Is the “Equity Risk Premium” Elevated Right Now? No.

• The Original Meaning of the ERP
• Yield is Not Return
• The Wrong Way to Use the ERP
• Using the ERP in a Semi-Legitimate Way (Charts)
• The Problem with Our Semi-Legitimate ERP Analysis
• The Use of ERP in Predicting Memetic Behaviors

If you’ve watched Hedge Fund Manager David Tepper cheerlead the market on CNBC, or if you’ve read the work of analyst Ed Yardeni, or if you pay attention to stock market discussions on Twitter or in the larger blogosphere, then you’ve probably heard appeals to the “equity risk premium” as evidence that US stocks are attractively priced right now.  The thought process goes something like this:

“The yield on the ten year treasury bond is around 2%.  The trailing P/E ratio on the S&P 500 is around 16, which implies an earnings yield of around 6%.  The difference, the equity risk premium, is around 4%, much higher than the historical average of around 1%.  Therefore, U.S. stocks are cheap, and should be bought.”

In the previous post, we explained why this way of thinking is flawed.  It makes the mistake of assuming that two asset classes on the investment menu, stocks and bonds, cannot both be cheap (offer high future returns), or both be expensive (offer low future returns), at the same time.  This assumption simply isn’t true.  There is no reason why it should be true, and the historical data confirms that it’s not true.

It turns out that the strategy suggested by this way of thinking, which tells investors to overweight stocks until the difference between earnings yields and bond yields approach the 1% average, cannot even be coherently implemented.  As I will illustrate later, to implement it, investors would have to willingly accept a subpar return relative to bonds, when the very purpose of the strategy is to generate a higher return than bonds, in compensation for the higher risk.

Ultimately, there are two ways to think about the “equity risk premium.”  We’re going to look at each way.  The first way, embodied in the quote and chart above, is just plain wrong.  But the second way actually has some validity to it.  When we employ it, we find, coincidentally, that stocks are actually fairly valued relative to bonds right now, and may even be a tad overvalued.

The Original Meaning of the ERP 

Bullish investors that appeal to the “equity risk premium” (ERP) typically use the term to refer to the difference between the earnings yield of the stock market and the yield on bonds.  But this is not what the term, as used by academics, was originally meant to refer to.  It was meant to refer to the difference in return between stocks and bonds.  

The idea that there could be a persistently large difference between the returns of different asset classes was a puzzle originally studied in the context of the efficient market hypothesis (EMH).  If the EMH is true, then we should expect investors to behave in a way that collapses large differences in excess return.  Investors should preferentially buy high-return asset classes, and preferentially sell low-return asset classes, until the returns are equal.

Over long periods of history, however, stocks have averaged a return that is meaningfully higher than bonds–around 4%.  The term “equity risk premium” was used to refer to this delta.  Students of the EMH explain its existence by appealing to risk.  Stocks exhibit greater risk than bonds–that is, greater disperson in return over a given time frame, with wider tails.  We know that investors are generally risk-averse.  Unlike pure gamblers, they view bidirectional risk as a bad thing, rather than a good thing.  Therefore, to invest in stocks rather than lower-risk alternatives, they demand compensation in the form of higher returns.  They price the stock market in ways that cause it to achieve such returns.

Yield is Not Return

In the quote and chart shown earlier, the concept of return in the historical understanding of ERP is being conflated with yield.  Thus, the ERP becomes the difference between the earnings yield of stocks and the yield on bonds.  This difference in yield is claimed to be mean-reverting, leading to ridiculous conclusions about where US indices “should” be trading at in the present ultra-low interest-rate environment.

When held to maturity, the return on a bond is just its yield.  If you a buy a freshly minted 2% 10 yr treasury bond today, and hold it for 10 years, you will receive coupon payments of 2% each year, followed by full repayment of  your principal, for an annual return of 2%.  Thus, in the case of bonds, over the long-term, it is correct to equate the 2% yield with an annual return of 2%.

But with stocks, this is not the case.  Stocks do not have a maturity.  No repayment of principal ever takes place.  To realize a return on stocks, or at least to get your money back, you must find other people to sell them to–at a price those people find attractive, given their expectations about future price performance.  For this reason, the return on stocks is not equal to the “earnings yield”–it is equal to the change in market price, plus the total quantity of dividends distributed.  The difference may sound trivial, but as we explained in an earlier post on liquidity and reflexivity, it changes everything.

If we want to understand the return on stocks in terms of the earnings yield, we can certainly construct a model.  But the variable that we need to know is not the earnings yield per se, but rather the change in earnings yield (or, more conveniently, the change in its inverse, the PE multiple) from the time of purchase to the time of sale.  Mathematically, the total return on stocks is the change in the PE multiple, times the change in earnings, plus the total dividends distributed (as a percent of the purchase price).  In other words, if you buy a non-dividend-paying stock at a 9 P/E, and sell it at a 12 P/E, and its earnings grow 10% in the interim, then your return is  (1.2/.9) * (1.10) – 100% = 47%.

If you buy the SPX at 3300, you might be buying at an earnings yield of 3%.  But I can assure you that your annual return over the next ten years will not be 3%.  It will be something closer to -1%.  You are a fool, you paid a price for the SPX that, absent a decade of strong earnings growth, no investor will ever be willing to pay you in return, at least not outside of a mania or a bubble.  

At the time that you buy the SPX at 3300, the bond yield might be 2%, which would suggest an ERP of 1%, in line with the historical average.  But this is irrelevant.  A bond purchased at a 2% coupon yield will return 2% over its term, but a stock purchased at a 3% earnings yield will not return 3% over its term–it doesn’t have a term.  Therefore, in buying the SPX at 3300, you are not going to receive a 1% annual premium over bondholders.  You are going to receive something closer to a -3% annual premium, because, to repeat, you are a fool that bought an asset at a ridiculous price.

The Wrong Way to Use the ERP

What we have, then, are two intended meanings of the term ERP.  One meaning is “difference between the earnings yield of stocks and the yield on bonds.”  The other meaning is “difference between the return on stocks and the return on bonds.”  To avoid confusion, we’ll call the first version of the ERP the CNBC-Twitter ERP.  We’ll call the second just the ERP.

Let’s assume that investors suddenly become believers in the CNBC-Twitter ERP.  They decide that earnings yield equals return, and that stocks should trade with an ERP of 1%, the historical average.   As a general rule, they buy stocks–and push up prices–until the stock market’s earnings yield is 1% higher than the 10 year treasury yield.

If this behavior is carried out consistently, then we can calculate what the return over the next 10 years will be, using a set of uncontroversial assumptions.   Assume the initial earnings are ~$100.  The nominal annual earnings growth rate will equal the average since 1995, ~6%.  The dividend payout will be ~35%, also in line with the average since 1995.   The dividends will be reinvested by almost all shareholders, and therefore can be approximated as the equivalent of share buybacks that reduce the float.  The starting bond yield is 2%, today’s value.  The bond yield 10 years from now, after the “great deleveraging” and the various QE interventions that have been implemented to support it are over, will be around 4%, close to what it was during the peaks of 2009 and 2010, when investors were expecting a more robust recovery.  

These are reasonable assumptions.  Let’s see what happens when investors try to implement the 1% CNBC-Twitter ERP rule in response to them.  The starting bond yield is 2%, therefore the starting P/E at which they buy will be 33 (for a 1% CNBC-Twitter ERP).  The final bond yield will be 4%, therefore the final P/E will be 20 (again, for a 1% CNBC-Twitter ERP).  Therefore, to consistently employ the strategy, they will have to buy knowing that, on a set reasonable assumptions, the P/E is going to change from 33 to 20 over the interim period.  How is that going to affect their return?

If we calculate it out (above excel spreadsheet), we find that this compression will erase almost all of the the gains received from earnings growth, and therefore, despite supposedly demanding a 1% excess yield over bonds, what the investors will actually have to accept in excess return, if they employ this approach, is 0%.  In other words, to employ the strategy, they have to accept no relative compensation whatsoever for the added risk that they take on relative to bonds–which, when buying at such a high price, is not small.

As conditions in the economy and in markets fluctuate and evolve, individual expectations, preferences, and behaviors will fluctuate and evolve as well.  It may be true that the CNBC-Twitter ERP will revert to its mean over a ten year period, but it is unlikely to stay pinned at that mean day to day or month to month.  There will be swings, and even a small swing would lead to horrifying losses for the strategy.  This source of risk demands more than 0% compensation.

We can see, then, that the strategy represents the equivalent of a contradiction in terms.  You price stocks over bonds based on a lazy thumb-rule intended to generate appropriate compensation for the risks associated with owning stocks, but then, in the final analysis, you get no compensation at all.  Thanks, but no thanks.

Now, remember, this example assumes that, over the long-term, investors will adhere to the 1% ERP rule, so that in 10 years you can close out your investment at the needed price.  But we know, in practice, that this isn’t true.  10 years from now, it is more likely that the CNBC-Twitter ERP strategy will have been abandoned due to its failures, and that investors will want to buy stocks for a P/E somewhere closer to the historical average, around 15.  In that case, the final price will be roughly 3,000, which implies a negative 10 year total return, below the return not only of bonds, but of 0% yield cash–an asset that offers perfect liquidity, zero volatility, and zero risk to capital.

Using the ERP in a Semi-Legitimate Way

Of course, there is a semi-legitimate way to use the ERP.  Instead of carelessly equating returns with “earnings yield”, we can look at returns in terms of what they actually will be.  Over the next ten years, investors in the 10 year treasury are accepting a 2% annual return.  Stocks have historically been priced to produce an annual return that is 4% higher than the 10 year treasury.  Therefore, to stay in line with the historical average, stocks right now should be priced to produce a 6% annual return.   If they are priced to produce a 10% annual return, or a 15% return, then they are cheap relative to bonds.  Unlike the previous way of thinking, this way of thinking actually has some merit to it.

