The cost of capital

The chronically low interest rates in the developed world – Britain has the lowest interest rates in the Bank of England’s 300 year history – are a symptom of a deep sickness in global capitalism. It is a sickness that may be long term. The problem afflicts most economies, including China, but for different reasons. It is unlikely to end well. And what is this malaise? The failure to adhere to capitalism’s most basic discipline – the cost of capital. This blog, by the way, is dedicated to Peter, who in my blog China’s unasked questions paraphrased me as saying that China is fine, “except for some minor weakness with cost of capital”. It is anything but a minor weakness, it is central.

The avoidance of this basic discipline in the United States and Britain has been achieved though what might be called “meta-money”. The massive creation of derivatives, which according to the bank for International Settlements, stands at about $US605 trillion, up from about $US20 trillion 20 years ago (as Satyajit Das commented in a previous blog). That is about triple the financial assets of the world, according to McKinsey.

The ploy, which produced the GFC, is to find tricks to avoid paying the cost of capital. Instead of having mortgage debt that might be repaid, for instance, you have mortgage debt that is securitised, repackaged, securitised again, then underwritten by an instrument like a credit default swap, then securitised again until the real price is so dissipated it is unrecognisable. The effect is to allow the tricksters of Wall Street and the City of London to avoid paying the cost of capital. In the end, the game ended up at the door of governments, because it had to end somewhere. But they will have trouble paying it (especially in places like Greece). And they have to resort to games like quantitative easing, which is a kind of negative cost of capital, just to keep the game going. So the basic discipline collapses. Interest rates fall off a cliff, the price of money takes a holiday.

In Japan, the disciple of the cost of capital has never been strong. In his book “The Real Price of Japanese Money” by R. Taggart Murphy, (one of the finest economic reads this blogger has ever come across) the author commented that “cost of capital calculations are not popular in Japan.” The result? A massive bubble in the property and stock markets, two decades of deflation, interest seemingly permanently at less than 1% and stagnation. If you want to see how important the discipline of the cost of capital is, just look at what happened in Japan over the last 20 years.

Then we come to China. It still has a largely communist financial system and has a long way to go before the cost of capital discipline applies throughout the economy. The weaknesses are starting to become evident – massive distortions in the property market and equity market. The problems of bad loans to the State Owned Enterprises has been partially addressed, but there is no corporate bond market. In most developed economies bonds are about a quarter to a third of the capital stock. China will take a long time to develop a financial system that adheres to the cost of capital, and may fail to do so.

So we have a world economy in which the West thinks the cost of capital is something to be fiddled with (by rocket scientists) until it goes away, and the East thinks the cost of capital is something that should be entirely subservient to political and industry goals. The result is that the basic organising discipline of capitalism, which was its defining difference with communist states, is being undermined.

So here is my suggestion for central banks. Develop a cost of capital index for the management of economies, which looks at the different asset classes. In Australia, for example, ask the question of what is the cost of capital in the residential property market (a rental yield plus a risk premium presumably). Then apply common sense. If the cost of capital seems out of whack, or is very hard to calculate, then it means there is a problem – and probably a crisis in the offing.

Comments

  1. Conclusion to second sentence, third paragraph ” … the game ended up at the door of governments” should read “at the doors of tax-payers”. Otherwise excellent.

  2. Spot on, SoN

    Cost of capital is the most important element of all economies – it influences (or at least, it should!) our purchasing decisions, wages, company profits, asset prices, the works!

    Your comparison of Western vs Developing mentalities is interesting… Across all that you can then add a layer of long-term macro-trends, the recent reversing of which (with GFC being the turning point) does not augur well for the decades to come.

  3. The ‘cost of capital’ is determined by investors. The Central Bank can set the benchmark for the ‘risk free’ return, however they do not set the risk premiums. The mispricing of ‘risk’ lies at the heart of the GFC, but raising the ‘cost of capital’ will not make the investors any smarter. Cheap money is not a problem in itself, the important issue is WHERE the money ends up.

  4. The cost of capital in China is essentially zero. After the GFC the Party said “Lend!” and lend the banks did. They lent to corrupt SOEs who built things that weren’t needed. They lent to property speculators who built empty apartment buildings. But none of this matters because in China money can be lent forever without consequence. Loans never turn bad, and if they do, they’ll never be called in.

    Its different in China.

  5. V interesting. Did you read the McKinsey report “Era of cheap capital draws to a close” , and if so any views on their outlook? The scenario they paint seemed alarmist.

    • Yes, I did. It seemed like a one way bet to me, given how cheap capital is at the moment. We know how low interest rates are in the developed world, and I think Lorax is, if not right, then at least starting from the right presumption with China (see the response above yours). I think that McKinsey paper is a version of the argument that the cost of capital is not in good shape throughout most of the global economy. In that sense I suppose I don’t see it as alarmist.