Tuesday, April 7, 2009

Depression, Recession, and Bubbles, Part II: When Assets Pay for Themselves

As we saw in yesterday's posting, the current financial crisis and that of 1929 share a common basis: money creation for the purchase of goods that do not generate their own repayment. According to Dr. Harold Moulton, first president of the Brookings Institution (one of America's oldest "think tanks"), all money creation for consumption purposes (including government expenditures), as opposed to investment in new capital formation is inflationary, unnecessary, and counterproductive.

Creating money for non-productive purposes leads to what can only be described as monetary and fiscal insanity. When money is created for things that do not pay for themselves, and yet are treated as capital assets (as in the securitization of home mortgages), prices are bid up as more money becomes available. Because the underlying assets can never generate enough income (or any income at all) to compensate the holders in due course of the securities as the prices go higher and higher, the bubble inevitably and necessarily collapses.

Think "P/E Ratio," or "Price to Earnings Ratio." The P/E Ratio is a tool used by financial analysts to try and determine whether a stock issue is a "good buy." It is a very old technique, dating back to at least the Middle Ages, where a prospective buyer would get an estimate of the value of the future crop to be produced from a plot of land, multiply it times a factor that rarely exceeded 15, and pay that price. The assumption was that the land would pay for itself in 15 years or less, depending on the factor used, and how productive the new owner could make the land. This was referred to as buying land for "15 years purchase," or however many years the buyer and seller agreed was fair — an implicit understanding of the idea of the "time value" of money.

Similarly, an analyst will look at the earnings per share of a company, and divide the price of the share by the annual earnings attributable to that share. Comparing the result with the company's ROI ("Return on Investment") presumably tells the analyst whether the stock is a good buy. If the P/E Ratio is, for example, 15, the pro rata income attributable to a single share will presumably be enough to pay for the share in 15 years, whether paid out as dividends (resulting in current income), or retained in the company (resulting in capital gains and realized income when the share is sold).

This theory, of course, assumes that the secondary market for shares ("Wall Street") accurately reflects share values as representative of the actual worth of a company. Since most investors are fully aware that is not the case — gambling and speculation have a great influence on share values on the secondary market, regardless of the earning power of the underlying company — the P/E Ratio, like most financial "tools," is considered only a handy, "rule of thumb" guide to the real value of the shares.

All of this, of course, assumes that savings have been accumulated before the purchase of the capital asset, and the new owner is simply recovering the cost of what he purchased, and thereafter deriving an income from whatever is produced. When existing accumulations of savings are involved, the damage is limited in scope, as we saw in the "Dot Bomb" collapse, which involved no one other than the people directly involved.

What happens when money is created for consumption or investments that do not pay for themselves is another matter entirely. That involves the whole of the financial system, which rapidly spreads to the whole economy as the consumer spending financed by the new money creation grinds to a halt in response to the sudden disappearance of the new money that was fueling the spending and the consequent inflation. That is what we will examine tomorrow.