Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

If asset focussed money supply growth (MS growth over and above GDP growth) drives asset prices upwards, then as Central Banks cut interest rates to stimulate economic activity (loans which create deposits) and or support asset prices (which includes QE which also creates new deposits), we should see a) increases in the demand for asset focused loans (which creates new deposits) and b) changes in the velocity of the existing stock of money supply within the market asset portfolio (I want to reduce money as % of portfolio). 

Increases in deposits and lower interest rates will have repercussions on relative wealth as asset prices are bid up, but this is a lot more complex than it first appears:

Those who own assets and benefit from an uplift in prices will see a rise in wealth and consumption capacity.  If the GDP flows remain the same for existing asset holders, units of capital consumption (used to make up any deficit between planned expenditure and income from assets) will now be a smaller % of the overall asset portfolio and capital consumption (selling an asset in exchange for money to be spent on consumption) gives up a smaller yield.  Total potential consumption, making no other assumptions, with respect to this type of asset class has risen. 

Many state that asset prices adjust because of discount factors, but the truth is discount factors only value flows; it is in fact monetary conditions and demand for money vis a vis other assets within the asset portfolio that drives asset prices towards discount factor benchmarks.

In a period of asset price inflation, those who do not own assets prior to the inflation, end up paying more for those assets and/or may have to borrow more for those assets.  

If the fall in interest rates translates into a rise in real flows from assets, that is the decline in the discount rate reflects a fall in inflation while nominal flows and their growth rates stay the same, existing holders will see a rise in wealth from future flows, whether or not this is discounted back into the price (price only matters when you sell, flows received are immutable). 

New holders, in this scenario, if we assume that the price adjusts to reflect the real value of flows, may end up paying a similar price for future flows that existing holders paid before the revaluation but, if we exclude any revaluation in human capital flows, they will not benefit from the rise in flows that led to the price revaluation – note also that the value of future flows for risky assets are not displayed in current yields but in in the growth rates of flows. 

But the wealth adjustment, if indeed the real economic flows have improved, should also be taking place in human capital, assuming all other things being equal

While those without or with fewer assets may be paying more for assets than before the revaluation, the risk and the cost of the higher asset prices may actually be balanced out by the rise in the value of their own discounted future earnings.  This enables them to pay for the higher prices via higher returns on their own human capital. If what we see in the aggregate is what happens on average then a rise in future GDP flows will benefit holders of risk capital and human capital alike and all would benefit equally from a rise in flows whether it be via asset prices or earnings.  On an economy wide basis this depends on income and wealth distribution.  

If growth in human capital income flows are unequally distributed (as they have been) the wealth effects are not going to be balanced.   Whoever gets more growth in income will be getting a a better deal on buying assets.  

In  Striking it Richer: The Evolution of Top Incomes in the United States (Saez E, June 2015) real growth in incomes over the period 1993 to 2014 rose on average by 20%, for the top 1% this was 80%, for the remaining 99% this was 10.8% (table 1); circa income for the top 1% rose 8 times relative to the remaining 99%.  Between 1993 and 2014 real earnings of the S&P 500 rose by 190%, the real price rose by 174% (source data Shiller/Yale dataset).  In a 2014 blog post, Atif Mian and Amir Sufi posited that 80% of all financial assets were owned by the richest 20% of the population (as of 2010). 

While the two data sets do not necessarily correlate, the point is moot: those who have higher incomes can save more and are more likely to own more financial assets: if income inequality is increasing then not only is the relative price of assets rising more for this with less income growth but the increasing gains we have seen, in terms of profits growth versus wage growth, on financial assets will also be increasingly distributed to those with higher income growth.  Risks therefore for accumulating financial assets are smaller for higher income growth brackets (personal earnings growth adjusted) and vice versa for lower. The wealth effects are accumulating for a large majority of the population while the relative risks of asset purchase via the human capital equation, have been much higher. 

Given that after tax corporate profits as a % of GDP flows have been rising, wages have been falling and corporate profits growth rates relative to GDP flows have been rising, it should be clear that those with higher earnings and higher percentage allocations to risky financial assets, in the US in this instance, are bearing a much lower level of asset price risk.   This risk further enhanced if we assume income earners outside the higher echelons are also taking on higher levels of debt and this is supported by a number of studies:

From “Income Inequality and Household Debt Distribution: A Cross-Country Analysis using Wealth Surveys”, Claire Lebarz, September 2015: “Our analysis provides evidence that the countries which have grown more unequal are also the one where the distribution of debt along the income distribution is the most unbalanced, in the sense that households at the bottom of the income distribution experienced a high increase in leverage compared to households at the top, without an increase in income mobility. This link is found persistent after controlling for sociodemographic differences, life cycle effects and shocks to households revenue in deciles regressions.“

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Unfortunately, a decline in the discount rate accompanied by a rise in the net present value of flows assumes real growth dynamics have improved: this is not the case in today’s world.  