To know if stocks are priced for returns that are commensurate with the 4% annual return differential that they have historically produced over bonds, we need a model to predict what types of returns they are priced for.  Obviously, the spread between earnings yield and bond yields won’t work.  I could tell you that the spread was -1% in December 1981, and -1% in November of 1998.  You would have no way to know, from this irrelevant piece of information, that the future returns on stocks in December 1981 would be a hefty 17% annualized, and that the future returns on stocks in September of 1998 would be a paltry 3% annualized.

Though imperfect, the best metric available to predict future equity returns is the Shiller cyclically adjusted P/E ratio, or CAPE.  The following chart regresses future 10 year U.S. equity returns against the inverse of CAPE, from April 1933, the month that the gold standard ended in the U.S., to present:

The coefficient of determination in this regression, at 0.634, would be garbage to a scientist, but to an economist attempting to regress noisy data that aggregates behavior over 80 years, it’s actually pretty good.

If we constrict the period further to the years after 1954, the earliest period for which S&P accounting data is available, we get an even tighter regression, with a coefficient of determination of 0.669:

Right now, if you use pro-forma operating earnings to calculate CAPE, the CAPE yield is 5.1%.  If you use reported earnings, the CAPE yield is 4.2%.  Historically, CAPE yields at those levels have been associated with a wide range of future returns–as high as 10%, and as low 0%.

To make a better comparison to present, we need to look at the specific investment environments that produced the past returns.  The following chart color codes each data point based on the 5 year bin into which it falls, back to 1933:

What we see is that the high returns in the current CAPE range of 4% to 5% were produced in the late 1980′s and early 1990′s.  These periods had their 10 year returns artificially boosted by the internet bubble that emerged a decade later.  The low single digit returns were produced in the 1960′s.  This period had its 10 year return artificially depressed by the inflationary malaise and subsequent recessionary monetary tightening that emerged a decade later.

In truth, neither condition adequately describes the current environment.  10 years from now, we’re not going to be in a stock mania, but neither are we going to be in an inflationary malaise that necessitates a series of Fed-engineered recessions.  Our aging demographics support neither condition.

Personally, I think it’s reasonable to suggest that future total returns for equities will be around 5%. If this guess is accurate, then stocks, which would sport a true ERP of around 3%, are slightly historically expensive relative to bonds–but nothing that a one time 15%-20% correction can’t fix.

To be charitable, let’s assume a 6% return for stocks.  If that’s the case, then stocks are priced exactly where they should be.  The premium in return that equity holders are going to receive over holders of the 10 year treasury is going to be roughly 4%, right at the historical average.

The Problem With a Semi-Legitimate ERP Analysis

There is a problem with this semi-legitimate ERP analysis.  The ERP, properly understood as the delta between stock returns and bond returns, is not constant, or even linear, as a function of the starting bond yield.  At lower bond yields, the ERP tends to be much higher than at higher bond yields.  This matters a ton, because right now we are operating at the low end of the distribution–at a 2% 10 year treasury yield, only 50 bps off the recently set record.  The only time in history when bond yields were ever this low was, not coincidentally, the last time the Fed QE’d its balance sheet–the war and post-war periods of the 1940s and early 1950s.  The ERP during that period ended up averaging 13%, versus the 4% that we are currently using in our model.

Of course, this problem is even more extreme with respect to the CNBC-Twitter ERP, which compares yields rather than returns.  The CNBC-Twitter ERP changes wildly depending on where the bond yield is in the period of history you sample.  If you sample periods of high bond yields–such as the early 1980′s–you get negative CNBC-Twitter ERPs.  If you sample periods of low bond yields, similar to the current period–such as the 1940′s and early 1950′s, or even the 1960′s–you get a high positive number.

Since 1933, the standard deviation in the CNBC-Twitter ERP is 3.4%.  A variable with a mean of 1% is not going to spend much time close to its mean if its standard deviation is more than 3 times as large.   Yet this is what bullish advocates of the CNBC-Twitter ERP are asking that it to do–that it go to its mean right now.

To argue that stock earning yields should revert to some average “premium” over bond yields, without paying any attention to where bond yields are, as if it didn’t matter, is just plain sloppy.  Unlike bonds, stocks don’t have maturity.  This means that as their earnings yields fall, the change in price required to achieve a unit change in earnings yield increases exponentially (or, more precisely, as f(x) = 1/ x).  If stocks were to try to keep up with bonds every time bond yields go to the floor, as they did in the 1940s and 1950s, their prices would have to go to infinity–and then violently crash back at the slightest bump in yield.

The Use of ERP in Predicting Memetic Behaviors

The CNBC-Twitter ERP–defined as the spread between the earnings yield and the bond yield–does not have legitimate use as a valuation metric.  However, it can still be important to track as a potential catalyst for memetic investor behaviors.   

It is possible that the memes “high ERP” plus “stocks are the only place left to get a return” plus “yield chase” will implant themselves into investors’ minds and create the expectation of rising prices, which will cause investors to buy, which will push prices higher, which will validate the prior expectation of rising prices, which will increase confidence in this way of thinking, which will lead to even more buying, and so on, in a positive feedback loop.  If an investor has the insight to get in front of such a process, he obviously should.  In that sense, the CNBC-Twitter ERP is probably something that is still worth paying attention to–not as a concept that has fundamental merit in itself, but as a concept that can influence the thinking and the behavior of other people.  

We have to remember, however, that this process cuts both ways.  If the economy improves, and the Fed hints that they might “taper”, a new meme will have have been inserted.  This meme will cause investors to fear losses, and to therefore sell, which will lower prices, which will confirm the validity of the thinking that led them to sell, which reinforce that thinking, creating more selling, in a negative feedback loop.  

“Taper” may not be a fundamental reason to sell, just as “high ERP” is not a fundamental reason to buy–but it doesn’t matter.  All that ever matters in a market is what buyers and sellers do, regardless of whether their thinking is fundamentally sound.

The Fed Model of Stock Market Investing

• The Performance of the Fed Model
• A Charitable Interpretation
• The Fed Model’s Mistake
• Legitimate Ways to Use the Equity Risk Premium
• Buying the Nikkei at 9,600 in September 2010
• Buying the S&P at 1400 in December 2012

In the last post, we examined how liquidity–the ability to trade an asset, rather than hold it to maturity–radically changes the dynamics of investment.  When there is no liquidity, the return of an investment can only come from one place: the underling cash flow.  That cash flow is all that matters.  There is no rising market price to use as confirmation of a successful investment, “Great job buying that dip. You nailed it!”, just as there is no falling market price to fear and fret over, “Geez, how low do you think it will go?”  There is just the investment.  The investor has already psychologically parted with his money, said his goodbyes, and is now patiently collecting the income that the investment is producing and delivering, with a focus on the very long-term.

When liquidity is introduced, the dynamics change completely.  The investor no longer approaches the investment as a genuine parting with his money–a long-term goodbye.  He views his money as still there, at a fingertip’s reach, contained within the market price.  For this reason, he takes the market price extremely seriously.  When he buys a stock that plunges in price, he conceptualizes the plunge as a real loss–and feels real regret and frustration.  When he buys a stock that rises in market price, he conceptualizes the rise as a a real profit–and rejoices internally.  In addition to serving as the arbiter of his performance, the market price impacts his anchoring, his assessment of the fundamentals, and his future expectations–these in turn affect the prices that he is willing to pay, which in turn affect future market prices.  The process is recursive and reflexive–with a tendency to exhibit momentum and to generate price equilibria in highly path-dependent manners.

The Performance of the Fed Model

A number of investment approaches wrongly attempt to evaluate liquid investments in the stock market in the same way that an illiquid investment in real business would be evaluated–based strictly on the underlying cash flow.  A classic example is the popular “Fed Model”, coined by analyst Ed Yardeni, and recently touted by Hedge Fund Manager David Tepper and researchers from the New York Fed.  For those that aren’t familiar, the “Fed Model” argues that the attractiveness of the stock market as an investment should be measured by comparing its earnings yield (trailing twelve month earnings divided by price) to the yield on long-term bonds.  On this model, the stock market at 20 times earnings (5% earnings yield) is “expensive” if the 10 year treasury bond is yielding 6%, and “cheap” if the 10 year treasury bond is yielding 1.5%.

What do the terms “cheap” and “expensive” mean, precisely?  Granted, if we define the terms to mean “has a higher yield than long-term bonds” and “has a lower yield than long-term bonds” respectively, then, tautologically, the Fed Model is the arbiter of cheapness and expensiveness.  But if that is all that “cheap” and “expensive” mean, then there is no immediate reason to care about whether the stock market is cheap or expensive.  The terms “cheap” and “expensive” are only worth caring about if they can be linked to future returns, on some time scale.  What we need, then, is a market-based definition.  Is the stock market, given its current price, likely to produce high future returns, or low future returns?  If high future returns, then it is cheap. If low future returns, then it is expensive. With the terms appropriately defined in this way, the Fed Model ceases to be the arbiter of anything.

With respect to future returns, the Fed Model does not appear to have any independent predictive power.  The following chart plots future 2 year annualized total returns (y-axis) versus the “equity risk premium” or ERP (the difference between the market’s earnings yield and the 10 year treasury yield, x-axis) from April 1933, the month that FDR ended the gold standard, to present:

The coefficient of determination is roughly 0.  You could splatter paint on a page and get the same chart.  There are a number of instances where low future equity returns followed high ERPs, and a number of instances where high future equity returns followed low (or negative) ERPs.  Let’s extend the horizon out to 10 years.  

The coefficient of determination increases to 0.10.  Still not attractive.  Granted, when the ERP approaches double-digit extremes (and it is nowhere near such extremes right now), it seems to correctly signal that high future equity returns are coming.  But at those extremes, the earnings yield itself (inverse of the P/E ratio) produces the same signal, without any reference at all to the bond yield.  Here is the simple earnings yield versus subsequent 10 year returns back to April 1933:

The coefficient of determination increases to 0.48, far more attractive.  Demonstrably, then, all that the comparison to bond yields is doing is taking an otherwise meaningful signal–the earnings yield–and distorting it, screwing it up.  The comparison is making markets that were generationally cheap–for example, the market of the early 1980s–look historically expensive (indeed, as expensive as the market of the late 1990s), and markets that were expensive–for example, the market of late 1936 and early 1937–look cheap.  

