This week, I read this passage in the Economist:
This in turn sparked huge and occasionally destabilising flows of cross-border capital and a massive burst of credit creation. Total credit in the American economy passed $1 trillion in 1964; by 2007, it had exceeded $50 trillion.
This debt explosion showed up not in consumer prices but in asset prices, notably in property. The cycle was self-reinforcing: banks lent money to people to buy property, causing prices to rise, making banks more willing to lend, and so on.
It got me to thinking. To understand the modern economy, you have to account for the general uptrend in availability and cost of credit as described above. The fact that the supply of money has an effect on valuation of assets is simultaneously obvious and also deeply strange and unsettling in highlighting that the notion of valuation is inherently unstable.
To see why, let’s step back and think of valuation. In simplest form, valuation is simply where supply meets demand, but the precursor question to that is how are the supply and demand functions set. Among the approaches to valuation, let ‘s talk about two.
The first is a function of the discounted cash flows of the specific asset to be valued; the second is driven by the ease and availability of credit in the economic generally. Where it gets interesting is when these two co-exist for the same asset and/or where there are both financial buyers (who are relatively indifferent to the asset other than as a store of value) and physical buyers (who will use the asset).
The most obvious place in our everyday lives where this is true is with housing. One method of deciding a fair price to pay is figuring out the sum of discounted cash flows of what you could get (or would have to pay) if you rented the place. Alternatively, you can just figure out what you can pay for something you like: the lower the interest rates are and the more credit is available, the more debt the buyer would be able to handle and the more she can pay. The latter approach — considering what we could pay versus what we would rent it out at — wins out more in our economic culture.
In one sense, one can say it doesn’t matter which approach wins, as long from an individual level the risk is appreciated. But, if you pay more than a home is worth from a rent/cash flow perspective because of a credit boom, then when the credit boom is over, you might find yourself deep underwater. That’s where we are today and have been for the last five years in the economy. So, the rub is that it does matter from a societal perspective, because distortions in valuation can have a serious aggregate economy-wide impact when they are way out of whack. In other words, serious trouble can result if the game changes.
With the historical growth in credit, the credit approach to valuation seems to be more and more dominant in our economy, even beyond property. The leverage needs a place to go. For more and more markets, there seem to be both physical users as well as financial investors looking at the same asset. What may have been at one point actual physical markets with a little bit of hedging are becoming deeper financial markets.
You see this play out in oil, coffee, food stuffs, private equity (the market for companies), in addition to real-estate. More and more, such markets that, in the past, were driven by fundamental supply and demand from physical users are flooded with money from non-physical user investors. These latter users are playing a different game — they are not necessarily concerned whether the underlying physical markets justify a valuation, but instead interested at their entry price and the attractiveness of the exit price.
On one hand, this is a problem in that it causes issues for buyers who need the physical goods. So, why should individuals pay more for coffee or gas because of “speculators?” On the other hand, those speculators/investors would argue that they are adding liquidity to the market, and give physical users a way to hedge and transfer some pricing risk. These are not just problems for little people, filling up their gas tanks or paying an extra nickel for their cup of coffee: big companies regularly complain about speculation in their input markets. For examples, airlines have been screaming about oil markets, and Starbucks has been complaining about the market in coffee beans.
These are real and hard questions. This post does not answer them. But here’s the lesson as players in non-financial markets. It’s important to know what game you are playing — when you are selling or purchasing something, is the market being driven by cash flows, credit, or something else. If you’re going to have to sell the asset, are the rules of valuation in the market going to change? Are the valuations suggested by underlying cash flows and credit so out of whack that there is a lot of risk that things might readjust during your time frame?
These are important questions to consider because if the game changes on you, you can end up being the one played.
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