But if GDP/income flows or their growth rates are declining, and let us say that flows are declining in proportion to the change in interest rates, then the revaluation of risky assets relative to flows and discount rate should not result in a change in price: the appreciation in capital value being equivalent to the change in present value of flows, for which the change would be zero in this instance.  Likewise, if the growth rate of income also declines then you will not see a revaluation in human capital via a downward shift in the short term discount rate. 

If income and wealth capital are unequally distributed, an upward re-pricing of assets that contradicts what is happening to flows (i.e. asset prices assume discounted flows have risen when they have not, or the discounted present values have remained the same when they have actually fallen) will see a “temporary” wealth effect concentrated in only a small % of the population – I say temporary because the differential will be picked up over time.   The risk is with those outside of the top few percent of income earners and who have not accumulated assets that have revalued upwards.  This segment of the population, if saving or buying homes, will be purchasing over valued assets – they will be sacrificing current consumption for less future consumption. 

We could therefore see a de facto latent embedded future consumption shock amongst a significant part of the population and it is likely that this is part of what we are seeing at the moment.   Increases in consumer credit, relative to growth in disposable income, to finance consumption in this segment further leverages this latent consumption shock.  The rise in debt to income may well reflect the decline in income growth, especially income growth outside the top income earners. (1, 2, 3, 4).

Therefore even those who are not directly buying into the asset market and who fall into those areas experiencing lower than average income growth are exposed to a negative wealth effect via declining real rates of human capital flows.  Wealth effects are not just conventional asset priced and human capital wealth effects can actually come pre asset price shock, especially where we see stress in the relationship (i.e. increased consumer credit relative to income).

Forced low interest rates and monetary support that raise asset prices while growth rates of flows are slowing within an economic paradigm that is seeing a) low income growth, b) increasing inequality in income distribution and c) higher rates of debt financed consumption will be seeing a negative human capital wealth effect for those with weak income growth even in the absence of an immediate asset price shock.   Supporting asset prices is merely an attempt to defer the necessary rerating in non human capital asset market prices.  In truth this issue is one that has been staring at us in the eye ever since LTCM, it is just that most are unaware of it.

So debt affects GDP flows and asset pricing, and GDP/national income flows and their distribution should affect wealth and asset pricing.  But within a paradigm where we have increasing inequality of income distribution (high versus low income earners and risk capital versus human capital) we are likely to see an accentuation of the divergence between asset prices and GDP and an accentuation in the asset focus of money supply growth. 

If assets revalue upwards during a period when flows and/or their growth rates are in decline, at a greater rate than the decline in the discount factor can adjust for, due to changes in frame dynamics, inequalities of distribution and other transitions, individuals will likely be subject to errors in expectations over future returns that may or may not include increasing consumption of capital (helocs) when they should not and raising consumption of present income (consumer credit) when they should not.  This builds latent demand and asset price shocks.

It is important to note that asset price shocks for correctly priced assets should not necessarily cause a drop in consumption: if real flows pre and post shock are more or less the same and asset prices stabilise and recover, nothing has really changed.  Incorrect pricing, i.e. where expectations over flows are incorrect and discount rates are enforced and do not reflect system dynamics are completely different.  There is a big difference between an asset price shock and myopic wealth effect from equilibrium levels and the same from out of equilibrium levels.   

Today, flows on fixed interest investment and money have also fallen lower and the risk with this is that flows on lower risk assets are being squeezed to maintain asset pricing margins on flows of higher risk assets.  This increases the duration of portfolios and exposes them to higher potential shocks to capital values while reducing access to areas of the portfolio that would traditionally provide yield and capital protection: this is especially important for individuals and entities who are liability constrained, i.e pension funds ans those outside the higher wealth/income echelons.  Again this is yet another potential risk wrinkle that would rise in portfolios from to aggressive monetary easing.  Yields on sovereign (1, 2, 3, 4, 5,  and corporate debt (1, 2)   have also been falling in real as well as nominal terms: these all pose consumption risks.