It makes perfect intuitive sense that the bond yield would represent a distraction in the analysis of long-term future equity returns.  To the extent that long-term future equity returns are driven strictly by the underlying cash flows of the equities themselves, in the approximation of an illiquid investment, we should expect the equities themselves–the cash flows that they produce–to be the drivers, regardless of how those cash flows stack up to the cash flows produced by other investments: bonds, real estate, collectibles, whatever.

The fundamental problem with the Fed Model is this.  It is simply incorrect to assess the cheapness or expensiveness of one asset class by comparing it to another.  Such an approach dismisses the very real possibility that both asset classes are cheap or expensive at the same time–that they will both produce strong or weak future returns.  History clearly demonstrates that such an outcome is possible.  In the spring of 1937, stocks and bonds were both expensive, they both produced unattractive future returns.  In the summer of 1982, stocks and bonds were both cheap, they both produced excellent future returns.

A Charitable Interpretation

But maybe the Fed Model isn’t saying that stocks should be considered cheap or expensive based on how their yields compare with bond yields.  Maybe the model is simply telling us which asset class offers a higher return, and therefore which asset class an investor seeking to maximize return should choose, if she is forced to choose.  In 1937, an investor should choose stocks.  In 1982, an investor should choose bonds.  

But if this is the model’s contribution, then it isn’t of much value.  With the exception of the ends of recessions and bubbles, stock earnings yields are almost always higher than bond yields.  You don’t want a model that will have you out of the market at the end of recessions–those are the most attractive times to invest.  And though the Fed Model can spot bubbles, so can a plain vanilla P/E approach–where the bond yield is thrown out of the calculation.  What value, then, does the model add?   

Surprisingly enough, if an investor reliving the 1933-present period demands any kind of premium at all between earning yields and bond yields as a condition for investing in equities, he will underperform “buy and hold” on an absolute basis.  The following chart illustrates the total return performance of various Fed Model approaches back to April 1933.  Each line shows a Fed Model that uses a different cutoff risk premium (where you own the stock market if the difference between its earnings yield and the 10 year bond exceeds that premium, and you own 10 year treasury bonds otherwise).  The decision whether to switch is made at the end of each month.  To simplify the calculations, and also to capture the full upside of the 1981-present bond bull market, it is assumed that when 10 year bonds are owned, they are rolled over each month into new issues at no tax or transaction cost, with the capital gain or loss pocketed:

To make the points of relative performance more clear, let me introduce a different type of chart.  This chart plots the ratio of the performance of each strategy (numerator) to the performance of buy and hold (denominator), over time.  When a line is rising, the associated strategy is accumulating outperformance relative to buy and hold.  When a line is falling, the associated strategy is accumulating underperformance relative to buy and hold.  When a line is straight, the associated strategy is tracking buy and hold (usually because it is invested in stocks):

All premia except a 0% premium generate a lower return than buy and hold.  The 0% premium generates a higher return by about 17% (total, not annualized).  This excess return is good, but in the real world, would not be enough to make up for transaction costs, switching (slippage) frictions, and tax hits, which we have not modeled.  The strategy spends essentially all of the time before the early 1970s invested in stocks, and then proceeds into bonds at various points during the 1970s inflation, where it generates the bulk of its excess return.  The strategy avoids the downside of the tech bubble, but there is no net gain, because it also avoids the upside.

Note that during the 1970s, cash invested at the Fed Funds rate outperformed both stocks and bonds.  From Jan 1972 to Jan 1982, $1 in cash became $2.44, versus $2.31 for the Fed Model, $1.64 for Buy and Hold, and $1.28 for the rolled-over 10 year.  Surprisingly, then, the only period in which the Fed Model reliably outperforms the return of Buy and Hold is a period in which cash is king–certainly not the kind of period that most analysts have in mind when they tout the model.

The Fed Model’s Mistake

The Fed Model makes an appeal for a certain a type of investment consistency.  If investors are willing to pay a lot for the cash flow that one type of asset–e.g., the aggregate bond market–offers, they should be willing to pay a lot for the cash flow that another type of asset–e.g., the aggregate stock market–offers.

As discussed in the previous post, if we lived in a world without liquidity or trading, where all investments had to be true investments, held to maturity, with all returns generated directly from the underlying cash flows–the earnings, coupons, and interest payments, rather than the appreciation of price–then this appeal might make sense.  If you are willing to pay 33 times earnings for a 30 year treasury bond, why wouldn’t you also be willing to pay 33 times earnings for a well-diversified index of blue-chip stocks?  With the stocks, you would accrue the same initial yield, plus decades of eventual growth in yield.  The only real uncertainty, over the 30 year period, would be the upside: how much would the earnings grow?  Over 30 years, probably a lot.  Maybe we would have a recession in a few years, and the earnings would fall by 20%.  Big deal.  Even if we assume no earnings growth between now and then, the yield would fall from 3% to 2.4%, before coming back to 3%.  The difference is 0.6%–the equivalent of a paltry one-time transaction fee, certainly not a reason to forego 30 years of growth in yield.

But the truth is this.  In a world without trading, where each investment had to stand on its own merits, investors wouldn’t want to be involved with either option!  They wouldn’t want to buy the aggregate stock market at 33 P/E, nor would they want to buy a 30 year treasury bond at 33 times coupon.  They would hold cash instead, because the financial and psychological value of decades worth of liquidity for them far outweighs the paltry 3% annual return that they might receive.  Maybe 8% or 10% would be worth it, but certainly not 3%.

Bonds and stocks are fundamentally different types of investments.  Bonds have a lower duration, and a defined maturity date, when the principal must be returned.  Stocks have no such date–to earn a decent profit over the time horizon of an adult human life, you must find someone to sell them to.  Bonds pay out all of their cash flows to the investor.  Stocks only pay a fraction–with the amount ultimately at the mercy of management, a group of strangers that can do whatever they want with the money.  Bonds are a guaranteed cash flow, a repayment contract that can be recovered in court and that moves investors to the front of the line in bankruptcy.  Stocks, in contrast, are risky ventures that have no repayment contract to back them, and that almost always go to zero in the event of business failure.  Finally, in the case of treasury and mortgage bonds, these bonds can be legally bought–suppressed in yield and supported in price–by the Federal Reserve as a stimulus measure, a measure that the current Federal Reserve is very much inclined to use.

Within a secondary market, these differences have caused each type of  investment to behave differently, with different financial and economic correlations, different trading properties and conventions, and a different audience.  In an environment where the market determines the outcome, the differences make all the difference in the world.  4% on a 10 year treasury feels reasonable to most bond investors, they will comfortably buy at that yield–at least in the current environment, where they know that short-term rates will be kept low for a long-time.  But to stock investors, the same 4% yield, which implies a 25 P/E–an S&P 500 price of 2,500–categorically does not feel reasonable, regardless of where short-term or long-term rates are.  Now, one can argue that it is irrational for investors to fear owning a market at 25 times P/E, if the bond yield is low enough to compensate.  But “rational” doesn’t matter.  All that ever matters is what investors feel, because what they feel determines what they do, and what they do determines the market’s outcome.  If you poll investors, they will make it very clear: outside of a recession, where profits are artificially depressed, 25 times earnings for the S&P 500 does not feel like a reasonable price.

Legitimate Ways to Use the Equity Risk Premium

If the equity risk premium has value as a market signal–and there may be cases in which it does–the reason is not that “consistency” dictates that an investor should choose higher yielding assets over lower yielding assets.  In a secondary equity market, on realistic time horizons, returns don’t come from yields, they come from capital appreciation.  So the point is a non-starter.

Maybe a high equity risk premium reflects excessive fear in the market–fear that is depressing equity prices, and that will create significant price gains when it normalizes.  Maybe a high equity risk premium reflects an aggressively expansionary Fed that, through its pro-growth stance, will eventually rekindle risk appetite, and push investors back into the stock market.  Or maybe, in a reflexive sense, “high equity risk premium” plus “stocks are the only place left to get a return” plus “yield chase” are memes that will implant themselves into investors’ minds and create the expectation of rising prices, which will cause investors to buy, which will push prices higher, which will validate the prior expectation of rising prices, which will increase confidence in this way of thinking, which will lead to even more buying, and so on, in a positive feedback loop.  (But be careful, because when the Fed hints that they might “taper”, everyone will freak the f— out and rush to the other end of the ship).

In each of these uses, the equity risk premium is being linked to price–and therefore the appeal has validity.  But a simple appeal to investor consistency in the purchase of yield does not.  The yield alone, especially the small part that investors actually collect–the dividend–will take years or decades to accrue in meaningful amounts, and can be lost in a single day of trading.  Whatever they may say, that yield is not what equity investors–or even many bond investors–are ultimately after.

Note that when a large equity risk premium is appealed to in this way, as a condition that sets the stage for higher future prices, the details associated with the premium become important.  Why is it large?  Is it large because the earnings yield is high?  Or is it large because the bond yield is low?  And if the bond yield is low, why is it low?  The fact that a 10% earnings yield and a 6% bond yield are correlated with fantastic future equity returns is not, in and of itself, a reason for investors to expect similarly fantastic equity returns from a 6% earnings yield and a 2% bond yield, especially if both the 6% earnings yield and the 2% bond yield were engineered through a policy intervention that will eventually end.

Put differently, any noteworthy return that an investor generates from buying a market with a 4% equity risk premium will not come from the premium itself, the “spread”, but from the future willingness of others to pay higher prices than they are willing to pay now.  For this reason, the underlying factors that are driving the premium, and the way that those factors are “setting the market up” for bullish future changes in investor behavior, are critically important to the calculation.    

Buying the Nikkei at 9,600 in September 2010

In September of 2010, the Nikkei 225 traded at roughly 9600, a P/E of 16.4.  The S&P 500 traded at roughly 1125, a P/E of 16.0.  The P/Es for all countries at the time are shown below, courtesy of FT:

The 10 year JGB yield was around 1%, and the 10 year US treasury yield was around 4%.  So the Japanese stock market had an equity risk premium of 5%, and the US stock market had an equity risk premium of 2%.

