth per worker as we had previously.  Some of this might just be a product of worker composition and young workers being less productive.  But, I think this shows why the 70s were a decade of economic insecurity even though it doesn't necessarily show up in real GDP growth or even real GDP growth per capita.

One plausible reason that equity risk premiums have been high recently and real bond yields low is that an aging population means that there are many households in the saving phase of their lives.  But, that doesn't explain the 1970s when real bond yields were also low.  In the 1970s, there was a surge of young adults.

Notice in this graph that total returns in equities seems to track pretty well with GDP growth per worker.  Since investor expectations can't be measured it has become widely accepted that even long term stock market movements are the product of fickle sentiment and that stock market returns are more volatile than changing economic growth rates because of that fickle sentiment.  Relationships like this suggest that sentiment isn't as fickle as it has been claimed to be.

There also seems to be a widely held belief that the US stock market is overvalued because of loose monetary policy.  To the extent that that sentiment affects public policy, and I think clearly it has, it is probably one reason why real growth has been so slow.  I'd like to stake out the principle that in order to propose the goal that the central bank should aim to lower real returns for existing shareholders, your model of how the world works should be at a level of confidence that is practically certain in a way that few economic models have ever been.

In my Upside Down CAPM model of thinking about capital markets, expected real total returns are fairly stable, at about 7% annually.  This is a combination of expected growth and current income.  When growth expectations decline, savers become risk averse.  So, two things happen to equity returns.  First, the equity risk premium (the difference between Treasury yields and equity returns) widens because safe-seeking investors are willing to accept lower returns while total expected returns on at-risk capital like equity remains relatively level.  Second, the growth portion of expected returns declines, which means that the income portion increases.

Recently and in the 70s and 80s, payout rates were high (dividends + buybacks) and in the 90s they were lower.  Generally, payouts are referred to as a bottom up phenomenon, as if firms can't find good investments, so they send the cash back to investors.  I think this is more appropriately viewed as a product of low growth, so that there may be some correlation between high payouts and low growth, but that it is more directly a product of low growth because equity investors require more cash flow in their total returns to make up for the lack of capital gains growth they expect.

The changes in real returns over time are related to the changes in GDP per worker, due to both the real shock of lower productivity and lower expectations that will naturally come along with that.  Those past equity investors, on the margin, expected returns of around 7% plus inflation, and where their realized returns differed from that, it was due to changing profits and changing expectations from those unforeseen changes in real production.

This is all a long-winded way of getting to the point I want to make, which is about the current decline in growth.  Here is a similar graph, but here I am comparing GDP growth per worker and per capita to the percentage of GDP going to residential investment, because that is the main reason for the recent decline.


Before the financial crisis, there was little relationship between Residential investment and GDP growth.  Some of the short-term growth in the 2000s before the crisis might have been related to it.  But, as I tend to point out, that was at least as much a product of building in the 1990s being below long term norms than it was a product of excessive building in the 2000s.  The low ten year moving average in 1999 was unprecedented in post-WW II data.  The high ten year average in 2007 was not.  So, maybe a lot of the rise in per capita GDP growth from just under 2% to somewhat above 2% was from homebuilding.  But it was homebuilding production that was reasonable and sustainable.

But, what I want to talk about is the post-crisis decline.  That decline can clearly largely be attributed to collapsing residential homebuilding.  GDP growth per capita declined from about 2% to about 1%, and residential investment declined by 2% of GDP.

I like Arnold Kling's conception of patterns of sustainable specialization and trade.  It is better to think of an economy as a coordination problem with frictions rather than as a set of accounting identities.  And, I think it would be uncontroversial in any audience to suggest that this is a large part of what happened after the crisis.  There were millions of construction affiliated workers after the crisis that faced frictions in finding work in a different sector.  Possibly, the recent uptick in per-worker GDP growth, the recent low levels of unemployment, and anecdotal claims that construction workers are hard to come by, are signs that those adjustments have finally been made.

My disagreement with the consensus on this is that none of that had to happen.  For the past decade, those workers should have been engaged in building homes, and GDP growth per capita should have been 2% instead of 1%.  Not only would that have meant that none of those painful adjustments needed to happen.  But, it also would have meant that we would have about $2 trillion worth of housing providing the service of shelter for American households.  And, the result would have been that American households would be shoveling a few hundred billion dollars less each year of unearned rental income to real estate owners.  (Of course, this is complicated by the fact that many of those real estate owners are homeowners, who can only capture that "income" by staying in a home that has inflated rental value, but a suppressed market price, so they can't actually realize the gains from their economic rents except by living in a home that has rental value higher than it should have to begin with.  But, this is getting too far down the rabbit hole.)

But, here we are, a decade later, and maybe most of those former construction workers have either moved to other sectors or just dropped permanently out of the labor force.  So, then, what do we do about the housing shortage?

Well, I have written some about the inequities in the way we have contracted the housing market, and I expect to write some more.  But, really, in the end, there is nothing unsustainable about this context.  We could have achieved similar ends by raising property taxes, or any number of things.  All consumption has some foundation of technological, tax, and regulatory factors that has an effect on supply and demand.  Just because our current context seems inequitable to me, that doesn't mean it can't exist as it is.  Non-owners will consume less housing, owners will consume more, and real estate investors will earn higher returns than I think they would in my preferred regime.  But, it's a sustainable regime.

So, the "economy" doesn't need housing to recover.  It could be that we now are at a new pattern of sustainable specialization and trade, and the new pattern just includes less consumption of shelter by the have-nots.  The workers that have been on the sidelines for a decade instead of building homes have slowly found other productive things to do.  So, fixing the housing shortage is more about equity than it is about growth.  It is possible that we have finally entered a new phase of growth, that ten years from now, GDP per worker will have risen by 20% and equity investors will have earned 12% annually plus inflation, that working class families will be moving to Sacramento by the thousands so that young entrepreneurs can rent their old studio apartments in San Francisco for $7,000 a month, and that marginal workers will still be paying $1,000 rent to live in homes in Cleveland that they could buy for $60,000 because we have decided as a public policy objective that it is too dangerous for them to have a mortgage.

Every line in those graphs could move back toward the top while the residential investment line stays at the bottom.  We would just live in an economy where some households don't consume housing like we did in the past, and real estate capital earns slightly higher returns.

PS: Since equities aren't as tied to domestic production as they used to be, it could be that the rate of real total return on equities will be less volatile going forward as a function of changing domestic productivity.  So, it could be that equity returns for the S&P 500 over the past ten years are higher than they would have been 40 years ago, given the same slow rate of GDP growth per worker, and that it won't rise as high as it used to with rising US productivity.

Upside Down CAPM: Part 7 - Debt is Ownership

I was reading this piece on debt jubilee (HT: JW) and it occurred to me that this is an issue that gains clarity from the Upside Down CAPM idea. (In short, capital is inherently at risk.  It has a natural long term real rate of return of about 7%, which is basically the return on equity ownership.  Fixed income is a trade between capital owners in which the lenders are the true consumers.  They want to transform risky capital into riskless deferred consumption.  They pay a premium <earning less than 7%> in order to avoid risk.)

