Delayed Impact

Listener 13 May, 2000.

Keywords: Macroeconomics & Money;

To understand the consequences of dramatic change in share prices, think instead about housing. Suppose you are told the value of your house has doubled. Suppose it makes no difference to your behaviour (except a bit of skiting, disguised as grumbling about higher local authority rates). When sometime later you are told your house price has halved, it wont matter much either (except you have another excuse for grumbling).

Another possibility is that because your house price is higher, you decide you are closer to your retirement savings target. So you save less and spend more out of your income. That spending would give an extra boost to the economy. If enough people behaved that way, production would increase and unemployment fall. (That seems to have been happening with rising share prices. Savings out of incomes have been falling here, and in many other countries.) When the price of your house halves, you are now further from your retirement savings target and so you increase your savings rate by cutting back spending. If enough people did that, economic activity would slow down, although in some circumstances the government can increase its spending as an offset.

Alternatively, you might reason that if your house price has risen, it will rise again. So you buy more houses. Perhaps you mortgage your current house, in order to buy them. To illustrate, suppose your house was originally valued at $50,000, and leaps to $100,000. Expecting further rises, you take out a $75,000 mortgage and purchase three more houses of the same value, mortgaging them on the same terms. The figures do not matter too much, but if you are following them you now have $400,000 (4 X $100,000) worth of housing and $300,000 (4 X $75,0000) of debt. Your equity remains the $100,000 of your original house.

If enough people do this, house prices will rise from the additional pressure on demand, and you will have made a tidy capital gain. (I leave the reader to work out how a 10% increase in house prices gives a 40% increase in the equity.) As long as house prices rise, you can keep buying more, using the past capital gains to finance the new acquisitions. Encourage your friends. The more there are in the market, the more demand pressure, and the more house prices will rise.

This seems to be a philosopher’s stone, turning nothing into something of value. For there is no additional production and no increase in the flow of income your houses are generating. A measure of net revenue is the price to earnings (P/E) ratio, which is the (share) price of the asset divided by the annual earnings of the share or asset. Most “new technology” stocks have P/E ratios of more than 100. If your houses had that you would be earning a hundredth (or less) of $400,000, or $4,000 (after paying rates insurance and maintenance and so on), out of which you would have to service the $300,000 debt. You could get a better deal by investing your initial money in government stock at 7 percent p.a. (This gives a P/E ratio of 100/7 = 14.3). Not all your friends will want to invest in such an ultimately low return market, others will get into cash flow difficulties, and some will pull out taking their money with them. Eventually the speculative growth will slow down, peak, and stabilize. With no capital gains, more leave, and prices fall.

Asset prices falls are dangerous. Suppose they halve. (Estimates of the underlying values of US shares suggest they have often been overvalued by a factor of two or three, so a halving is not that implausible.) Then your total assets will be valued at a half of $400,000 to $200,000. But your debts will still be $300,000 so your equity is now negative. To (mis)quote Mr Micawber: “Total assets, twenty pounds, total debts nineteen, nineteen six, result happiness. Total assets twenty pounds, total debts twenty pounds ought and six, result misery.” It is not only your misery. Your debtors may suffer. Suppose you borrowed some money from dear Aunty Flo to buy a house. You wont be able to refund her.

We do not know how much of the US sharemarket boom has been financed by unwise borrowing, although every previous boom has. So we do not know the extent to which, as the market comes off the top, it will implode as investors struggle with negative equity (or illiquidity, when they have the assets to cover their debts but cannot quickly convert them into cash).

What I do know is that it is easier for the sharemarket to get into a speculative bubble than a housing market (where transaction costs are higher). The hype is correspondingly greater there too. (Which major media outlet gives real estate agents a daily slot to unashamedly promote their products? They do for the financial sector.) Thus the greater volatility of the share market will be compounded by great hysteria as it returns to equilibrium. The economic impact takes longer to emerge.