What was the investment outcome two years later, in September 2012?  The S&P was up 31%, and the Nikkei was down 6%.  All while Japanese investors were (supposedly) collecting an (invisible) 5% spread, versus an (invisible) 2% spread for US investors.  Did the (invisible) spread matter?  Not in the slightest.  Yields of 2%, 5%, or 6% collected over a year don’t matter when they aren’t actually collected, and when the price can change by twice that amount in a period of a few days or weeks.

Now, fast forward to May 2013.  Voila, the Nikkei is up 51%.  Have the Fed Model and the Equity Risk Premium been vindicated?  Hardly. What drove the abrupt increase in returns was not Japan’s high ERP (due mostly to a low bond yield), but “Abenomics”, which turned horrid investor sentiment into budding optimism, a contagious desire to be invested for the coming “recovery.”  That’s all it took.  On the time scale that most investors care about, changes in sentiment, outlook, expectation, and the effect on price, are what drive returns–not small yields or spreads that take years to collect in meaningful amounts.

Buying the S&P at 1400 in December 2012

If you joined David Tepper last December and bought the S&P 500 because it was “cheap” relative to its earnings, or relative to what bonds can offer, you’ve made about 17% on your investment so far, including dividends.  Congratulations.  But you haven’t made that 17% directly from the earnings themselves, or from their spread relative to bond yields.  All that the earnings themselves amount to–assuming they were paid directly to you, which of course they weren’t–is about $40-$50, 3%.  The added 14%–almost 5 times as much–came from the changing sentiment of others, who will now pay you 1630 for each share, instead of 1400.

What has driven this changing sentiment?  The answer: steadily improving U.S. economic conditions, especially in the housing market, a sense of a return to normalcy after the resolution of the “fiscal cliff” and the stabilization of the European debt crisis, both of which suggest an end to the “era of crisis” and a return to a more normal era of steady progress, an investor-friendly Fed that continues to promise to support the economy and the market with zero interest rates for an extended period of time, corporate earnings that are managing to hold up despite feared headwinds, and finally, the market’s best friend: QE.  The Fed is perceived to be endlessly “flooding” the market with liquidity–newly “printed” money that, allegedly, has to go somewhere–thereby lifting the prices of every asset that is considered to be worth owning.  It doesn’t matter whether this dramatized description reflects the actual mechanics of the low-yield asset swap that takes place in QE–all that matters is whether investors think it does.  And many do.

These trends and conditions have not lifted the markets directly.  They’ve lifted the markets indirectly–by functioning as “inputs” into the minds of investors.  They’ve caused investors to focus more on the long-term gain of equities, and less on the short-term risk, which seems to be dwindling.  As a general rule, whenever investors are thinking optimistically about the long-term–personally, financially, or economically–they tend to want to be invested in equities, the asset class that has historically offered the highest long-term returns.  They exhibit this tendency regardless of where P/E ratios, or ERPs, or whatever other metric you prefer, happen to be.  If they see the future as sufficiently promising and exciting, as in the fall of 1999, they will buy equity markets all the way up to 40 times earnings to be “in”, even with bond yields at 6%.  And if they see the future as sufficiently scary, as in the spring of 2009, they will sell equity markets all the way down to below 10 times earnings to be “out”, even with bond yields at 2%.  Compare this 400% swing in price to the 7.5% difference in earnings yield that it represents–a yield that would take a full year, 365 days, to collect–and you will see what really drives returns.

Rest assured, if the improving trends and conditions that have materialized in the US and global economy had not emerged, you would not have your 17% return right now, even though you bought at a “cheap” price.  And if the trends and conditions had emerged at a more expensive price–if, in December, the market had been treading water for months at 1630, rather than 1400–the bottom line would have likely been the same.  Instead of moving up to 1630 from 1400, the market would have moved up to 1860 from 1630, or to some other attractive number.  Investors in the 1630 to 1860 move would be just as happy as you are now–completely unaware of the fact that they bought the market at a P/E a couple points higher, or an ERP a point lower, than you did–and those left out, just as frustrated to not have bought the market, regardless of what some manufactured metric says.  Moves in a secondary market are constrained not by absolute levels, but by the levels that participants are psychologically anchored to.  The outcome is path dependent; where you start matters.

Arguably the biggest “input” of all is the steadily rising price itself.  It creates a positive feedback loop in the minds of investors that confirms the “rightness” of the decision to invest and strengthens the optimistic expectation of what future investments will produce.  It validates the narratives that investors have been using to rationalize why they should be in the market, why it is heading higher–in this way, it increases their confidence and willingness to take future risks.  On the other end of the spectrum, the price action creates a negative feedback look in the minds of those that are not invested.  It confirms the “wrongness” of their decision to be cautious, to wait, and creates fears of perpetually missed future gains–a train that will permanently leave the station–if they stay on the sidelines.  Eventually, the pain of being the only person on the block that is not participating in the collective prosperity becomes too much to bear, and they jump back in.

When things are good, and the market is in an uptrend, most people–even those near or in retirement–want to be involved.  They want to be invested in the high-return asset class, participating in the gains that “everyone else” is enjoying.  But per the “Hold Rule”, not everyone can be invested in the high-return asset class–someone has to hold the other stuff.  It certainly doesn’t help, in the present situation, that the other stuff is yielding zero, and will continue to yield zero for many years.  But even when the other stuff is not yielding zero, these types of uptrends still happen–sometimes, more aggressively than they are happening now.

The Stock Market: Thinking About What Matters

We can distinguish between two types of investments: liquid investments and illiquid investments.  An example of a liquid investment would be the online purchase of a stock.  If you change your mind two seconds after making the purchase, you can sell the stock at virtually no cost.  An example of an illiquid investment would be the construction of a new production line in a factory.  If you–the CEO or business owner–change your outlook after the new line has been built, you can’t easily turn around and sell it to someone else.  The engineering and labor costs are unrecoverable, and the scrap prices that you will get for whatever materials you used will be a fraction of what you paid.

A mistake that fundamentally-oriented stock market investors sometimes make is to assume that liquid and illiquid investment decisions are governed by the same considerations.  They are not.  Liquidity in an investment is an enormously powerful feature.  In addition to having significant economic (option) and psychological (comfort)  value in itself, its presence radically changes the way in which investors evaluate their investments, as well as the mode in which they receive their returns.

In an illiquid investment, all of the return comes from the payout of the underlying cash flows, over decades of time.  And so evaluating the attractiveness of the investment is straightforward.  Project out the cash flows, and discount them–for risk and uncertainty, the cost of money, and the cost of illiquidity, which is not small.

In a liquid investment, the cost of illiquidity is extremely small (only the bid-ask spread and transaction costs).  The majority of the return comes not from payout of the underlying cash flows, but from the ability to sell the investment to others.  For this reason, the piece of information that really matters, that effectively decides the outcome, is the market price: what others offer to pay for the investment in the future.

Some investors will claim that their time horizon is forever, and that they don’t care about the market prices of their investments.  If they make this claim, ignore them; they are bullshitting.  They definitely care.  When the prices of securities they own rise rather than fall, you will not hear them talking about “infinite time horizons.”  You will hear them touting their investment process, celebrating their “return”, which they consider to be very real.

In the paragraphs and posts that follow, I am going to explore the different considerations that pertain to liquid and illiquid investments, and present a general framework for how we should think about each type–with a particular emphasis on how to think about liquid investments in a stock market.

A Simplified, Easy-To-Understand Model

As always, we begin with a simplified, easy-to-understand model.  We will use this model to help clarify the true, illiquid value of assets, as well as the importance of liquidity preference as a determinant of the price that will be paid to invest in them.  Try, if you can, to think about the model as if you were really in it, right now, making the decisions that each person has to make.  You will see first-hand how impactful considerations about liquidity are.    

Suppose that you, John and Laura are investors in a closed market.  This market contains three types of assets: stocks of different companies securitized into an index ($SPY), government bonds similarly securitized ($TSY), and cash.  

There are 90 oustanding shares of $SPY, 90 outstanding shares of $TSY, and $9,000 of cash.  That is the universe of existing assets.  At present, each share of $SPY earns $6 a year in profit from the underlying companies, with the earnings growing over the long term at roughly the rate of inflation, which we will assume is around 2%.  The earnings grow only at that rate because there is no internal reinvestment; 100% of the earnings are paid out as a dividend each year.  Each share of $TSY pays out a constant $4 of cash per year in interest, and will mature in 10 years, at which point each share will be exchanged for $100 in cash.  The $9,000 of cash is just money: dollars held electronically in a bank account.  Currently, for each dollar that is not used to make purchases, the bank pays out 1 penny of interest per year, in compensation for the ability to lend it to others.  This interest rate is set by the government, and changes based on the government’s management of economic conditions.

Because you, John and Laura are the only individuals in this market, one of you must hold each outstanding unit of each asset class at all times: each share of $SPY, each share of $TSY, and each dollar bill (or byte).  We call this rule the “Hold Rule.”  There are no exceptions to it.  If no one wants to hold a give unit of an asset, the “price” of that asset, expressed in terms of other assets, will fall, until someone emerges that does want to hold it.  

Suppose that you, John and Laura come into existence with the assets distributed equally, so that each of one of you owns 30 shares of $SPY, 30 shares of $TSY, and $3,000.  This distribution satisfies the “Hold Rule”, because the sum of what each of you is holding equals the total outstanding quantity of each asset.  But this randomly chosen distribution is unlikely to satisfy your various preferences.  So I am going to “open the market.”  That is, I am going to give you the opportunity to trade the assets freely among yourselves, at whatever exchange rates you choose.

The million-dollar question is, once the market is opened, what will the exchange rates between the assets be?  How many dollars for each share of $SPY?  How many dollars for each share of $TSY?  And if shares of $SPY and $TSY can be swapped directly, without going through the medium of cash, what will the ratio between them be?