I have written skeptically about jubilee before.  The idea is popular because the first order effect is forgiveness of debts.  It is imagined to be a transfer from the powerful to the powerless.  But, that just isn't a very useful way to think of debts, in the aggregate.  We tend to think of debts through the prism of consumer debt, but consumer debt is more of a transactional device.  Most household debt is mortgage debt, which is a clear case of Upside Down CAPM.  The ownership of the house is split between an equity holder who takes responsibility for upkeep and maintenance and takes on the risks of market volatility, and the debt holder who exchanges those risks for a fixed return.  The only reason mortgage financing works is that home equity is, itself, very nearly a fixed income type of ownership, in which most of the return comes from rental value.  (That is one of the core problems with Closed Access housing supply.  It makes home equity less like fixed income and causes a breakdown that makes housing financing less functional.)

Thinking about jubilee from an Upside Down CAPM perspective helps to clarify this.  Modern economies have already incorporated jubilee financing deep into our economic systems.  Capital markets are already dominated by a financial security that automatically forgives the debtor all of their principal when they are unable to pay it.  That security is called shareholder equity.

Sometimes, borrowers (for lack of a better word) opt out of jubilee by selling fixed income securities instead of equity.

Incidentally, I wonder how much overlap there would be on a Venn diagram of people who think debt jubilee would be a great idea and people who think limited liability corporations have been a good idea.

The problem comes from contexts where selling equity is difficult or impossible.  The problem with selling equity as an individual is that this is essentially indentured servitude.  Where that can be managed safely (see, currently, Lambda School, which seems to be a great example of this) it can work, but it is difficult.  So, where jubilee is discussed today, it typically has a focus on things like student debt.

But, student debt is an anomaly.  It probably shouldn't exist in the way that it does, and it only does because it is subsidized by Federal guarantees.  Debt is a service provided by the borrower to the lender - providing risk free deferred consumption.  Students aren't remotely in a position to provide that service.  So, the government steps in to provide that service in their name.  But, since policymakers have not come to terms with the incoherency of this program, the program has been designed to leave many indebted former students in dire straits with unpayable debts that they should never have been in a position to take on.

I hope that developments like Lambda School can help lead us to a new financial technology that better matches funding with students, and creates an equity-like funding mechanism (a jubilee-eligible mechanism, as it were) for school funding.  That probably means being more honest about the demand for education, and the difference between the development of marketable human capital, which is a powerful source of economic equity and betterment, and education that is less vocational and is better viewed as consumption than investment.

Yield Curve Update

I have written previously about the yield curve.  It appears to me that as interest rates get lower, there is an option value embedded in long term rates because of the zero lower bound.  That means that it is harder for the curve to invert at lower rates.

I suspect this comes from my "Upside down CAPM" way of thinking.  There is a relatively stable expected return on at-risk assets like corporate equity, and fixed income is a way to trade off some of those expected returns in exchange for cash flow certainty.  So, a real 10 year yield of 1% is really a payment of about 6% subtracted from the expected real yield on corporate equities of 7%.  Low real rates are a sign of risk aversion.  They are not stimulative.  It seems that others view them as stimulative.  They are wrong.  And, this gives them a false signal about the yield curve.  It makes it look like an inverted yield curve is less dangerous at lower interest rates, because the low rates are seen as stimulative.  But, an inverted curve at low rates is actually more dangerous, not less dangerous.

Here is a graph of the yield curve slope, my adjusted slope, and forward changes in the unemployment rate.

We have been treading right along the edge of "adjusted" inversion since 2016.  It seems to me that at this point in the recovery, the long term interest rate is a simple and important signal.  If the Fed can keep the yield curve spread between 0% and 1% (or, if my claim that an adjustment is necessary is accurate, then the spread now should be between about 0.75% and 1.75%), then that seems like a great first step in thinking about monetary policy through an interest rate lens.

My main concern is that if my adjustment is accurate, a positive yield curve of 0.5% or so is actually equivalent to an inversion, and even people on the lookout for an inversion won't notice it until it is too late.  The expected December rate hike puts us into inversion territory, in that case.  I have been early to this worry, and was surprised by rising long term interest rates, so you may want to take this with a grain of salt.  But, it seems like something worth watching.  If the unadjusted yield curve inverts, it seems unlikely that the Fed will accommodate nearly quickly or strongly enough.

Upside Down CAPM: Part 6 - Leverage before a crisis

I recently saw these graphs, from the IMF:



Source

Here is text from their Global Financial Stability Report (Chapter 2),  "The prolonged period of loose financial conditions in recent years has raised concerns that financial intermediaries and investors in search of yield may have extended too much credit to risky borrowers, potentially jeopardizing financial stability down the road. These concerns are related to recent evidence for selected countries that periods of low interest rates and easy financial conditions may lead to a decline in lending standards and increased risk taking."

It seems to me that there is a strong and common presumption that complacency or risk-taking lead to borrowing, and that this presumption really does all the work here.



Source

In the text above, there are several red flags.  Has there been a prolonged period of loose financial conditions?  I don't think so.  There is that phrase, "in search of yield".  People who want yield buy equity.  High yield bonds may be somewhat like equity on the gradient from low yield/low risk securities to high yield/high risk securities.  This horrible phrase is central to my "Upside Down CAPM" framework.  Low yields for fixed income securities aren't a signal of risk-taking, and investors complacent about risk wouldn't push yields down, even in high yield bonds.  If expected returns for equities are around 7% plus inflation, then investors funding bonds that pay 5%, nominally, aren't searching for yield or risk, because there is a better source for both of those things in equity markets.

I'm not sure we can even conclude how attitudes about risk might influence the relative level of high yield corporate debt.  And, household debt, which is mostly associated with mortgages, should grow inversely with risk-taking, as it would signal a bias toward real estate with stable cash flows over corporate investments with highly cyclical cash flows.  It seems plausible that the relative amount of risky debt securities could either rise or fall with attitudes about risk.

This seems like a simple counterfactual to consider.  What if the level of risky debt outstanding wasn't positively correlated with systemically dangerous attitudes about risk.  What would these charts look like?  Wouldn't they look just like this?  When a contraction hit, wouldn't we see disequilibrium in the market for high risk debt and a surge in low yield safe securities?  And, then, as cash flows stabilized and markets healed, wouldn't we see markets for riskier securities recovering?  In other words, the drop in risky lending and the initial recovery reflect the market dislocations that come from uncertain and volatile cash flows, not from attitudes about risk.  This is movement into and out of dislocation, not a shift in a steady equilibrium.

So, the top graph is a spurious correlation.  Of course risky debt outstanding is highest right before economic contractions.  There is no reasonable counterfactual where this wouldn't be the case.  And, the second graph shows that (in the years before a financial crisis), risky debt levels first rise as markets re-attain normalcy, and then the level of risky loans actually levels out in the years before the crisis.