So we also have liquidity issues building up within asset market structures that likely  reduce volatility on higher risk asset classes on the way up, as monetary policy becomes more accommodative and liquidity moves outwards, that lays the groundwork for higher volatility and liquidity issues in an actual asset price shock, magnifying the wealth effects.   This greater potential for a wealth effect shock can be traced directly to asset focused monetary policy and leverage occasioned by money supply and interest rate dynamics.

So returns on lower risk assets are being squeezed to maintain the flows on risky assets via ever lower levels of interest rates and returns to human capital are also falling as a % of national income while corporate profits have risen.   So we have further issues accumulating in full view.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

The reality is that at present the growth rate of GDP flows needed to support asset prices are declining.  Asset prices are being supported by monetary policy that emphasise assets as opposed to GDP/national income flows and are being further leveraged by income and wealth inequality dynamics.   This accentuates what may be a natural higher payout to equity capital during frame transitions. 

The very fact that increasing portions of revenue flows from goods and services production are being paid out to holders of capital (dividends, buybacks) is something that will itself magnify risks to consumption given the wealth disparities we have accumulated within our economic structures.  This would not be a wealth shock per se in a competitive market, at equilibrium, with rationale and informed individuals.  Hence we have further de facto shocks to consumption that are part and parcel of current economic and financial habitat.  These are wealth shocks being transmitted despite the fact that total wealth to GDP still stands close to historical peaks.  The rise in wealth to GDP rather than indicating the health of the financial system is more an indicator of its stresses and imbalances.

If we are in a declining frame, whether this be declining nominal flows, declining growth rates of flows or even outright contraction in real flows (which could happen), then the imbalances caused by the higher payouts of flows to holders of risky productive capital will continue to aggravate the economic frame and its stability.  That Central Banks and governments have chosen asset price support as opposed to more direct support of GDP flows is a cause for concern: the longer imbalance continue the greater the divergence and the larger and more prophetic the asset price correction.  This has tectonic parallels.

In conclusion we have some very important issues:. 

  • Asset prices to GDP ratios are at extremes globally and especially so with respect to the growth rates of flows.   Yes, discount rates have fallen, but so have real flows.  Wealth effects are greater for those buying at high valuations, especially those with leverage.
  • Debt to GDP/national income flow ratios have increased and stand at extremes globally, and this debt appears to be more highly weighted relative to income at income distributions outside the higher echelons. 
  • The rise in asset values relative to income flows is a concern given that human capital values should be similarly valued in an economy at equilibrium.   As we know we have imbalances in the distribution of income flows, significantly raising risks for the majority, and reducing relative risks for the small minority of income earners with high income growth rates.  
  • Point C is compounded given that we have structural imbalances with respect to distribution of national income at a number of levels: between lower and higher earners and especially so in the top 1% and higher; between profits growth and GDP growth, especially with respect to wealth inequalities, and higher growth in payouts to equity capital vis a vis human capital. 
  • We have a clear disconnect between the valuation of human capital and assets, and especially so with respect to human capital outside the top few percent.  Combine this with higher levels of debt and lower levels of financial asset wealth for those outside the top few percent and the risks to debt and wealth accumulation increases for this majority. 
  • Wealth effects are not uniform and unconventional monetary policy likely exacerbates this divergence.  Unconventional monetary policy supports asset prices a) via low interest rates that impact portfolio allocation and flows to different asset classes (impacting liability and liquidity risks), b) via QE that leverages asset prices via additions to MS and the subtraction of assets for the increased MS focus, c) via possible accentuation of share buybacks and capex declines in a declining growth frame dynamic (demographics,productivity and income inequalities).  
  • The accumulation of issues are further leveraged via the natural dynamics of declining frames (either absolute or in terms of growth rates) that see higher distributions of earnings via dividends and share buybacks to owners of capital: increasing income and capital inequalities and asset focused monetary policy plausibly aggravates this natural process.    

Interesting links and documents

The Relationship Between Income and Wealth Inequality: Evidence from the New OECD Wealth Distribution Database, July 2015,

Determinants of US Household Debt: New Evidence from the SCF , Draft version, September 2015.

Debt, Inequality and House Prices: Explaining the Dynamics of Household Borrowing Prior to the Great Recession, September 2015

Britain in the Red: Provisional Report Damon Gibbons & Lovedeep Vaid September 2015

Credit Card Market Study Interim Report: Annex 6 – Affordability analysis November 2015, FCA

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