Illiquid Investment: No Uncertainty, No Trading

To get a better picture of the true, fundamental value of each asset, we need to eliminate trading, wherein an investor can generate large returns by correctly anticipating the changing preferences of others, rather than by collecting the cash flows of the asset itself.  So let’s assume that the market will remain open for only one day.  On that day, you, John and Laura will be able to freely conduct exchanges in accordance with your preferences.  Once the day is over, the market will close forever, and the three of you will have to stick with whatever you have.  Whoever is holding shares of $SPY will have to stick with those shares, forever.  Whoever is holding shares of $TSY will have to stick with those shares for the next 10 years, at which point each share will be redeemed for $100 of cash that will have to be held forever.  Whoever is holding cash will not be able to hold any of the other assets, but will have the ability to use the cash to purchase goods and services at any time.  In theory, the person holding cash would have the ability to use it to create a new asset, but to be fair to the other asset classes, we will consider this “real investment” to be a type of trading, and assume it is not a viable option.

If you, John and Laura are perfectly rational agents, then 3 questions will determine the relative rates at which you will offer to exchange the assets.  These 3 questions are:

(1) What will the future $SPY payouts be?     

(2) What will the future interest rate on cash be?

(3) What is your liquidity preference?  How important or valuable to you–both economically and psychologically–is the ability to have and spend your money now, versus later?  What is the cost to you–again, both economically and psychologically–of having to separate with your money, not be able to touch it, for long periods of time?  As an investor, what is your time horizon?

Unlike question (3), questions (1) and (2) are outside of your control.  In the present scenario, we are going to eliminate them.  Suppose, then, that I tell you exactly what the future payouts of $SPY will be, and exactly what the interest rate on cash will be, in each future year up to eternity.  Because we’ve eliminated the ability to make money by trading, you will know everything there is to know about the returns offered by each asset class.  Those returns are shown in the table below:

As we see from the table, the advantage of $SPY relative to cash is that it will pay out more over time. $TSY also has this advantage, but the advantage is lessened by the fact that the payouts do not grow with inflation, and also by the fact that the fund matures into cash in 10 years.  

The disadvantage of $SPY relative to cash is that you will have to wait to get the money.  If you exchange $100 of cash for $SPY, it will take you 14 years to get that amount of cash back (by then, you will have $100, plus your shares of $SPY).  In the interim, you will only be able to spend what you have accrued.  $TSY carries this same disadvantage relative to cash, but the disadvantage is reduced by the fact that there is a maturity date, a time at which a lump sum of cash will be paid to close out the fund.

Think about the scenario in real terms, as if you actually had to make the investment choice right now.  From the initial distribution, you have $3,000 of cash, 30 shares of $SPY, and 30 shares of $TSY.  You can trade any of these assets for any other asset, at whatever ratio you choose.  The only catch is that John and Laura–the individuals with whom you will be making the exchange–have to agree to the ratio for a trade to be carried out.  

Suppose that John makes the first offer.  He has a very long investment time horizon, and doesn’t need the cash.  To get the highest long-term return, he wants to acquire shares of $SPY.  So he offers to exchange $100 of cash for each $SPY share.  He says “Look guys, I’m offering 15 times earnings, that’s a very fair price.”  Would you take his offer, and sell your shares?  If not $100, then what would your minimum price be?  $150?  $200?  $300?

Let’s assume that, like John, you and Laura both have very long investment time horizons.  Whatever wealth you have, you plan to put it aside and not spend it for decades.  If that’s the case, then the eventual price in cash that each of you will end up offering to pay for each other’s shares of $SPY will be much higher than $100–maybe $150, or $200, or $300.

These prices would represent price-earnings (P/E) ratios of 25, 33.3 and 50 times earnings respectively–quite expensive relative to what most of us are used to.  But it doesn’t matter.  There is no rule written into markets that says that the P/E ratio must equal some number.  The only rule is the “Hold Rule”–the rule that each unit of each asset in existence must be willingly held by someone at all times.  If each of you wants to hold $SPY, and none of you wants to hold cash, then the exchange rate between $SPY and cash will rise until one of you changes your mind.  Period.  The same is true of $TSY.  The only difference is that there is a limit to the price that an investment in $TSY can rationally command.  In our example, if, to hold $TSY, you pay more in cash than $145.98–that is, $100 of principal plus $40 of collected coupon payments compounded for the relevant period of time at the cash interest rate–then you will have essentially given away your money to someone else for free.

Ultimately, $SPY and $TSY are a type of cash–with the access delayed over time, in accordance with the intervals specified in the table.  And so if you think about the dynamics of the decision in front of you, you will see that everything comes down to that same question: what is the difference in value, for you, between “cash now” and “cash later”?  What is your liquidity preference?  If the three of you perceive there to be no difference whatsoever between the value of cash now and the value of cash 10 years from now–if having the actual money in your hand, being able to spend it whenever you want over the next 10 years, is worth zero to you–then the maximum amount of cash that you will be willing to exchange to hold $TSY will approach $145.98, an excess return of zero.  And if the three of you perceive there to be no difference whatsoever between the value of cash now and the value of cash in a million years, then, assuming low and stable cash interest rates in the interim, the amount of cash (or $TSY, if you exchange the security directly) that you will be willing to exchange for $SPY will approach some absurdly high number.

Being willing to pay enormous amounts for $SPY might sound crazy, but it makes perfect sense, provided that you have a long enough time horizon.  Even if you pay $1,000 a share, there will come a time when your investment will have produced more than that amount, and, assuming low and stable cash interest rates, more than cash or $TSY will have produced.  The only question is whether it’s worth it to you to wait that long.  For most of us, it isn’t.

Illiquid Investment: Add Uncertainty 

It is common for economists to speak of a “risk premium”–a premium, in added return, that the holder of an asset with uncertain cash flows (such as equity in a company) demands in exchange for holding it, as opposed to holding a guaranteed asset.  In the first scenario, no risk premia were necessary, because we disclosed the future cash flows of each asset out to eternity.  In this scenario, we will reintroduce uncertainty to see how the problem changes.  What we will see is that because we are utilizing indexing, the problem doesn’t change much at all.

Before we begin, let’s ask the question, why does uncertainty even require a risk premium?  For each investment, there is an expected (or mean) return.  The uncertainty around that return applies in both directions–to the upside and downside–therefore it doesn’t change the mean.  So why should we consider the uncertainty to be a net negative that requires compensation?

The answer lies in the disparate way that the human mind evaluates profits and losses of the same magnitude.  They are not the same, and they do not cancel each other out.  To illustrate, suppose that there is a company that has a 50/50 chance of generating a $150 total profit, or a $50 total profit, tomorrow, after which it will dissolve.  Mathematically, the expected (or mean) return of an equity investment in the company (+$150, +$50) is $100.  Even though the expected return is $100, investors are not going to pay $100 in exchange for the equity.  The reason is that the prospect of a $50 gain is not commensurate with the prospect of a $50 loss.  Investors are, on average, risk-averse.  The cost of a loss is perceived to be greater than the benefit of an equally-sized gain, and therefore investors demand to receive compensation over and above the expected return on the investment.  That compensation is the risk premium–the compensation for taking the risk, which could be avoided altogether.  For a given expected return, the greater magnitude and probability of the potential loss, the greater the risk premium needs to be.

To test this out in your mind, consider the following proposition.  I’m going to flip a coin. If it comes out heads, I will pay you X dollars.  If it comes out tails, you will pay me X dollars.  Would you accept the offer?  The expected return of the offer is 0, which is exactly what I am you charging to take it.  So will you take it?

Granted, if X is really small, like a few dimes or pennies, you might take it.  Gamble a bit, for fun.  On the scale of extremely small potential losses, human risk-aversion approaches zero, and the rewards of excitement, humor and leisure can outweigh it.

However, as the amount of money that can be lost grows, the risk-aversion grows–in non-linear fashion.  To illustrate, suppose that X equals your entire net worth.  If heads, you double your net worth, if tails, you lose your net worth.  Would you accept the offer?  Of course not.

To get you to accept the possibility of losing everything that you own, I would have to compensate you by dramatically skewing the expected return–with the extremity of the skew determined by how much the loss of your net worth would hurt right now.  Depending on your personality traits and life situation, I might have to offer to pay you as much as, say, 10 times your net worth if you win the flip.  But even 10 to 1–an expected return equal to 9 times what you are putting at risk–might not be enough.  When your net worth is at stake, we could very well be at a singularity, where no expected return, no matter how large, is worth a 50% chance of losing everything that you own.

Obviously, with respect to an individual company, there is significant uncertainty around the outcome.  The cash flows that the company ends up producing could fall dramatically below the expectation.  Worse yet, the company could go bankrupt, disappear forever, creating a permanent loss of capital.  Subjecting one’s wealth to that uncertainty demands compensation.

But in our scenario, we are not contemplating an investment in an individual company.  Rather, we are contemplating an investment in a collection of thousands of companies pooled together.  When  pooled together, the winners among the companies cancel out the losers.  The result is a much tighter distribution around the expected outcome, and therefore a much smaller required risk premium.

In the case of $SPY, we can be reasonably confident, based on history, that next year the asset will produce something close to what it produced this year–$6.  We can also be reasonably confident that the $6 will grow over time, at about the nominal growth rate of the economy.  There will be expansions and recessions in which earnings will rise and fall around the trend, and so a risk premium is still necessary, but there is no reason why it needs to be particularly large.  As a consideration in the problem, it is going to be dwarfed by the far more important consideration of liquidity preference.

To capture the point intuitively, put yourself back in the scenario, except without the table that tells you what $SPY’s returns will be.  You know that $SPY is currently paying out $6, but you don’t know for sure what it will pay out in the future.  John offers to sell you $SPY for $150.  Based on your estimates, the payback will be roughly 20 years.  But you can’t be sure of that estimate.  Depending on how the economy performs, the payout could be 15 years, or it could be 25 years.  How much does this uncertainty dissuade you from the investment?  Probably not much at all.  The key consideration for you, far more important than the uncertainty around the trend in $SPY’s payout, is your liquidity preference, the difference in value for you, economically and psychologically, between having cash now and having cash in the future.  Ultimately, it is that preference that will make the difference in determining the maximum price that you will offer to pay.      