There are any number of models that could explain this pattern.  The conclusion comes from the presumptions, not the evidence.

This is where turning the model upside down seems useful.  In the IMF report, low yields are associated with easy financial conditions.  I think this leads to confusion.  Low yields are associated with demand for certainty in cash flows.  I realize it takes some hubris to stand up against an entire body of research, so that having this discussion is sort of unwise of me.  I'd love to see evidence that there is more to it than this.  But, from where I stand, it looks like low interest rates are a sign of difficult financial conditions, and that fact is so counterintuitive that we have just gone barreling along with economic models that are backwards.

Part of the problem is the unfortunate habit of equating low long term interest rates with loose monetary policy.  Using the financial sector as a measure for financial conditions might, itself, be part of the problem.  When the financial sector increases in size, this is generally treated as risk-seeking behavior.  But, the financial sector is generally in the business of being an intermediary for fixed income securities.  Investors didn't need the financial sector to invest in Pets.com.

Note, that Pets.com wasn't put out of business through bankruptcy, because the ownership was completely in the form of equity.  They simply liquidated and paid any remaining cash to the shareholders.  Notice that the collapse of the internet bubble is not associated with a financial crisis.  That is because there was little debt involved.  The IMF has it correct in this regard.  But the reason it wasn't associated with debt and the reason it didn't lead to a financial crisis is because it was associated with risk-taking!  And risk-takers had equity positions.

So, this is where the standard models go off the rails, because that error flips the story on its head, and it leads the IMF and most other observers to a position where they see signs of risk-aversion and their solutions are to limit lending and cut back on monetary expansion.  Then, the collapse in cash flows that ensues gets blamed on risk takers.  The correlations between debt - even high yield debt - and subsequent financial crises are correct.  The interpretations are suspect.  What leads to a crisis is when a large portion of the set of savers demands certain cash flows and then subsequent cash flows become so volatile that those demands are not met.

Zero is also part of the problem.  Zero looms large in the way we construct these models, and it shouldn't.  Take zero out of the equation.  Now, think of an economy where savers can expect yields of minus 2%.  Or, let's take that to an extreme.  Savers can expect yields of minus 50%.  These economies exist.  Would you associate these economies with "easy financial conditions"?

Upside Down CAPM: Part 5 - Returns on real estate investments

To review: upside down CAPM is the idea that CAPM models should start at the expected rate of return on diversified at-risk capital and the rate of return on risk free savings is the at-risk rate of return minus the premium savers pay for the service of protecting savings for deferred consumption.  Changes in actual returns for at-risk capital come from cyclical changes in profit and from changes in expected long term real returns, but expected real returns at any point in time tend to remain fairly stable at 7-8%.  Fluctuations in real risk free returns come from shifts in the premium savers are willing to pay to avoid risk with deferred consumption.  The equity risk premium doesn't come from changes in expected at-risk returns. It comes mostly from changes in the premium for safety that determines the risk free rate.

This model has led me to realize that I have probably been approaching real estate markets with some misplaced hubris.

Mortgage rates generally follow risk free rates with a small spread, so that mortgages basically fall in the category of low risk saving - deferred consumption.  To the extent that we can measure returns on home equity systematically, real rates of return seem to generally follow risk free rates. Owned home equity is also basically a low risk fixed income security.

But, that doesn't seem to be the case on institutionally owned real estate.  Equity REITs seem to have a fairly stable cap rate and dividend rate.  I had chalked this up to an undeveloped marketplace, where there aren't aggregate market measures that change everyday like in bond markets.  So it seemed like this asset class was like a fixed income asset class, but with a real yield that didn't fluctuate as much.  That didn't seem rational.

However, thinking with an Upside down CAPM framework, having a more stable expected rate of return is a characteristic of equity.  There isn't a mystery here. Institutionally owned real estate is basically a low-beta equity, and it has a low and stable expected rate of return, just as we would expect low beta equity to have.  Its risk comes from cyclical and long term shifts in real returns.

Keep in mind that I am talking about the entire market, so that cap rates are similar to expected returns on all equities, conceptually.  For developers, expected returns on individual projects, or even on all new projects at a given time, may fluctuate more, just as the market for IPOs or private equity seems more volatile and cyclical than the equity market as a whole.

The reason it is more equity-like than owned real estate is because it comes with management costs and vacancies.  This makes net margins lower and more cyclical than owner-occupied real estate.

So owner occupied real estate acts more like low risk fixed income, and the level of debt on a property is mostly related to the owner's need for capital.  Young owners tend to be more leveraged and older owners are less leveraged. Investor owned real estate is like low beta equity and the use of credit is more a product of the market and the property. To the extent that a property can offer the service of safe savings because of relatively certain cash flows, equity holders can optimize profit by using credit as a source of capital.  In fact, market forces will cause profit to be bid down to the point where real estate equity holders have to use credit to achieve a market rate of return.  This is similar to the utilities sector.

This would mean that real long term interest rates would moderate real estate activity between owned and rented properties.  When interest rates are low, at the margin some households would be induced to ownership. There are several ways to think about this. Low real rates reflect demand for low risk savings and deferred consumption. Owner equity serves this function in a way that investor owned equity doesn't. Another way to think about it is to think in terms of cap rates. Cap rates on investor owned properties, being more equity-like, remain stable.  But "cap rates" on owner occupied properties fluctuate with long term real interest rates, so as rates decline, owner-occupied property is worth more than investor-owned property.

It happens that homeownership rates (controlling for age demographics) were high in the late 70s and the 2000s.  In the 70s, inflation (and nominal rates) was high, so rising ownership was explained as an inflation hedge.  In the 2000s, inflation (and nominal rates) was low, so rising ownership was explained as a result of cheap and easy credit.  (Most of the rise in homeownership happened in the late 90s when rates weren't particularly low, so that's not a great explanation.)

Low long term real rates can explain why price/rent ratios were high at both times, but I haven't felt that comfortable explaining why that would lead to higher ownership rates.  Maybe this relationship between owned and rented properties, and the difference between equity and low risk savings, could be part of the explanation for why ownership rates rise when long term real interest rates decline.  (This isn't the case today because housing markets are dominated by credit repression which keeps millions of households out of the market.)

This framework also suggests that multi-unit building should have been much stronger in the 1990s when long term real interest rates were relatively high.  The bias toward equity exposure at the time should have translated to a bias for investor owned real estate.  Maybe some of the increase in homeownership rates in the 1990s was already coming from limits on multi-unit developments in the Closed Access markets, which was blocking this natural shift to rented property when real interest rates were high.

This is all still speculative.  Please provide conceptual or factual criticisms in the comments.

Upside Down CAPM, Part 4: National Debt

The basic premise of the Upside Down CAPM (comment if you have a better name for the concept) is that there is a pretty stable expected real rate of return on at-risk assets.  This is about 7%-8%.  The problem with at-risk investments isn't that the expected rate of return changes much over time.  It's that realized returns over short time frames are highly volatile.  (This is why NGDP level targeting would be so beneficial.  Those short term fluctuations are waste.)

