Apr

8

the asset side of the economy
I think we have a problem that stems from a confusion between the asset side of the economy and the liability side of the economy. The assets are land, plants, people. They produce something. They create wealth. Sometimes this is called "the real economy."

The liabilities are financing the asset side, but they don't create wealth by themselves, or only at the margin (via tax arbitrage mainly). They are: stocks, bonds, etc… They are the oil in the engine, not the engine itself. The Fed is part of the liabilities.

What macroecomics is sorely lacking is a Modigliani-Miller theorem. As you know, the Modigiani-Miller theorem is a corporate finance finding that what matters is the asset side of the balance sheet, not the liabilities. The way it is financed doesn't change the value of a firm. It needs to be extended from corporate finance to macroeconomics, and I am happily providing it here as a conjecture, because at this stage it is not a theorem yet: "In a tax-free world, finance is irrelevant to the real economy." That means monetary policy is irrelevant, the Fed is irrelevant. What matters for wealth creation and growth are people, plants, and land.

Things were going well until the late 1990s because of the asset side:

1. reconstruction after WWII
2. baby boom
3. cheap oil
4. wave of innovation
5. no competition from emerging countries– they were communist, and, in hindsight, communism was great for Western Europe and the USA, because it meant less international competition

All these positive factors meant the asset side of the economy created huge value. It would have done so with or without monetary policy, with or without central banks, with or without banks actually. Now the positive factors are gone. The real economy is doing poorly and it will do so no matter what is done in terms of monetary policy, which is I repeat, irrelevant.

That's why we can have huge unemployment, that's the assets world, and a booming stock market, that's the liabilities world. They really operate independently.

Alston Mabry writes:

I'll bite.

The last few years appear to have been a story of how much finance does matter, unless one argues that the global downturn was a purely secular matter coincident with a financial collapse. Now, I have felt that the importance of the cyclical downturn in real demand got less credit than it should have, but it would be tough to argue that finance doesn't matter.

At any given point, there is some interplay between the finance side and the real asset side. The nature of that interplay changes over different regimes. There are times when lax monetary policy is just "pushing on a string" because there is no demand waiting to be unleashed by loose money. There are other times when changes in policy can have a much larger effect. And monetary policy is just one vector of finance. Finance can matter a lot, in different ways, at different times.

The asset world and the liabilities world certainly can operate independently, but we may also be seeing the markets work as predictors of what is going to happen in the "real" world.

Rocky Humbert disagrees:

I disagree that what macroeconomics is sorely lacking is a Modigliani-Miller theorem.

The practical interpretation of Modigliani-Miller is that leverage doesn't matter (to an enterprise) and while it has limited merit in structuring an enterprise during normal times, any sensible executive (or hedge fund manager) who has lived through a severe business contraction or credit squeeze will laugh at the notion that leverage doesn't matter. M-M correctly observes that a lousy business with 2% ROE is still a lousy business with 20% ROE (after 10:1 leverage). However, M-M doesn't say that a decent business with 7% ROE can be turned into a lousy business with 70% ROE (after 10:1 leverage). That is, leverage can't turn a lousy business into a great business, but it can turn a great business into a lousy business. After after that cyclical downturn, the company with less leverage will have less competition, more market share and greater unleveraged ROE. Lastly, if debt doesn't matter, why does anyone care about a rising national debt? Given the choice, I'd prefer a restoration of the Papal Vix Pervenit to a M-M in macroeconomics.


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