Liquid Investment: Enter the World of the Stock Market

What we have in our first two scenarios, where you, John, and Laura must decide who will hold a set of outstanding equity, fixed income, and cash assets over the long-term, is a nice, neat problem that we can solve rationally with only two pieces of information: (1) the total future cash flow that each asset will deliver, and (2) each investor’s liquidity preference, i.e., the cost to each investor–both economically and psychologically–of parting with money, not having it or being able to use it, for extended periods of time.

Now, let’s remove the artificial constraint that the market will close forever tomorrow, and that each individual will have to stick with whatever she chooses to hold.  Assume that assets can be freely exchanged indefinitely, and that cash, in addition to being spent on goods and services, can be used to create new assets.  

Unfortunately, this new formulation radically changes the dynamic of the problem.  Because we’ve introduced the concept of trading in a secondary market, the problem is now recursive.  With respect to (1) above, the total future cash flow that the asset will deliver to the owner is no longer just a function of what the asset will earn or generate in its own operation.  It is now a function of what the asset can be sold to others for.  With respect to (2), the consideration that encapsulates the true cost of the investment in terms of lost liquidity is no longer the maturity or payback period of the asset, but rather, the future willingness of others to purchase the investment from the owner, should the owner want to sell it.  Each investment becomes fully liquid as if it were cash, except that its value fluctuates every day based on how eager others are to own it.  If you choose to get out of the investment, you will have to expose yourself to that fluctuation, which is a net negative to the proposition, given risk-aversion.    

It is extremely difficult, if not impossible, to try to logically model how these considerations should interact to determine the price of an asset.  If I don’t plan on holding the asset until maturity, and generating a return from its cash flows directly, I can’t know, with precision, what the highest price I should be willing to pay for the asset is, unless I know what price others will be willing to pay, at various points in the future.  But I can’t know what price others will be willing to pay, at various points in the future, unless I know what price those others think yet others–to include me!–will be willing to pay, at various points farther out into the future.  

The logical intractability is made worse by recursion inside the individual: what George Soros calls reflexivity.  The prices that the investments are trading at are displayed on a “tape”, for all to see.  The investors’ views about the investments determine those prices, but those prices also determine the investors’ views about the investments.

Each investor is a human being with insecurities.  Whatever he might proudly say, his views are influenced by the aggregate views of others–which is what the “tape” expresses to him, the collective wisdom of his peers.  The tape can make him scared, cautious, greedy, confident, impulsive, excited, elated, bored–emotions that have the power to alter his investment time horizon, his tolerance for risk and uncertainty, his assessment of the underlying merits of his positions, and his sense of how well those positions will perform.  The result is a pricing mechanism that exhibits both momentum and path dependence.  Past prices can influence future prices, and securities with the same fundamentals can easily arrive at disparate prices, depending on the paths they take to get there.

Because a liquid market functions in this way, the insights that matter are not insights about what is worth what, or what is “cheap”, or what is “expensive”, or what my “discounted cash flow model” says, based on information already given or information about to arrive.  The insights that matter are insights about what other people are going to choose to do in the presence of that information.  What other people will do in the face of whatever path reality takes is what decides returns, and is therefore what investors in liquid markets should be trying to understand and model.  Anything that cannot in some way be related to that question is a distraction, an attempt to treat liquid investing as if it followed the radically different rules of the illiquid.

In the next piece, we will use insights gained here to refute the popular “Fed Model” for equity investing, which evaluates the attractiveness of the stock market as an investment based on how its earnings yield compares with long-term bond yields.

Profit Margins: A Comment on Bianco and Suzuki

Business Insider’s Sam Ro @bySamRo recently highlighted arguments from equity analysts David Bianco and Dan Suzuki that purport to show that currently high corporate profit margins are, in fact, sustainable.  These analysts conducted research that found that most of the strength in corporate profit margins can be attributed to two factors: (1) low corporate taxes, and (2) low interest expense (from low interest rates).  Since corporate taxes are not going to rise, and since the Fed is not going to start meaningfully raising interest rates, at least not any time soon, the analysts concluded that there is no need for currently high corporate profit margins to fall.  Unfortunately, the argument misses the point, as we will explain.

Before we begin, let us return to the Levy-Kalecki equation that we proved analytically in the previous post:

Profit =  Investment + Dividends – Household Saving – Government Saving – Foreign Saving.

Now, divide each term by GDP:

Profit / GDP = Investment / GDP + Dividends / GDP – Household Saving / GDP – Government Saving / GDP – Foreign Saving / GDP.

This equation gives a crude approximation for profit margins, and clarifies the conditions necessary for them to be high.  If Profit / GDP is going to increase relative to its historic average, then, necessarily, either investment and dividends must increase relative to their historic averages, or Household Saving, Government Saving, and Foreign Saving must decrease relative to their historic averages.

As a % of GDP, the current increase in profit appears to be attributable to a combination of low Household Saving and high Government Deficits.  Consider the following chart from Hussman:

Now, when Bianco and Suzuki focus on changes in taxes and interest payments as the “drivers” of margin changes, they miss the point.  Taxes are the revenues of the government.  If the government reduces the amount of tax that it collects from corporations, as it has done over the past 30 years, then either it must borrow (increase its own deficit–which it has also done), or it must increase taxes on households.  If it increases taxes on households, then they will need to reduce their savings, otherwise they will not be able to maintain constant expenditures.  Similarly, corporate net interest expense is the net interest income of households.  If corporate net interest expense falls, then household income will fall as well (all else constant).  To maintain constant expenditures, households will have to reduce their saving.

Thus the correlation of profit margin with household and government saving remains intact, even if lower corporate taxes or lower interest expense are a primary culprit for the change.  If you don’t believe that household saving and government deficit as a % of GDP can sustainably stay at their depressed and elevated levels respectively, then you must agree, absent large changes in exports or investment, that profit (as a % of GDP) must come down–whether the mechanism is increased wages, taxes, interest payments, whatever (again, all as a % of GDP).

Ultimately, Bianco and Suzuki set up something of a straw man in their analysis.  I know of no one that is arguing that profits must collapse. That would require a recession.  More likely is that profit / GDP will fall as GDP grows.  The GDP growth will reduce, and, theoretically, could prevent entirely, the fall in profits–but the contracting margins will also prevent their growth.  And to the extent that profit growth drives long-term equity returns, we should expect those returns to be lower than normal.

Note that the inverse relationship between profit margins and profit growth is quite clear in the data–with a correlation greater than 80%.  A chart from Hussman,

Now, the proof is in the data itself.  Profits are not growing robustly right now.  Whether you look at S&P or NIPA, profits are growing slower than nominal GDP and slower than consumer prices (inflation).  And note that this growth includes the help of float shrink from share buybacks.  So not only are profits not growing consistently with their historical growth rates, corporations are finding it necessary to spend last year’s earnings on efforts to keep this year’s earnings from falling.  That, of course, raises the important question: what is actually being earned?

If you look at the work of sell-side analysts, Bianco included, you will observe that they have consistently and significantly overestimated earnings growth since 2011.  We don’t hear about the misses and the downward revisions because the market is up.  In aggregate, investors care only about the bottom line–the price of the market, that which determines their profit and loss.  Far from a market driver in the near-term, earnings are just one of many things that participants “chit-chat” with each other about–along with Greece, China hard landing, the sequester, the debt ceiling, QE, taper, Tepper, bla bla bla.  

Even looking a few years out, market returns are driven far more by the state of the economy, by investor sentiment, and most importantly, by expectations about Fed policy, than by profit per se.  We know this from history.  We can look back, for example, to periods such as 1984-1987, where profits fell significantly, but where markets boomed in ways that no one could have expected.  

If any sort of profit matters to market returns over the horizon of a few years, it is the expectation about future profit: “Forward EPS.”  But if the economy is improving, if investor sentiment is positive, and if expectations are that the Fed will remain accomodative, then future profit will always be high and growing, because it is just a concept that the investor himself invents, imagines, dreams up, rather than a piece of cold, hard data that reality forces upon him.  If he is optimistic, then when reality finally does force a disappointing number upon him, a refutation of his prior estimates, he will already be looking out to the next year, and will have dreamed up a new estimate of what’s to come.  This is precisely what bullish analysts have done from 2011 to now–take comfort in the future, an idea in their minds, which, until it comes, can be whatever they want it to be.

The Profit Equation Explained

There’s been a lot of analysis over the past year of profits, profit margins, and their implication for future equity returns.  Profit margin bears, such as John Hussman and James Montier, appeal to the Levy-Kalecki profit equation to show that current levels of corporate profits–which are in excess of 10% of GDP–are unlikely to be sustained.

To my knowledge, no one has actually gone to the trouble of proving this equation to be true.  So, in this piece, I am going to derive it analytically.  It only takes a few steps, and is extremely easy to understand.

We begin by grouping the economy into four sectors: households, corporations, government, and foreign.  We define “saving” as increasing one’s net stock of financial assets.  If, in a given time period, I receive $100, and spend (or invest) only $50, then I have saved $50.  Alternatively, if I receive $50, and spend (or invest) $100, then I have saved -$50.  That is, I have borrowed $50 (or printed it or counterfeited it–because the money had to come from somewhere).

Trivially, over a given time period, the total sum of net saving of financial assets by each of the sectors in the economy must equal  zero, always.  If, each year, I receive $100, and only spend $50, then, each year, I take $50 out of the system.  That is, I take $50 out of the receipts of other sectors, which means that for those sectors to continue to spend what they are spending each year (what ultimately becames my $100 of income), those sector need to borrow the missing money (or print it or counterfeit it).

So we have an equation:

(1) Household Saving + Corporate Saving + Government Saving + Foreign Saving = 0.

This equation is analytically true, a logical consequence of the way each term has been defined.