My hypothesis is that the waste isn't expressed much in the rate of return on at-risk assets.  Held over long periods of time, real returns are somewhat stable.  There are some persistent real shocks that change long term returns, so long term returns aren't completely stable, but variance on total returns to equities starts high and then declines regularly as the holding period increases.

Any asset manager knows this, and so savers with longer holding periods are more likely to hold equity positions.

In the context of the Upside Down CAPM, my point is simply that the basket of total assets, accounting for some maintenance reinvestment, is basically a perpetuity.  Diversified equities, the proxy for that basket of assets, are a perpetuity.  This long-term stability and mean reversion means that expected returns of equities tends to remain around 7%-8%, and long-term investments reflect this long-term stability.  The sharp changes in valuation are mostly due to short term shocks, real and nominal, and the fickle nature of the valuation of a perpetuity with minor shifts in cash flow and long term growth expectations.  The portion of ownership we call debt is simply a subset of this basket where some capital, seeking shorter durations and more cash flow certainty, pays a fee for that certainty.

So, right now, highly rated corporate bonds pay a little less than 4%, or about 2% in real terms.  The Upside Down CAPM approach says the proper way to think about this is that some subset of the capital base is paying a 5% annual fee in order to receive 2% annually rather than receiving 7% annually with short term fluctuations.  Debt supply is mostly a transaction where savers are paying a convenience fee for keeping their capital safe for future consumption.  It just happens that in developed economies, the base return on capital - 7%-8% real - is high enough that the fee paid for certainty still leaves a residual return that is greater than zero....most of the time.  As we have seen recently, this doesn't have to be true.  Zero is not particularly important, especially in real terms.

Equity holders currently expect about 9% returns (roughly 2% inflationary capital gains + 2% dividends + 3% buybacks + 2% real growth).  The 7% + inflation figure is pretty stable.  There are some small shifts between growth expectations and capital payouts over time.  So, for instance, in the late 1990s, growth expectations were high.  Since the real return of 7-8% doesn't change much, that mostly meant that dividends and buybacks were lower, and PE ratios were higher.  Since those growth expectations are negatively correlated with risk aversion, the fee lenders required for capital protection at the time was very low - maybe 2%, so that bonds paid close to 5% real returns after the discount.

If we think of national public debt through this framework, I think this argues for (1) less concern about the level of debt outstanding and (2) a higher standard of returns on public investments.  As a first conceptual step, I don't think there is much difference between funding public spending with taxation or borrowing.  Either way, $x in capital is removed from the private stock of capital.  If spending is funded with borrowing, that is just a separate transaction where the government is providing the service of capital protection.  So, deficit spending is really a combination of two transactions.  First, taxation and spending.  Then, a transaction where the government accepts cash and promises to protect it, with some interest, and pay it back in the future.

Thinking of public debt in this way, I think the typical understanding of deficit financed spending being stimulative is overstated.  The spending part of the transaction is the same either way.  If there is anything stimulative about the deficit financing, it is just that the government has a competitive advantage in providing capital protection services.  Comparing treasury yields to investment grade corporate bonds, this amounts to a little more than 0.5% on average.  The reason deficit spending is useful in a contraction is if that spread rises, then that is an indication that the public service of providing capital protection is especially valuable.

So, it is stimulative.  But, only to the extent that it provides this service.  It is better to think of this stimulus in terms of the spread between AAA-rated private securities and treasuries than to think of it in terms of the government borrowing cheaply to inject spending into the economy.  There is no injection of capital here.  It is just a transfer between a saver and a lender.  And, if spreads are relatively low, then it is a service that can nearly as easily be provided in the private sector.  For a few months in late 2008 and early 2009, that spread was more than 3%.  The spread could have been brought down by more accommodative monetary policy that would stabilize nominal activity.  Eventually it did.  But, lacking that, massive public debt expansion was valuable then, including actions like guaranteeing GSE MBSs to reduce spreads.

As long as public debt levels are low enough that they don't induce a credit spread, then the public benefits from having the government provide this service.  Debt outstanding is just a measure of the extent to which there is demand for that service and the government is meeting it with a supply of capital protection.

But, this argues for a high required return for public investments.  In private markets, at-risk investments are expected to return 7%-8%.  The spread between private bonds and public bonds is only about 0.5%.  So, public spending has a small advantage over private spending because of the government's ability to provide this service.  But, in order for public spending to be more valuable than private spending, it still needs to return something like 6.5%-7.5% or more to justify taking that capital out of private markets, even with the public advantage in providing capital preservation services.

This also means that high real interest rates are probably not something that we need to fear in the context of the national budget.  High real long term interest rates will only happen if risk appetites and growth expectations rise.  As in the late 1990s, this would be associated with rising growth, innovative investments, and rising federal revenues.  In the late 1990s, the relative weights of these factors was so favorable, that federal officials feared a shortage of treasury securities might develop among institutions that utilize them.

Housing: Part 286 - Upside Down CAPM and the Housing Bubble

One of the over-riding themes and lessons about the housing bubble was the realization that we weren't as wealthy as we thought we were.  That we drove up the prices of American assets with debt and then took out more debt using that inflated collateral in a doomed attempt to live beyond our means.

I have discovered that all of that was wrong.  The truth is really more the opposite of that.  We have hung a weight around our collective economic neck, consisting of restricted ownership that requires transfer payments to the politically protected owners.  Home prices during the bubble were a reflection of the value of their restricted ownership.  Debt was a product of attempts to buy those restricted assets.  And debt-fueled consumption was mainly consumption smoothing by the owners of those assets, who could liquidate their real estate by sale or through credit, to consume today from their future claims on ownership.

An idea central to the conventional story is the idea that debt and leverage can be used to increase the total market value of asset classes, and thus creates a sort of false growth.

Part of the foundation of the Upside Down CAPM idea I have been developing is that this is largely false.  It comes from thinking of borrowing from the perspective of a consumer.  But, thinking in terms of a national balance sheet, it is more accurate to think of the nation's assets as the anchor - the left side of the national balance sheet.  The right side of the balance sheet shows us how ownership is divided - between creditors and equity owners.  It is more accurate to think of rising debt generally as a shift in ownership between equity and creditors, with a stable amount of assets.  Debt levels are a pretty slow moving animal, and I like to point out that the frothy markets of the late 1990s happened through rising equity values and rising growth expectations.  Interest rates at the time were high because there was a bias then for equity ownership to have a claim on that growth.  Creditors weren't bidding down interest rates in an effort to avoid risk.  They wanted risk.  And savers looking for risk want to be equity holders, not creditors.

So, how does this hold up if we look at the housing bubble?

This first graph is a graph that has been an emblem of the American spending problem.  Debt keeps rising relative to incomes.  This is unsustainable, it would seem.  Households were dealing with stagnant incomes and they were borrowing in order to keep afloat.

