By John Rutledge
2002
Twenty years ago I wrote a piece for The Wall Street Journal op-ed page called "Why Interest Rates Must Fall in 1982." At that time Wall Street economists were divided up between those who believed Reagan's tax cuts would lead to big budget deficits, which would drive interest rates up, and those who argued that Reagan's tax cuts would stimulate more savings, and drive interest rates down. I argued they were both wrong: Their deficit and savings rate changes would be rounding errors in the biggest portfolio event of the century.
As it turned out, I could not have been more right. Between 1981 and 2001 people in the U.S. shifted more than $10 trillion out of their existing holdings of stuff-tangible assets, like gold, commodities and property-and into financial assets including stocks, bonds and mutual funds. Responding to the collapse of inflation and to tax rate reductions, they drove the prices of paper assets up and hard assets down, creating the biggest bull market in history and forcing a massive restructuring of American industry. If you had gotten that one thing right in 1981, you would be reading this article on the beach. A $100,000 investment then in default-risk-free, thirty-year zero-coupon Treasury bonds, the quintessential financial asset, would be worth more than $2 million today, more than twenty times your initial investment. How many of you can say that about your house?
Don't look around you for economists on the beach: they missed the whole thing. They spent the whole time arguing about budget deficits and trade deficits and revising their quarterly GDP forecasts. Their fixation on macroeconomics-unemployment rates and the GDP accounts-made them miss the greatest show on earth: the $20 trillion repricing and restructuring of the U.S. balance sheet over the past twenty years.
Macroeconomics narrowly beats out Modern Portfolio Theory as the most destructive invention of the 20th century. It gives people the illusion the government can control the economy by manipulating spending and taxes. It provides a rhetorical smokescreen for politically driven tax, spending and regulatory policies. Worst of all, it corrupts our thinking by telling us our standard of living is determined by how much money people are willing to spend.
Macroeconomics textbooks begin with an island metaphor. Some people on the island catch fish, other people pick coconuts. They exchange fish and coconuts with each other, presumably so they get all two major food groups. The island economy's gross domestic product is measured by adding together all the fish and coconuts produced in a year, using an appropriate exchange rate (the market price). GDP serves as a measure of the value of the work people did during the year.
I actually live on the island of Maui, so I know something about island economies. I have fish in front of my house and coconuts in the back, just like in the textbooks. When I go to sleep every night, however, I don't worry about fish and coconuts. I worry about the volcano the island is sitting on. If the volcano erupts during the night, we won't be there to calculate GDP in the morning.
The volcano the U.S. economy is sitting on is our $86.5 trillion balance sheet-the total value of all the financial and tangible assets in the U.S. economy, equal to 8.6 years worth of this year's projected $10 trillion GDP. Even minor disturbances in our huge balance sheet can make waves so large that they swamp the changes in spending, savings rates, budget deficits, and other "flow" measures that macroeconomics talks about. This is especially true for asset prices.
In that Wall Street Journal piece twenty years ago, I outlined a simple idea. There are two price theories. The first-supply and demand-is the price theory of Alfred Marshall and George Stigler. It works well for haircuts, guitar lessons, and other perishable goods and services. The second-portfolio theory-is the price theory of Irving Fisher and James Tobin. It works for bonds, Rembrandt paintings, and other storable assets. To get useful answers we must be careful to use the right price theory for a given situation.
By goods and services I mean things with lots of current production relative to existing stockpiles. Perishable products like professional services, airline seat miles and fresh strawberries are good examples. Assets, by contrast, are things with large stockpiles relative to the rate of production. Examples include Rembrandt paintings (he is no longer painting), '57 Chevy's, and beachfront property (they aren't making any more).
Most products, of course, fall somewhere in between: they are somewhat storable and wear out over time. By measuring their stockpile as a multiple of a year's production, though, we can get a pretty good sense of where they belong in this stock/flow continuum. Medical services, food and apparel are all pretty much goods and services. Land, homes, copper, gold, and even automobiles (there are 150 million used cars, about 10 years production) are assets.
Bonds are assets-their outstanding value is many years' new supply. So their prices, and therefore interest rates, will be whatever it takes to make people willingly hold the existing stock of bonds along with other outstanding assets. Indeed, this must be true for all assets. The mechanism that makes this work is portfolio balance.
Portfolio balance refers to the situation where owners are just content to hold the stock of assets that exists. In that case asset prices will remain at current levels. But anything that materially alters the relative risks or returns of the assets in the portfolio will cause investors to revise their preferred asset mix, forcing asset prices to change until investors are again content to own the existing assets.
The balance sheet for U.S. households and nonprofits showed $48.8 trillion of total assets on October 30, 2001. Roughly a third were held as tangible assets, the remaining two-thirds as financial assets-stocks, bonds and money market funds. The reason I split the household balance sheet into tangible and financial assets is that changes in tax rates and inflation affect tangible and financial assets in qualitatively different ways. Increased inflation, as we experienced during the 1970s, encourages households to increase the share of assets they hold as tangible assets at the expense of financial holdings. An increase in tax rates also shifts demand toward tangible goods by reducing the relative return of financial assets.
The point is that inflation and tax rates exert powerful influence on asset markets and asset prices. Over the past twenty years, inflation and tax rates have both decreased, causing households to steadily reduce tangible holdings as a percentage of total assets. This shift in the national balance sheet has deflated commodity prices to their lowest levels in decades, pushed stock price multiples to historic highs and interest rates to today's low levels. It has also played havoc with the economics of durable-goods industries, which are forced to compete with their own previous products.
Investors ignore this at their peril. During the 1980s, a basket of stocks, as represented by the S&P 500 Index, was valued at two median-priced U.S. homes. This stock-to-home ratio increased to four in 1996, and peaked at more than eight in late 1999, before falling to just under six today (which makes the stock market about fairly valued, at today's inflation and tax rates).
The changes described above have pretty much run their course, so don't look there for your next investment idea. It's the next volcanic eruption in the balance sheets that is going to make you money or eat your lunch. As investors in Enron recently learned, new information hits asset markets fast and hard. Holders of Argentine debt and currency are learning the same lesson. Relying on rating agencies for investment information is just too slow.
My worry list today includes the risk that the Daschle gang succeeds in raising tax rates, the possibility that Argentina's default extends to other commodity-producing countries in Latin America and Asia, and the risk that the Fed and the Europeans will prematurely tighten this year at the first sign of growth, sending commodity prices down yet again.
Here are just a few of the implications of balance-sheet analysis:
*To keep the economy healthy, the proper inflation target for monetary policy is zero inflation of tangible asset prices, not consumer or producer prices. To a first approximation this means stable land, property and commodity price values.
*Real interest rates should be measured using the tangible-asset inflation rate, to ensure that the result properly reflects the spread between tangible and financial asset yields.
*Regulatory changes such as the 1996 Telecommunications Act, by distorting relative returns, exert profound and destabilizing effects on the economy and the financial markets.
*Falling land prices are the heart of Japan's economic problems, implying that real interest rates, measured properly, have been extremely high for more than a decade. There will be no fix for the Japanese banks, and no Japanese recovery, until this deflation ends. Given the myopia at the Bank of Japan, the likely reason for that will be a major drop in the value of the yen, which will have important effects on the economies of China and other Asian nations.
*Balance sheet disturbances in other parts of the world are just as important as asset shifts at home. At the turn of the year, Germany's capital-gains tax rates were reduced to zero for corporate shareholders. This will tilt relative after-tax returns toward Germany, push the Euro up against the dollar and let loose a wave of intra-European business consolidations.
Keep your eyes on the balance sheets, not on GDP accounts, and I will see you on the beach in Maui.