Now, we take Houshold Saving, Government Saving, and Foreign saving and move them to the other side of the equation.  We then have,

(2) Corporate Saving = – Household Saving – Government Saving – Foreign Saving.

What this formulation tells us is that if the corporate sector chooses to net save financial assets, the other sectors must net borrow or net create financial assets, and vice versa.

Now, let’s simplify Corporate Saving into its components.  Corporate Saving, i.e., the amount of financial assets that corporations accumulate in net terms, equals their profit (what they have leftover from revenue after they pay the costs and taxes of doing business), minus what they invest, minus what they pay out to shareholders in the form of dividends, buybacks, and acquisitions.

Put differently, the way corporations receive net financial assets is by making profits, and the way they part with net financial assets after they have made a profit, is by either investing the profit in an economic venture (which ultimately becomes wages that are collected by households), or by paying the profit out in the form of dividends.  The net saving of corporations is what they receive, minus what they pay out, therefore,

(3) Corporate Saving = Profit – Investment – Dividends.

Combining (2) and (3) and rearranging, we have an equation for profit,

(4) Profit =  Investment + Dividends – Household Saving – Government Saving – Foreign Saving.

This is the Levy-Kalecki profit equation, first proposed by Jerome Levy in 1908.

What a Free Lunch Looks Like in a Barter System

This is the third part of a collection of pieces on money and debt.  Be sure to read the first part, The Meaning of Money, and the second part, Money: Power, Security, and Status.

The best way to understand the costs–or risks–of continually financing large portions of public expenditures with newly-created, i.e., “printed” money, is by removing “money” from the equation altogether, and tracking the concept instead.  In this piece, we will analyze a fictional economy that conducts the same print-and-spend activity without there being an actual printing press, or any referential money of any kind.  We will explore what such an economy looks like, and how it functions.

Suppose, then, that we live in an economy in which there is no money, just people with time and labor to trade among each other.  Though each person in this economy has unique, specialized abilities, we will assume that, with a few exceptions, these abilities add the same value, and that the time and labor of every healthy adult in the economy is therefore worth a similar amount, in real terms.  This assumption is not true in a real economy, but we are positing it in our hypothetical economy to simplify.

You are sick.  I am a doctor, so I give you treatment–it takes an hour of my time.  In exchange, you provide me with a steak that you grilled up–it took an hour of your time.  Alternatively, if Jim is sick, I provide him with the treatment, and he gives me the steak that you provided him in exchange for his having cleaned your house–which took an hour of his time.  An incredibly inefficient system, no doubt, but one that effectively conveys the tangibles that are traded through money in a real economy.

Because there is no money, individuals in our barter system have to use promises to coordinate reciprocation across different time periods.  During the time that I am treating your sickness, you will not be able to grill a steak for me.  All that you will be able to do is promise to grill one for me later, when I tell you that I’m hungry.  So you make that promise to me, and I treat your sickness.  Later, I tell you that I’m ready for the steak, and you prepare it.

There is an interesting analogy between promises used in this barter system, and money and debt used in a monetary system.  Money would be analogous to the promise: “I will grill a steak for you, at any time, on your request.”  You can “spend” that promise, i.e., demand redemption on it, any time you want.  You don’t have to wait for anything.  Debt, in contrast, is analogous to the promise: “I will grill a steak for you, on your request… but not until some period of time has passed.”  You cannot “spend” the promise until the term expires, i.e., demand redemption on it, until the term expires.

Obviously, when a person promises a good or service later in exchange for a good or service now, the provider of the good or service needs to make sure that the promise can be fulfilled.  Otherwise, a “default” will turn his contribution into charity–time and labor given away for free–which he is obviously not interested in.

Now, suppose that we have a bum who is ill.  He needs help, but he is too weak and mentally deranged to reciprocate help.  Granted, if he is left on the street as a spectacle, he will get public sympathy–those that see him suffering won’t like what they see, and will want to help him, even if for free.  But they aren’t necessarily capable of helping him, and even if they were, the help would represent too much charity, too much uncompensated sacrifice, to ask of a small group of people simply because nature happened to thrust them into his world.     

Because we feel a natural empathy for the bum, we band together as a society, as a collective, and make a deal with the doctor.  If he provides services for the bum, out of his time and labor, we will collectively reciprocate.  We will each give him a small piece of our time and labor, to do something that he needs done.  Right now, he is working on building a house and wants help–so we will increase the number of hours we work each day to help him on that project.

We can think of this action as a kind of crude, bartered version of redistribution through taxation–a charitable obligation that is collectively fulfilled and enforced.  We part with a portion of what we have–our time and labor–and give it to those that need it, through the doctor, who we collectively compensate.

Now, we might ask, in this barter system, what would public borrowing, as opposed to taxation, look like?  It would look like this: instead of offering our time and labor to the doctor now, we would promise, as a group, to provide him with some amount of our time and labor on a date he specifies in the future–to build the house, or to do whatever else he happens to want.

The promise we make, and its mirror image, the claim that the doctor receives on us, could be executable on demand, in which case it would be analogous to newly “printed” money in a monetary system.  Alternatively, it could be executable only after some period of time, in which case it would be analogous to debt in a monetary system.

Now, suppose that we decide that we want to live in a society where doctors perform a lot of compensated public charity–charity for the poor, the sick, the disabled, the elderly, everyone in need.  But, as a collective, we don’t want to have to part with our time and labor, to compensate the doctors for their efforts.  Can we escape the burden?

The answer is yes, with an important caveat.  If the doctors want to have claims on our time and labor not for the purpose of actually exercising them, but for the intangible value–the power, security and status–that having those claims brings, then we can make promises endlessly.  The doctors will be performing uncompensated charity, free labor, without even knowing it.  They will be doing work for others that will never be reciprocated.  Or rather, the reciprocation will take the form of the comfortable thoughts, feelings, and states of mind that come with knowing that one has power, security, and status.  Because no actual redemptions need to be made, there is an infinite supply of the promises that can be given.

Unfortunately, we cannot be sure that the doctors won’t ever want to exercise the claims or demand redemptions on the promises.  Maybe they won’t want to exericse them now, but that doesn’t mean that they will never want to exercise them, or that the promises won’t slowly leak out of their hands, into the hands of those who will want to exercise them.

Suppose, then, that in the future, the doctors decide that they want to exercise them.  They identify a need, and tell us to do work to satisfy it.  We will either have the free time and labor to do that work, and, equally importantly, be willing to provide it, or we won’t.  If we will have the free time and labor, then we will provide it, and this will be our act of reciprocation, of “paying” for the services that were never intended to be provided for free.  If we won’t, for example, because we’ve made the same commitments to other people, who also want to exercise claims on our time and labor, or because we’ve made commitments to our own leisure–and aren’t willing to do the work right now–then we will need to utilize interest.

We have these claims on our time and labor that we’ve created and given away.  More of them are being executed than we have room to support, and so we need to find someone with a claim who is willing to refrain from exercising it.  The way that we do that is the same way that an airline finds people to get off of an overbooked flight,

“Unfortunately, this flight is overbooked, and we are actively looking for people to take the next flight.  Please, if you are willing to give up your seat, we will give you a free future flight to any city in the country.”

This is the same thing that happens with interest: we offer to give claimants more future claims if they agree, for some period of time, to not execute the claims they currently have, claims that we don’t have the present ability to make good on.

Notice that in a monetary system, this problem can be resolved through inflation.  We stand back and let all of the people to whom we’ve made promises exercise their claims, spend their money, or deploy it into non-money investments.  The economy doesn’t have the capacity to fulfill all of these claims, receive all of this spending, support all of this investment, so prices rise.  Whoever holds money during the rise–and someone must, because not everyone can win the bid–becomes the sucker who loses out, whose claims are automatically reduced by an adjustment of the monetary index itself.

But notice that this can’t happen in a barter system, because there is no money!  The collective is trapped, there is no self-created currency that it can inflate to escape from its prior commitments.  Thus, if the claimants want to exercise their claims, even though the spare capacity to meet those claims does not exist, the collective must either explicitly default on the claims, or offer to pay sufficient interest to motivate claimants to postpone their exercise.  The collective has to become American Airlines, and promise future flights to whoever agrees to get off of the currently overloaded plane.

Now, when we, the collective, use interest to postpone the exercise of claims that want to be exercised, we don’t really escape from the burden they entail.  We still have to give our time and labor to those to whom it is owed.  The interest simply allows us to push the obligations off.  Unfortunately, the interest also grows the obligations.

If we are growing faster than the interest payments that we will have to offer–now and in the future–to keep the overflowing commitments that we have made from being exercised, or even better, if the services that we wish to fund through those promises will increase our productive capacity, our ability to redeem promises, it makes sense to use interest to delay the reciprocation.  But if we are funding unproductive charity, then using promises and interest to postpone the reciprocation would not be the right choice, especially in a barter system where we cannot use inflation as a way of extracting work from people (i.e., the holders of money who lose parts of their wealth to it).

Let’s conclude with some monetary insights from this barter example.  The problem is this.  When we fund government expenditures–such as healthcare–with newly created money, the person that we pay with the money–the doctor–is doing for work for someone else–the patient.  But no one–not the patient, and not the collective, i.e., the taxpayer–is doing any work for the doctor in reciprocation.  It seems, then, that the doctor is doing work for free.  But, if you ask the doctor, he will insist that he is not doing work for free.  He is running a business, not a charity.  So what gives?

Trivially, over a given segment of time, an economy will only have the capacity–the labor base, the real resources–to absorb some finite quantity of claims placed upon it, some  specific amount of money spent.  When new money is created and paid to people for the work they do, there are three possibilities.

(1) The economy’s capacity might grow commensurately with the creation of the new money, allowing the new money to be spent without inflation (assuming all else is held constant).

(2) A sufficient number of people might want the money not to spend or invest it, but to have it, to hold it–for its psychological value.  In that case, their saving of the money will cause it disappear from the economy.  There will be no inflation.

(3) The money might be spent in a situation where the economy does not have the capacity to absorb the spending, in which case there will be inflation.