The first problem with that story is that the borrowing was heaviest among the households with the highest incomes.  They represent the vast majority of borrowing and they also represented most of the new borrowing during the bubble, in absolute dollars.

The conventional thinking about this shifts upon this evidence to say that, well, the debt was used to bid up housing in a frenzied bubble, so while the evidence that the bubble was built on lending to households with low incomes may not hold up, the use of debt to push up home prices still sits at the middle of the story.

Of course, I have written, ad nauseam, about how the debt was mostly funding access to Closed Access labor markets, and that rising rents explain rising prices better than credit.  But, what about those crazy high debt levels?  How can I explain that away?  Households taking on new debt amounting to half a year's income, over the course of a single decade?

But, that graph shouldn't bother us because of what's on it.  That graph should bother us because of what's not on it.  We should view the economy as a complete balance sheet, where debt is just one form of ownership.  This is a partial picture.*  Debt is the least important part of the balance sheet.

In this next graph, debt is the yellow line.  In thinking about household net worth, I want to walk through these items one step at a time.  All measures are as a percentage of disposable personal income.

Step 1: Blue Line
Step one is the value of all financial assets.  This is stocks and bonds, etc.  Not housing.  This is the value of capital held by households, except for housing.

Step 2: Red Line
In Step two, we subtract debt from the total value of financial assets.  This is how we should think about household balance sheets.  The blue line is the total (non-housing) balance sheet and the ownership is divided between debt and "equity".  (Some of the "equity" may be in the form of fixed income securities, but here, those are assets on the left side of the balance sheet.  In terms of the household's balance sheet, those are part of the household's net worth, similar to a corporations equity, or market capitalization.)

Step 3: Black Line
Most household debt is used to buy real estate.  In step 3 we add the value of real estate to the total.  If we assume for the sake of simplicity that all household debt is secured by real property (most is), then we can roughly think of the distance between the blue line and the black line as the value of household equity in their real estate.  The distance between the blue line and the red line is the value of real estate funded by debt.

Since debt has already been subtracted from the total, the black line represents American households' total net worth.**

I apologize that I have made this a bit more complicated than it needs to be.  It would make more sense to add up the real estate and financial assets and then subtract the debt from that.  You would still end up at the black line as a measure of household net worth.  But, gross household asset ownership would be at a line higher than the black line, representing the total amount of assets, before accounting for debt.  I have done this because I want to make a point.

Let's look at 2005 with the full perspective of American household balance sheets.  The credit bubble story says that we were borrowing from foreigners in a housing bubble, where that borrowing was propping up the value of that real estate.  If an American household borrowed from foreign savers to bid up the housing stock, then that would leave the blue line where it was, it would lower the red line, and it would raise the black line.

So, let's not give American households any credit for the value of those homes.  Take a look at 2005 to 2007.  In terms of gross financial assets, without housing, American households were in a better financial position than at any time in recent history - roughly on par with the peak of the internet bubble.

You might respond that this is an average and that there is gross inequality.  But, remember, the borrowers were households with high incomes.

You might respond that the stock market was still in a bubble, but PE ratios were under 20x and declining.  Bond rates were at cycle highs (so that valuations were low).

Now, subtract all that debt that Americans used to buy those homes.  The red line.  Even after subtracting debt worth 130% of disposable income, American balance sheets were as healthy as any time in modern history, except for a brief time during the internet bubble.

And, I have been arguing that the CDO boom at the end of the housing bubble was actually the beginning of the bust - part of the shift out of home equity because sentiment was already changing - even though American balance sheets were in great shape.  Notice that household net worth (the black line) was level from late 2005 to late 2007.  But, outside of housing (the blue and red lines), household balance sheets were still growing strongly.  Again, give Americans no credit for their real estate, but saddle them with the mortgage debt.  Even after that, from late 2005 to late 2007, when housing starts were collapsing and the Fed hiked the target rate to 5.25%, American balance sheets were expanding - even relative to incomes.

This is especially the time when American households were supposedly loading up on debt to live beyond their means, and now that home values had stopped rising, the end was supposedly inevitably near.  If we think about the equity and mortgage components of real estate, then, during this time, the distance between the red line and black line shrunk.  In other words, total real estate value was shrinking as a portion of household incomes.  And the equity portion was shrinking while the debt portion was rising.

Household balance sheets were healthy, but they had lost faith in housing markets, and they were disinvesting in home equity.  They still had plenty of net assets, and those net assets, seeking safety that no longer seemed available in home equity, they funded things like MBSs and then CDOs.  If, on net, that activity was the result of a global savings glut, then non-real estate net worth would have been declining.  But, on net, American net worth was rising.

When we only looked at the debt component, we missed all of this.  Part of that debt component is due to the Closed Access problem, that some urban real estate contains a capitalized claim on future political exclusion.  But, when we only focus on the level of debt over time, we miss the broader important factor.  Who borrows?  Rich people borrow. (See chart above.)

The reason debt has increased is because American balance sheets are healthy.  The reason there was a frenzy for AAA securities in 2006 and 2007 was because Americans were wealthier than they had ever been and they were scared about the housing market.  The most expensive housing markets, by far, were markets that we now know, with a decade's hindsight, were not destined for a bust.  Prices in the most expensive cities have performed as well as anywhere.  Yet, even in 2004 and 2005, homeowners were selling out of those markets and moving to other cities in large numbers - disinvesting in equity.

Were households borrowing out of home equity in order to consume?  Many surely were.  To the extent that they were, household net worth would have declined.

Today, American net worth as a percentage of disposable income is well into record levels by all of these measures.



* Oddly this selectivity is...selective.  For some reason, when talking about capital's claim on national income, economists seem to always use corporate profits - ignoring the part of corporate operating profits claimed by creditors.  When talking about household balance sheets, economists seem to only look at debt and ignore equity.  In both cases, the partial view is not very useful.

** There are also a small amount of non-financial assets amounting to about a quarter or a half of disposable income over time, so total net worth is slightly higher, but I have left that out for simplicity here.

Upside-down CAPM, Part 3: Capital Growth

There are problems with the way we talk about capital and leverage.  Frequently, leverage is discussed as if it is a way to multiply the amount of capital we have in some unsustainable way.  During the housing bubble, it is homeowners taking out equity LOCs or investment banks using high levels of leverage in their business models when they were underwriting MBSs and CDOs.  But, leverage doesn't really do that.  Maybe we talk that way because we are thinking in terms of a household taking out consumer debt, or a small business owner getting a loan to make a capital investment, so that for the protagonist in the story, there is some sense of magnifying their economic ownership and risk.  Or, maybe, we are thinking of how banks can make loans, which are re-deposited in the system, seemingly creating capital out of mid-air.

But, none of those things actually increases the real stock of capital.  None of it makes a building appear or stocks a store's shelves.  To do that, capital must bid on the same stock of real inputs that existed before those loans were made.

We might think of the stock of capital something like this:

For this exercise, let's think of public debt simply as deferred taxation.  It might fund some public capital that provides public benefits, but it doesn't have to, and its value is just a claim on future taxes in either case.  So, I am not going to address public debt here.

