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Share markets, equities and monetary policy
Gerard Jackson
The current debate about the state of the markets has highlighted the gross error that a rising stock market always signifies economic growth. It does nothing of the kind. This is a fact that America's Great Depression should have rammed home but clearly failed to do so. Then there the error that springs from the so-called "equity premium puzzle".
For those not acquainted with this rather remote debate, it concerns the difference in returns to bonds and equities. It is generally taken as given that the risk premium emerges because equities are volatile while bonds provide a 'guaranteed' income. However, it has been noted that the extent of the difference between the two investments significantly exceeds any reasonable estimate of risk. This is where Glassman and Hasset entered the scene. They argued that the difference is generated by investors irrationally demanding an excessive risk premium.
One can therefore deduce from their argument that investors' excessive estimate of risk keeps markets undervalued. It follows from this that once investors realise their error the risk premium should quickly drop causing stock prices to surge. It is my opinion that this view is a grave error and that it probably derives from the application of general equilibrium thinking to market processes, i.e., static analysis to dynamic situations.
Equities are shares in companies while bonds are fixed interest securities. When one buys a bond it is the equivalent of lending money at a fixed rate of interest. The bond itself is not a claim on capital in the sense that equities are. Buying equities means buying entitlements to capital goods employed by the firms that issued the shares. As the value of a firm is the sum of its discounted anticipated earnings, it is clear that the value of its shares will vary with the earnings stream.
Looking at the situation from this angle, it becomes clear that there is no reason why the return on equities should correspond with the return on bonds. Those who argue that they should are tacitly assuming an equilibrium situation prevails. It is true that if the economy was in equilibrium all returns would be equalised and would correspond to the rate of interest. In fact, these returns would be the rate of interest and markets would have ceased to exist.
However, we live in the real world of uncertainty where markets exist because we do not have perfect foresight. Therefore the role of the market is to coordinate and distribute expectations and masses of incomplete knowledge to market participants who will then act according to their own expectations and experience. The world of uncertainty brings us to the nature of profit and its effect on shares. In a progressing economy — one that enjoys rising per capita investment — aggregate profits will always exceed aggregate losses.
Obviously, if firms consistently make profits then the value of their shares must steadily rise. This means that equity returns must exceed the return on bonds. The reason is the nature of profit. Ludwig von Mises explained that profits are maladjustments between supply and demand. Hence factors become underpriced in relation to the value of their products whenever a genuine profit appears.
Let us assume a general equilibrium position where all returns have been equalised. There would be no profits or losses and uncertainty would have disappeared. Let us now introduce uncertainty and losses but not profit into our model. Obviously a risk premium would now emerge. It should be equally obvious that the difference between the return on bonds and equities would be pure risk.
The final step takes us into the real world of profits and losses where economic progress is the order of things. We would now find that the difference between bonds and equities has widened further because we now have to account for aggregate profits exceeding aggregate losses. Therefore profit equals any return over the rate of interest plus any attendant risk.
In a progressing economy new ideas, inventions, techniques, innovations, etc, are being constantly applied through new capital combinations. This process constantly renders older capital combinations obsolete and leads to their dissolution thereby creating profitable opportunities.
Unfortunately misconceptions about the so-called premium puzzle have provided ammunition for socialists. For example, John Quiggin, an Australian socialist professor of economics, argues that the 'premium' justifies socialising the economy because the difference between returns to bonds and equities means that markets are wasting vast amounts of capital because the risk premium is being overstated (The Australian Financial Review, 6 May 1999).
In his dogmatic view — and Quiggin is nothing if not dogmatic — the case for privatisation rests on the assumption that the "the premium represents the true cost of risk . . ." Actually it rests on the verifiable fact that markets are vastly more efficient in allocating resources than any socialist state could ever hope to be.
If markets are left alone investors can expect to earn profits on their portfolios so long as the economy continues to accumulate capital. Unfortunately, gross monetary mismanagements distorts markets and inflates share prices. Sooner or later unavoidably painful corrections have to be made. When this happens the market gets the blame and calls are made on politicians to take action. This invariably results in highly damaging interventionist policies. All because basic truths about how shares are truly valued and how bad monetary policies cause financial crises have been forgotten.
Gerard Jackson is Brookesnews' economics editor
BrookesNews.Com
Monday 27 July 2009