Now, many hardcore fiscal expansionists appeal to (2) as a reason why US policymakers should undertake a large money-financed spending effort right now.  They point out that the economy is in a slump.  People want to have money just to have it–they don’t want to spend it, and they don’t want to invest it.  Therefore, new money can be created in excess of the economy’s capacity to absorb the spending of it.  No inflation will occur because it won’t be spent.  A genuine free lunch is available, and policymakers are stupidly declining it.

The problem of course is that the economy is cyclic.  It’s not enough to say that the newly created money will not be spent or invested now.  To be a free lunch, the money needs to never be spent or invested.  And, in fairness, it may never be.  According to many, the US and the western world face significant future stagnation as populations age.  Presumably, this will create significant demand for idle monetary savings.  But such a gloomy outlook is hardly guaranteed–it is certainly possible that the cycle of animal spirits, which leads people to prefer to spend and invest their money, rather than hold it cautiously, will return again some day.  If the economy has not grown enough to absorb the plethora of new claims that will come out of the woodwork and be placed upon it at that time, then either interest will have to be paid to keep those claims on the sidelines, or there will be an inflation problem.

What if the cycle is not dead, and does return?  Again, interest will have to be paid to the holders of money to keep them holding it–because there is not enough room for everyone to be spending or investing it, given the amount that has been created.  Put differently, the central bank will have to raise interest rates to discourage people from spending or investing their money (and also from borrowing the idle money of others).  Given the huge stock of money and debt that will have been built up by then, the cost of those interest payments will be quite expensive.  Unless it is financed with even more money printing (which will obviously be inflationary), it will require a large tax increase.  Note that this tax increase is just the “pushing out”–in one big move–of the tax increases that did not occur now to fund the needed stimulatory expenditures.  So unless we can be sure that circumstances will arise that will cause the excess of printed money to never ever be put to use, the free lunch is not really free.

The problem with a big tax increase later, forced by ballooning interest obligations, is that it shocks the economy.  It’s always better for growth, and for prosperity, to change things in an economy gradually, rather than all at once, in an emergency.  This is why, even though the level of expected future savings demand makes room for deficit spending right now without a risk of inflation in the future, the Democratic platform of reducing some of the deficit via tax increases on the wealthy–those who, for various reasons, are amassing large amounts of excess money that they are not spending or investing in labor, the taxation of which will not hurt the economy–makes economic sense, and is better for the economy’s long-term health.  If or when the cycle does turn, the money collected now will represent money that will not need to be paid interest to, and that will not need to be taxed to pay for.

Note that the reduction in wealth inequality that would come from a progressive tax increase of this sort is just an added benefit.  If my having a lot of money brings me security and status in my social universe, that shouldn’t be a problem for you.  Why should you care?  But things are different when we talk about the other intangible that money offers–power.  There are very good reasons why you might not want me to accumulate extreme amounts of power.  Therefore, there are very good reasons why you might not want me to accumulate extreme amounts of money.  That money is power over the economy, over it’s resources, over it’s people, and ultimately, over you, because you, like everyone else, are a slave to it.

Money: Power, Security, Respect

This piece is the second part of a collection of pieces on debt and money.  Be sure to read the first part, The Meaning of Money.

Once money is in the hands of the individuals in an economy that exchange it–individuals with minds, who are constantly thinking, feeling, judging, comparing, evaluating, remembering–it takes on a psychological meaning.  That meaning is what makes it possible, within certain limits, for new units of money to be printed, without any liability attached, and used to compensate individuals for the time and labor they provide to those who cannot repay the favor.

Suppose that the United States were to change its currency to the Grumpel.  One evening, bank accounts are shifted over–every Dollar becomes 43,297.65 Grumpel.  All debt liabilities to others, and all tax liabilities to the government, must now accept settlement in this new currency–which looks different, feels different, and sounds different when spoken.  If you were to go to the store to make purchases in Grumpel, how would you know what was expensive, what was cheap, and what was reasonably priced?  Because you have no psychological history with the currency, you would have to continually make conversions in your mind–to the currency that you do know, Dollars.  When you see something selling for 7,144,112.25 Grumpel, you would calculate, and realize, ah, that’s $165.  For a pair of Levi’s jeans?  No way.

Because we have lived in an environment of stable prices, with gradual, virtually unnoticeable inflation every year, dollars have an independent, objective meaning to us.  They are real things in our minds, with their own independent worth–on a par with the worth of the types of things they have always been able to buy.  Consequently, they are able to offer intangible value to whoever holds them, value that is not contingent on their actual use in making purchases.  Earning $100,000,000 and sticking it in the bank can feel great–even when you don’t have anything you want to spend it on, and never will.

When you have large amounts of money, you have power.  Even though there is nothing extra that you want others to produce for you right now, over and above what they are already producing, having money means that if, in the future, you identify something that you do want produced for you, you will have the ability to secure it for yourself.  Simply knowing that you have this ability will bring you satisfaction and comfort–sometimes more satisfaction and comfort than its actual use.

When you have large amounts of money, you have security.  If something bad unexpectedly happens to you, the money that you’ve set aside will allow you to continue your current lifestyle.  Simply knowing that your current lifestyle is secure–protected from capricious threats and dangers–allows you to relax and more easily enjoy it.  For this reason, you continue to add to your savings, you continue to work and generate income, even though you don’t plan to currently use it, and might never use it.  If you don’t ever put the money to use, no problem at all.  You can leave it for your family, your children, to provide for their security.

When you have large amounts of money, you have status.  Money is one of the chief ways that society measures status.  Imagine that you are at a dinner party with interesting people that you haven’t met.  Someone asks you, what you do for a living?  Answer #1: “I’m a boys special education teacher at the local middle school.” Answer #2: “I’m an investment banker, I work at Goldman.”  In terms of improving the plight of real human beings, the special education teacher might add more value to the world than the banker.  But who will receive more fawning?  The answer is obvious.  Like it or not, money has immense meaning as a status indicator, and a significant portion of society uses it to measure who’s who.

The satisfaction of almost every success in life has a large social component.  The gratification is not only in the success itself, but in the fact that it is seen and acknowledged by peers–or better, celebrated by them.  Money is one of the main ways in which this social component is accounted and displayed.  It lets people keep score–assess how they fare relative to their peers, those against whom they measure themselves, and with whom they expect to maintain par.  Nothing breeds more strife in the workplace, for example, than for a person to find out that she makes significantly less than her coworkers.  The money differential takes on the meaning of an insult–”we don’t value what you do as much as we value what they do.”  And it doesn’t matter how much she makes.  As long as there is a meaningful difference relative to those that she views as her equals, she will be hurt, angered.   

Now, to the economic question.  Suppose that we have an economy of producers and moochers.  The producers have excess capacity, the ability to produce X more things than they are currently producing.  The moochers want those X things, but they don’t have the ability to reciprocate.  To the extent that the producers want more money, not to spend, but to hold as a source of power, security, and status, then new units of money can theoretically be created in perpetuity to accomplish the transfer, without inflation.  Once spent, the new units will accrue into the hands of the producers, where they will disappear from the system.  The moochers will then have what they want–stuff–as will the producers, who will have money and its associated intangibles.  Everyone will have what they want, and will be happy.

In this process, the structure of a well-defined, psychologically-entrenched monetary system will have been exploited to create bona-fide charity: producers doing work for moochers without any need for reciprocation.  Note that this phenomenon is not limited to monetary interactions–it happens in many other areas of life.  As an example, consider a biochemistry professor that works obsessively in a lab to find cures for fatal diseases.  He doesn’t do it for the money, he does it for the intellectual achievement itself–the psychological satisfaction that he experiences in mastering his craft, making discoveries that no one else has ever made, solving problems that will change the world, creating value that will be acknowledged, respected, and jovially envied by everyone in his peer group, and by future generations.  Instead of being compensated for his work in the currency of money, promises of reciprocation that he has no need for, he is compensated in the currency of meaning, challenge, excitement, victory, congratulation, admiration, respect, each of which is far more satisfying than the consumption of the stuff that somebody else can make.

Because so much of the value of money lies in the intangibles that it offers to its holder, rather than in its use as a claim to consume, there is room to print new units of it even when the economy does not have the productive capacity to support the expenditure of those units.  In the US economy, there is ~$11.5T of M2 money, 70% of it locked in savings accounts, a record relative to GDP.  There is ~$3T of base money, net money that is not mirrored or offset as an asset by a corresponding private sector liability, a record relative to peacetime GDP.  If, by the flip of a psychological switch, even a fraction of that money were taken out of savings accounts and used to make claims on things in the here and now, or conversely, if the velocity at which each unit is exchanged were to return to its level of say, 15 yrs ago, the economy would not be able to support the use, and a significant inflation would result.  But because the money sits comfortably (for now, at least) in the hands of those who seek it for its intangible value, who want to have it to have it rather than to exchange it for increased consumption, there is no inflation.

Fortunately, or unfortunately, the individuals most likely to accrue new money that is printed into the economy are individuals who add the most value through their labor, or who own, through corporations, the factors of production, and who can profitably collect rents on the use of those factors.  For perspective, in the US, almost all of the saving that has occurred to mirror the government’s borrowing in the current recession has been conducted by the top quintile of earners, who, not coincidentally, own ~90% of all corporate assets.  Naturally, these individuals tend to be much closer to saturation in their consumption than their counterparts on the other side of the tracks, and to be pursuing the money for the power, security, and status that it provides.  Ironically, it is this entrenched wealth inequality, rightly lamented by so many, that keeps the money from moving around, from being put to aggressive use, and from causing inflation.  To the extent that the individuals who accrue it remain tight and efficient in allocating and distributing it, to the extent that they hold it rather than spend it, and thereby minimize its unnecessary leakage into the hands of those who would spend it rather than hold it, no inflationary harm is done.

If not immediate inflation, then what is the cost of financing large portions of public expenditures with new (net) money creation (or with debt, promises to pay later, which will be financed from such)?  In the next piece, we will explore the answer.