Private capital might be broadly divided into four categories: Two debt categories that generally have nominally fixed claims and income streams, and two equity categories that generally have nominally flexible claims and income streams based on constantly changing residual income streams to the full basket of income-producing assets.

There is a consumption vs. saving decision that is important on the margin.  But, over time, the growth to the capital base largely comes from growing equity, not new saving.  (I saw a great graph on this recently that I have lost track of.  Please post in the comments if you know what I'm talking about.)  Now, here is where there is a bit of magic.  Let's say Amazon makes some transformative consumer electronics announcement tomorrow, netting $5 billion in new market capitalization.  This means that equity value grew by $5 billion above any investments that Amazon will make in new tangible assets.  I contend that this is an increase in the real capital base, even though it is intangible value.  Amazon might reinvest cash, borrow, or issue stock in order to make that investment, and those activities will affect the stock of capital in the way we normally think about it.  Yet, those are all just reinvestments and shifts in ownership claims.  One could say that the only real increase in the capital stock from that initiative is the new intangible equity value it created.

And that value comes from the real intangible value that Amazon's organizational capital creates.  In the aggregate, this is the primary source of capital growth, and the funding comes from future broad growth in incomes.  Over the long term, the division between capital income and labor income is quite stable.  This means that the added value to business equity that comes from future profits is a reflection of broad-based future economic growth.  In that sort of time-travel hocus pocus that modern capital markets create, the capital base largely grows from its own future intangible value.  The investment Amazon makes has to outbid some other potential use.  It is the intangible increase in value that grows the base of measured capital.

Debt has little to do with this growth.  Changing levels of debt are generally simply changes in the ownership of those future intangibles, between residual owners (equity) and owners with nominal claims and income streams that are fixed in some way (debt).  So, when economic progress happens, some of that accrues to equity.  When equity increases, that actually means that the total capital base increases.  But, when debt increases, that is simply a balance sheet decision by the firm.  The total level of capital remains the same, but the proportions by which it is divided up change.

This is the opposite of how capital seems to be generally understood.

Real estate is no different.  Changing mortgage debt levels are simply a reflection of shifting ownership between equity and debt.  Changing equity levels actually change the total level of capital.  But, the source of value in housing capital is a little tricky.  Business equity value comes from growing future real production.  But, the rent we pay for shelter appears to track pretty closely with about 19% of total personal consumption expenditures, regardless of how much real capital we invest in real estate.  In other words, demand for housing is overwhelmingly mediated by the income effect.  Future income levels are largely a product of investments outside of housing.

If we look at past consumption of housing, there was a great housing boom after World War II, where both real and nominal expenditures on housing grew.  The capital base was growing, part of that was through deferred consumption creating new real housing stock.  When housing expenditures reached about 18% of PCE, that leveled out, and both real and nominal spending on housing remained flat for 20 or 30 years.

By the 1990s, though, we had entered the age of Closed Access, and so, while nominal spending on housing remained level, the real housing stock declined.  This is the period of time where households segregate into metropolitan areas by income.  High income frequently means high rents in a Closed Access city and low income means moving to other cities.  Nominal spending on housing remains level, but Closed Access households are spending a portion of those high incomes on a stagnant housing stock.  Their real housing expenditures (size, commute, amenities) continue to grow at a slower pace than their real incomes.

We can see the shadow of this in the measure of operating surplus to housing.  This is the net income to all homeowners (equity and debt investors, for both owned and rented units) after expenses and depreciation.  Even though nominal spending on housing has been level for 40 years, income to real estate owners has captured an increasing portion of that spending.  That is because Closed Access real estate owners capture income from political exclusion instead of from building new and better units.  Notice that net operating surplus to real estate owners was starting to decline during the big, bad housing bubble.  That's no accident.  The housing bubble was largely the acceleration of the great American housing segregation event, where builders were investing in new real housing stock and households were moving out of the Closed Access cities to other cities where their rent actually paid for shelter instead of transfers to politically protected owners.

During the boom, real estate equity grew substantially - the real stock of capital grew.  But, unlike what happens when business equity grows, this wasn't because future real incomes were growing.  This was a combination of three factors.  First, finally, after decades, new housing stock was being built at a rate that maintained real housing expenditures as a proportion of real incomes.  (That maintained the size of the housing portion of the capital stock.)  This meant that the nation's interior had to build enough homes for its own population and for the Closed Access housing refugees.  Second, low real long term interest rates caused home values to rise.  (I see this mainly as a shift in proportions, similar to the shift we might see if creditors take a larger portion of the balance sheet.  Real estate equity and mortgages grew, but at the expense of business equity, in a complex mix of investment and valuation shifts.)  Third, the capitalization of future rents into Closed Access home prices increased the capital base.  (This did increase the capital base as a portion of domestic income.  But, whereas business equity grows because future incomes will grow, in this case, real estate equity - and debt - grew because they were claiming a larger portion of domestic incomes, which we see in the upward trend in housing operating surplus.)

Because of the way we tend to think about capital, consensus descriptions of the housing bubble get this all wrong.  The conclusion we came to about the bubble was that banks were creating capital by increasing the level of mortgage debt outstanding, and households were using that newly created capital to consume.  This is wrong because lending doesn't create capital, it can only reallocate it between classes of owners.  What was actually happening was that real estate owners were capitalizing their future, bloated rental claims.  The rising levels of housing equity and mortgages outstanding weren't creating capital, and on net they weren't funding unsustainable consumption.  Early in the boom, real estate owners were mostly tapping debt markets to use their capitalized rents to consume.  Non-owners and foreigners provided that capital by shifting it from other capital or by curtailing consumption.  (Foreigners were doing it by maintaining a trade surplus with us.)  But, those netted out.  For every owner shifting consumption to the present, there was another household who was consuming less.  There had to be, in the global sense.  So, real estate owners held politically exclusive assets, this raised future rental income in selected cities, which raised home prices, which raised the value of home equity, and eventually some of that equity was shifted to debt ownership because we don't have a developed system for liquidating home equity to other equity holders.  Partial liquidation of real estate holdings is typically done in debt markets.

The net effect of these shifts was a drag on long term real income expectations, which is why the marginal effect was to keep real long term interest rates low rather than high.

As the boom aged, more owners were tapping those capitalized rents by selling out and moving or renting.  During the later period, there was a transfer of homes from old owners to new owners (either new buyers or investors.)  By then, total value of real estate had peaked, so that the increase of capital in mortgages clearly wasn't increasing the capital base.  There was a large transfer of ownership from housing equity to housing debt.  Much of that transfer was from previous homeowners, tactically reinvesting away from home equity, which had ceased to be considered a safe asset class, and in that search for safety, moving down the array of asset classes, mortgage debt seemed a reasonable resting place, even if that decision was filtered through financial intermediaries rather than being a direct decision of the savers themselves.  For the households taking out that debt, there was nothing stimulative about it.  The debt was simply funding the transfer of their wages to the previous real estate owners.  Those mortgages were a reflection of the reduction in real wages created by Closed Access, manifest through higher rent expenses.

