Wednesday, December 10, 2008

The Timing of Deflationary Downtrends

Austrian economics conceptualizes asset bubbles as being the result of credit expansion in fractional reserve systems. Once the forces fueling the expansion have exhausted themselves, it anticipates asset prices will drift back to “fundamentals” where costs of investments are justified by dividends and risk. Austrian economics explains the reason economic bubbles happen and their ultimate deflationary course (excepting cases of hyperinflationary events).

This post will examine two questions: how long and how high can these credit bubbles go, and once they reach their stall point, how long can inflated prices persist before they return to fundamentals.

Prior posts proposed the “cash-inventory equivalency” where the combined prices of all goods for sale in an economic system tend to self-adjust such that the sum exactly equals the money supply, which in a fractional reserve system is the sum of printed currency and credit. If money supply increases, then prices will follow; if credit and/or printed currency contracts then there is downward pressure on prices else velocity of sales slows and inventory starts to build. “Price disequilibrium theory” anticipates that if money supply grows through an unsustainable expansion of credit, then prices which were inflated as a consequence will be pressured downward once credit collapses.

If such is the case, then peak prices would be consistent with peak credit, assuming printed currency holds constant. Though printed currency is not holding constant at the moment, this discussion will consider the theoretical situation where it does. In hyperinflation, the entire economy collapses and would be in limbo until a new money supply is established. Settings of moderate printing could still be assessed with this model where money supply is the sum of printed currency and credit. But for simplicities’ sake, it will not be.

I have argued before that in our current system banks have nearly infinite capacity to lend, so the limits of credit expansion is not with banks but with borrowers. The limit of credit growth is when borrowers do not have the ability to repay loans anymore, so they can’t borrow anymore. This stands to reason. Unfortunately, it is wrong—otherwise this would all be mathematically straightforward. In the present crisis, credit was expanded beyond and oftentimes without regard to the likelihood of loans being repaid. Banks didn't seem to care. So the question becomes, how far can that go?

The farther this trend does go, the more corrective forces will start to resist further lending. Failure to repay loans will erode the capital base of banks. The political tolerability of bailouts will eventually wear thin as these loses start to mount. As the capital base of banks heads toward zero through failures of loan repayment, the terminal limits of credit expansion would be the willingness of banks to risk their corporate viability on loans which have little chance of being repaid. For each bank, risk appetite will be slightly different, but the general erosion of the capital base of multiple banks marks the endpoint of credit expansion.


Now, for the second question of how long it takes for prices to return to fundamentals after the credit contraction begins. If the prices of investments rise above their fundamental values, and prices keep going up and up, then their worth as investments is driven by the expectation of continued capital gains. Once the credit peak is reached and begins its contraction, further capital gains ought to no longer be expected, and the investment value of an asset is only its ability to generate dividends, rents, or yields. If there is a great discrepancy between disequilibrium asset prices and their fundamental values, then once the peak is reached asset prices should descend immediately to their fundamentals. At this point no buyer should pay more than that. To do so would be “catching a falling knife.”

But the price correction won’t happen immediately; they are slow with losses and advancements, and occasional bear runs, cycling over and over around a downward trend line toward the eventual correction.

Another way to look at the question is to ask why the seller should lower their prices? Prices are a negotiation between the buyer’s desire for the good and the sellers want of money. As desire for over-inflated assets drops, and as sellers need the money—if they need the money—then prices begin to budge downward. If a seller has infinite resources an can hold out forever for a supposed turnaround, and they never need to “cash in” on a held property or investment asset, then prices could stay elevated forever, as velocity slows to a crawl.

If there is a holding cost to an investment—like interest payments on the money to purchase it, or property taxes, maintenance, and fire insurance—then pressure starts to mount on underperforming investments. If maintenance costs exceed rent for comparable properties, then the duration one can wait for the turnaround of property values is a function of economic capacitance, or duration one can weather negative cash flows through dipping in to savings or selling unneeded assets. Once economic capacitance is exhausted, the asset must be sold and the price it fetches reflects market value.

An economic system is composed of many micro-economies—of individuals, families, businesses small and large, non-profits, and government at all levels—and the economic capacitance of each will vary. In a disequilibrium contraction, prices move downward if a critical mass of asset holders are forced to sell at re-adjusted prices such that the market value is reset downward.

So, in price disequilibrium events, the upper limit of credit expansion is when the capital base of banks erodes through the non-repayment of loans. The maximum duration prices remain elevated after credit stalls is a function of the economic capacitance of those who hold the assets.

No comments: