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Tuesday, December 07, 2010

When to support Asset Prices and at what level?

Back in 2007-09, during the peak of the crisis, world central bankers and regulators initiated strong actions to support asset prices. Some of the ideas continue to seep into the current bailout and stimulus strategy. However, to my mind, supporting asset prices is not a right strategy as it depends on the level at which supports are extended. Let us look at dynamics of asset prices to understand if their actions were warranted or not.

The asset price support strategy is in effect a response to bursting of asset bubble. There are two central considerations about supporting asset prices. First, should we support asset prices at all. Second, if we had to support, at what prices level should we support?

Why support asset prices at all?
The logic for sustaining asset price level rests on the fact that negative asset prices hurt a lot more than declining incomes. This is particularly true if the assets have claims on income (because of debt funding of assets). The collapse in claims result in cascading effects on the economy resulting in asset price deflation spiral.

For example, if a person or household earning $1000 per month with a conservative mortgage payment of $500 loses employment, then it immediately goes under prompting a loss to the bank. As the bank tries to recover its money by asset sales, the value of asset declines if many people lose their jobs and houses simultaneously. The situation is converse of a bank run. In a bank run, the liabilities of the bank get called in while assets are locked up. In this case, assets start getting marked down thus increasing the risk of liabilities being called in. Hence it renders banks undercapitalized. An undercapitalized bank freezes the entire money flow channels as it desperately tries to hold on to all the money it can.

At what prices should we support asset prices?
Given that there are situations wherein asset prices may need support, the question comes at what price can support be justified? To answer this question we must understand asset prices in more detail.

Asset prices have an income equivalence. In other words, every price point of an asset corresponds to an income level of the population. For example, if a person can spend only $100 on a car, then that will form the ultimate ceiling on the cost of making a car. Similarly, if an income producing asset can produce $100 worth of income (present value discounted appropriately), then that forms the ceiling of the asset price. For houses the income of future buyer will form the ceiling price of the house. This principle is captured as affordability ratio. About 100 years of data indicate that typically the house price is 5-7 times the current annual household income of the buyer. Conversely, when we support asset prices at a certain level, we should be sure of incomes rising to near affordable limits in short span of time (no longer than 6 months). This makes sure that prices can be sustained by the buyers through their own work and contribution.

Support for asset prices, particularly housing, should come at affordable prices and not at artificially high prices created during bubble times. I would also venture that the support for asset prices should be established at a point just below the affordable price so that tax payers' (those bailing out or helping support the prices) interests are protected.