PS. The show Shark Tank is a good example of how this capital creation happens.  Someone with a good idea and little else walks onto the set.  They have very little capital.  They connect with a "Shark" that has the means to capitalize that good idea, and now, suddenly, they have hundreds of thousands of dollars in capital.  If execution of the plan goes well, they will soon have millions of dollars in capital.  That capital appeared as if out of thin air, but it really was created out of the execution of the plan that creates future consumer surplus from their good idea.  That's why it's hard to think about the offers and valuations that are given in a simple mathematical framework, because even if the presenters give up a lot of equity based on their existing business, the payoff really comes from the creation of capital, not from divvying up existing capital.  In that context, one of the "Sharks" may offer a deal that has a debt component, but their shift from an equity stake to a debt stake has little or nothing to do with the capital that will be created from their partnership.  It is just a reallocation between equity or debt forms of ownership.

PPS. These models, along with my narrower viewpoints regarding the housing market and the financial crisis specifically, lend themselves to a coherent and unique asset management process, both strategically and tactically.  I have been gauging interest in that sort of thing among some readers.  If you know of someone or if you have clients that would also be interested in a fund run on these principles, please contact me via the e-mail address in the right margin.

PPPS. So I have this conceptual framework, and I can use to it tell a story about capital.  But, I haven't debunked the other story, have I?  What if everyone else thinks mortgage lending did cause home prices to rise, increase the base of capital, make everyone feel richer, and lead to overconsumption?  Why should you care if I came up with a story?  In the end, this is all rooted in the empirical evidence I have found regarding the financial crisis and the housing bubble.  And, the core empirical evidence that confirms the conceptual model here is the realization that rents explain everything.  The empirical presumptions underlying the other story are wrong.  Not only does my conceptual framework make sense, but it rose out of the array of empirical evidence that I discovered which contradicted the presumptions of the other framework.

Upside-down CAPM, Part 2: The magical elasticity of investment demand

I previously have discussed my skepticism about the idea that monetary policy works by inducing leveraged investment with low interest rates.  I just don't see evidence for it.

But, I don't really even quite get it, theoretically.  The idea is that the Fed lowers interest rates to well below their market rate, and this induces households and firms to borrow.  There are countless examples, which I won't bother to link to here, of either laypeople or financial professionals referring to phantom activities such as firms propping up share values by borrowing cash on the cheap and buying back shares.  There are certainly firms that borrow.  And there are firms that return capital through buy backs.  Sometimes there are firms that do both!  Thus, as with the idea that loose money or loose credit is responsible for high asset prices, this is an idea that will never die for those who are disposed to believing it.  Hey, maybe they are even right about it.  Surely, getting rid of money and credit will solve these supposed problems.  Who could deny it?

It seems to me that there are two basic camps, here.  Austrian business cycle proponents, who attribute the misallocated borrowing to Fed signals, and Minsky-type proponents who attribute the misallocated borrowing to complacency as economic expansions progress.  Some version of this idea seems to be an important part of Fed policy decisions, given comments made by FOMC members on occasion, though I'm not sure if it is the Minsky idea or the Austrian idea that dominates.

In either case, it seems the proscription is the same - nominal stability (which is managed by the Fed) leads to over-leverage, which must eventually lead to a sharp contraction when it becomes clear that loose money or nominal stability can't endure forever and the economy contracts, triggering a debt-spiral.  Thus, the contractionary policy is demanded now, before the over-borrowing becomes larger, so that the contraction will be more muted.  Please correct me in the comments if you feel that I have misrepresented either school of thought.

But, these bubble theories have a wildly uneven sense of elasticity.  Here is a graph of the one year change in Fed assets (before 2008, Fed assets were almost all funded by currency in circulation), and total borrowing in the US.  I have graphed them both as a percentage of GDP in order to maintain scale over time.

Source

It is true, if we look at the graph, that borrowing sometimes rises during periods of declining and cyclically low rates.  It is also true that levels of borrowing were rising during the high inflation 1970s and 1980s, which I touched on in the previous post on this series.

But, if I understand these business cycle theories correctly, the Fed lowers interest rates by purchasing bonds with cash.  The reason this lowers interest rates is because the market for the securities is not very liquid, so that the extra demand represented by the Fed moves the price.  So, the Fed buys bonds worth around 0.3% to 0.4% of GDP each year, and this changes short term interest rates.  (This is pre-QE.)  It may be hard to see, but on the graph, this is the blue line near the x-axis.

So, the idea is that over a period of months or years, the Fed pushes interest rates down by buying bonds totaling less than half a percentage point of GDP.  Now, one could argue that this bond buying uses new cash, which adds more boost than, say, new bank lending.  But, that is a monetarist argument.  That is not an argument from interest rates.  That is an argument from quantity of cash.  It seems perfectly reasonable to me that injecting cash into the economy will boost nominal values, in the long run, proportionately, and some combination of immediate liquidity and expectations of future liquidity will create short term inflation pressures, too.

I should note that there are many complexities here, and even the effect of the quantity of money is hard to pin down.  There isn't much of a systematic relationship between the rate of new bond buying by the Fed and either NGDP growth or inflation.  Lower market rates increase demand for money, which is disinflationary but a lower target rate is inflationary.  So, the monetarist story is difficult to quantify, too.

But, the interest rate approach has a widely referenced mechanism - lower interest rates lead to borrowing.  So, the strange thing, to me, is that 0.3% of GDP worth of lending by the Fed can apparently move interest rates around by several percentage points, and hold them in place for years.  Yet, when the borrowing that this change in interest rates triggers amounts to 5% to 15% of GDP, all that extra borrowing has no effect on interest rates.  That is some magic elasticity.

The same question remains if the cause of new borrowing is low credit spreads.  If complacency causes spreads to tighten, why doesn't the new borrowing push rates back up?

In fact, the new borrowing does push rates back up.  This is where the Upside-down CAPM fits in.  When equity risk premiums are low, credit spreads tend to also be low, and real interest rates tend to be high, as they were in the late 1960s and late 1990s, at the end of long periods of stability.

This seems to be the motivation behind concerns about NGDP targeting, that nominal stability will cause complacency and that low credit spreads will lead to massive over-borrowing which will get out of hand.  This idea relies on interest rates that are insensitive to investment demand.  The idea is that if investors feel confident that stable NGDP growth will keep equity values from collapsing, for instance, they will invest on margin, borrowing at 4% to invest at 7%-10%.

It's true.  If you could do that, it would be tempting.  Too tempting.  So tempting it would be inevitable.  It would also be inevitable, then, that nobody would be lending money at 4%!  But, if you're working with some whacky model that imagines that cyclical surges of investment keep happening without any consequence to interest rates, this may not seem obvious.  In fact, I think one of the many benefits of NGDP targeting would be that fixed income yields would be high, which is exactly what the global economy could use right now.

