Why Alan Greenspan is wrong again
In a course I had just finished teaching at the Singapore Management University, I told the students that bonds could never be in a bubble and only stocks could and are. On 1 August, according to a Bloomberg story, Alan Greenspan said, “We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.” This column contests his conclusion.
Bubbles are a reflection of optimism gone to excessive levels. Prices of stocks reflect a discounted stream of future cash flows from owning that stock. The denominators are future interest rates and the numerator is the future cash flow stream. Stock markets can ratchet up expectations of future cash flows from owning the stock and thus rationalize any stock price. In theory, there is no ceiling on optimism about future earnings. That is why it is hard to call the market top in stocks correctly. The reputation of market seers is destroyed before stock bubbles burst. So, it is irrational exuberance or optimism over cash flows from assets that gives rise to asset price bubbles.
On the other hand, bond prices reflect the present value of future coupons and the redemption value of the bond. Cash flows from bonds are fixed at the time of bond issuance. Hence, bond investors cannot become optimistic about future earnings from holding the bond. Regardless of their state of mind, they will receive only the fixed coupon payment. Bond prices rise or decline depending on the movement in interest rates in the market—below or above the coupon rate on the bond. If bond prices are “higher” than they should be, as Greenspan suggests, it cannot be due to optimism, but pessimism about future growth and inflation. In other words, when the bond market anticipates lower economic growth and lower inflation in future, it marks down the future path of interest rates and bond prices rise. Pessimism does not result in asset price bubbles.
Instead, we commend another argument for Greenspan’s consideration but we doubt that he would ever accept or make that argument. Bond prices in the US ignore sovereign default risk arising out of the current stock of government debt and its contingent liabilities. Indifference to risk is one feature that bond markets share with the stock market. But then this feature of the bond market has been in evidence for more than three decades. Even as government debt in dollar terms and debt ratios have risen steadily since the 1980s, government bond yields have steadily declined over the same period. That is not what efficient markets should do. Bond markets should price in the future inflation risk arising out of the rising stock of debt. Instead, bond prices reflect mostly the current inflation rate and current short-term interest rate. Bond markets have been myopic.
The Bank for International Settlements expressed similar sentiments, in particular about the bond market, in its annual report for 2015-16: “There is no guarantee that over any period of time the joint behaviour of central banks, governments and market participants will result in market interest rates that are set at the right level, i.e., that are consistent with sustainable good economic performance. … Might not interest rates, just like any other asset price, be misaligned for very long periods?” One doubts very much if Greenspan intended this criticism for the bond market.
If bond markets were right about the future, then stock market are wrong in being optimistic about future earnings growth. But if bond markets were wrong, then does that make the stock market less of a bubble, as Greenspan argues? It turns out that the stock market wants to have its cake and eat it too.
Stock markets have already benefited from low interest rates in many ways. Corporate earnings have received a boost because of lower interest costs. Second, cash flows are discounted at lower interest rates. Third, low interest rates have enabled companies to borrow cheaply and buy back expensive stock. This has been a key source of support for stock prices in recent years. Hence, the bond market “bubble” (in Greenspan’s mind) has played a very big role in the stock market performance of recent years. Therefore, if the bond prices are “wrong”, then so are stock prices. Further, if stock prices reflect better economic growth and inflation than are implied by the current level of bond prices, then it is not clear if future cash flows from stocks are discounted at interest rates that are consistent with such optimistic economic growth and inflation outcomes. Ergo, stock markets are having their cake and eating it too.
I write this column two days before the 10th anniversary of the commencement of the economic crisis of 2007-08, when BNP Paribas stopped withdrawals from two of its funds that had been exposed to sub-prime mortgages in the US. That crisis resulted in calls for monetary policy to recognize that financial stability mattered as much as price stability, if not more. Ten years later, little has changed. Monetary policy is fuelling stock prices bubbles yet again by reinforcing bond market myopia. This columnist wrote (“Economics Is A Belief System”, 5 July 2011) in these pages, “Financial markets, inebriated with liquidity, addicted to zero cost of funds and manipulated by sovereign investors, have become utterly incapable of valuing assets correctly.” It is a pity but not entirely surprising that Greenspan chose not to confront the real elephant in the room.
V. Anantha Nageswaran is senior adjunct fellow (geoeconomics studies) at Gateway House: Indian Council on Global Relations, Mumbai. These are his personal views. Read Anantha’s Mint columns at www.livemint.com/baretalk
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