Can anyone direct me to readings that address this elasticity question?  How can the Fed buying a few T-bills lower interest rates persistently, but when this triggers hundreds of billions of dollars in new borrowing, that doesn't move interest rates back up?  This seems like such a basic question, I am afraid that I am simply exposing some ignorance.  Enlighten me, readers!

Upside-down CAPM, Part 1: Why interest rates are a poor indicator of monetary policy

I have previously written about an Upside-down CAPM, meaning real total returns on corporate assets are generally quite stable (with some noise) at around 7%.  Those returns are divided between equity and debt owners.  Total real returns of the total stock market can be considered the sum of the long term real risk free rate (estimated by long term TIPS bonds) and the equity risk premium (ERP).  Total real returns of an individual firm are shared between its equity holders (with expected returns equal to some multiple of ERP, depending on the firm's "Beta", or sensitivity to market volatility) and its creditors (with yields equal to risk-free returns plus a credit spread).

Thinking about market returns in this way helps to see how thinking about monetary policy in terms of interest rate targets is not helpful.  Thinking about monetary policy through interest rates seems to lead to the idea that low rates induce leveraged investing, and that this is how monetary policy affects spending and economic growth.  But, interest rates don't systematically affect corporate leverage, at least in terms of inducing speculative cyclical investments.

Source

Here, the red lines are the Fed Funds rate and the 10 year treasury yield.  Generally, when the Fed Funds rate is well below the 10 year yield, this is when monetary policy is generally viewed as being loose or accommodative.  The dark blue line is nonfinancial corporate leverage as a proportion of enterprise value (debt + equity), based on historic cost.  The light blue line is leverage based on the market value of equity, instead of historic cost.

We can see that most of the cyclical shift in leverage is based on collapsing equity values during a contraction, which then recover.  Based on book value, there is usually little cyclical shift.  And, leverage has been declining as interest rates have fallen, both in real and nominal terms, for several decades.  And, when the Fed Funds Rate is low relative to the 10 year yield, there is no noticeable shift in leverage.

The Modigliani-Miller thesis says that debt financing is advantageous for firms because profits are taxed at the firm level, but interest expense is not.  I don't see any reason to doubt that this is true, to an extent.  The counterintuitive result of this is that higher interest rates provide a tax advantage, so that higher rates actually could lead to higher leverage.  In fact, if the total required returns on equities are stable (which I assert that they are), which means that a 1% increase in the risk free long term interest rate will generally be matched by a 1% decrease in ERP, then declining interest rates should lead to declining leverage and declining firm share value!

Note, the Modigliani-Miller effect is nominal, not real, so that it would be related to high leverage in the 1970s and 1980s because of the high inflation rate.  Mostly, this seems to flow through lower equity values, because high inflation increases the de facto tax rate on firm profits.

Interest rate induced cyclical corporate leverage simply isn't a thing.  For as much bandwidth gets used up talking about it, you'd think there would be something there.  There isn't.

This makes sense, if we view markets through the upside-down CAPM model.  First, firms don't borrow based on the overnight rate.  In fact, the iShares Core U.S. Aggregate Bond ETF (AGG) currently has an average effective maturity of nearly 8 years.  This is a mixture of various forms of debt, but the point is that long term yields really are a more important factor in aggregate borrowing costs than short term yields.  And, certainly, a firm will try to match the duration of its borrowing with the duration of its investments, to a certain extent.

Total operating profits to firms don't change because of changing interest rates.  Changing interest rates change how operating profits are shared between equity holders and creditors.  Real interest rates mostly reflect a discount taken by creditors compared to the return claimed by equity holders, because creditors avoid cash flow and market price volatility.

The idea that interest rates would effect corporate leverage is especially suspect when we think about the standard way in which any CFO would manage a firm's balance sheet.  Firms don't leverage up specifically based on each individual project.  They don't say, "Oh, we can now borrow at 3% and here is a project that has come across my desk that returns 5%, so let's borrow cash to make this project happen."  Firms generally use the weighted average cost of capital ("WACC") and they compare the full range of projects to that WACC.  The leverage that the firm targets will be based on a number of preliminary factors of risk and its effect on credit spreads.  In most cases, WACC is largely a product of the returns to equity.  If a firm with any substantial amount of risk was leveraged enough for the cost of debt to be dominant, they would have a high credit spread, which would overwhelm any effects of lower risk free interest rates.

The riskiest firms and the firms with the most pro-cyclical risk tend to be the firms with the highest credit spreads.  They tend to be more equity financed, so that in those cases WACC will especially be immune to changing short term interest rates.  It will mostly be a function of the cost of issuing equity.  In that case, the cost of capital will be related to short term interest rates, but contrary to how people seem to normally think about it.  Let's say you have a highly cyclically risky firm, with a Beta of 2 - twice as volatile as an average firm.  Then, if investors are feeling safe, ERP might be 3% while real long term rates are 4%.  So, the risky firm has a real cost of equity that is 10% (4% + 3% x 2).  But, if investors are risk averse or afraid of cyclical volatility, ERP is 5% while real long term rates are 2%.  And the risky firm's cost of equity would be 12% (2% + 5% x 2).  Risk aversion increases the cost of capital.  The Fed moving around overnight borrowing markets just isn't going to do much to change those long term borrowing costs.  But, if cash it injects into the economy improves NGDP growth expectations, then ERP will decline, long term real interest rates will rise, and WACC for cyclically sensitive firms will decline.

In fact, if we think about it this way, to the extent that monetary policy affects the cost of capital, it would happen mostly as a result of NGDP growth expectations.  NGDP growth expectations would increase expected corporate profits, increasing share prices, decreasing WACC.  But, this would happen through equity-financed investment, not debt.  And, in fact, that is what we see in the graph above.  During recoveries, market-based leverage declines because the value of equity rises.

We can imagine this in an extreme example where a firm in distress has financial leverage above their optimal target.  If equity becomes so cheap that the firm's enterprise value is dominated by its debt, then WACC would be determined mostly by the firm's interest rates.  In those cases, the firm will be credit constrained, and marginal investments will be limited to generated cash.  So, in that case, lower interest rates will be unlikely to generate leveraged investments, but accommodative monetary policy might lead to a stronger economic recovery in general, which would boost revenues and profits, and for a firm like that, those improvements could lead to a sharp recovery in equity value.  Enough equity recovery might eventually allow them to draw on credit markets again.  But, the recovery plays out in the value of the equity.

Loose monetary policy is frequently blamed for leading to a build up of risky borrowing.  But, cyclically accommodative monetary policy actually leads to systemic stability as equity financing grows.  If monetary policy is loose in a secular sense - over the entire business cycle - so that it does lead to increased inflation, like in the 1970s, then leverage tends to rise because the de facto rate of tax on corporate earnings is higher, and interest expenses bloated by inflation serve to defer taxes.  So, we might say that loose monetary policy does lead to destabilizing leverage, but this happens through high interest rates, not low interest rates.