The capital markets have greeted the European Central Bank's (ECB) loose monetary policy with euphoria. The prices of shares and property are shooting up to dizzying heights. The ECB seems to have stumbled across a magic formula for creating wealth from nothing.
However, will this magic also make savers' worries about their pensions disappear into thin air? Unfortunately, that is out of the question.
Anyone who looks only at the current value of financial assets is laboring under a valuation illusion created by the ECB's zero interest policy. In reality, the central bank's policy has made savers and asset holders seeking financial security for their old age poorer, not richer, by robbing them of interest on their savings.
Its effects can be clearly illustrated by the following scenario:
Imagine an economy that has a fixed amount of real-estate and shares both of which that annually generate 50 billion euros ($55.9 billion) in rents and dividends for their owners respectively, and assume these assets have a market value of a trillion euros each in an initial conceptual scenario.
In addition, the economy has financial assets worth a trillion euros that are lent to foreign borrowers at an annual interest rate of five percent; and thus generate another 50 billion euros in revenues on an annual basis.
The total value of this economy's assets is three trillion euros, and asset holders dispose of an annual cash flow of 150 billion euros. Let us assume they spend that cash flow on consumption.
Suppose that the interest received on financial assets falls to zero for a certain number of years. The cash flow available for consumption will then fall from 150 billion euros to 100 billion euros.
The drop in interest rates will encourage asset holders to convert part of their wealth into real estate and shares, as both promise higher returns. However, they will be unable to do so, because of a dearth of spare real estate or shares on the market.
Asset holders' endeavors merely drive up the prices of these assets so high that buying eventually loses its appeal.
For richer, for poorer?
Let us assume that prices double. The value of the economy's assets will increase in this scenario from three to five trillion euros, for the shares and real-estate will then have a value of two trillion euros each, while the value of financial assets will remain unchanged. Savers will feel richer although, in reality, they have become poorer.
The explanation for this valuation paradox is that assets are expressed as units of goods available for consumption today. Although this is not incorrect, it is arbitrary and misleading insofar as the savers in the scenario cited do not want to consume their assets at the present time. Instead, they plan to live from the income that they receive from them. And that income has fallen, not risen.
In reality, asset holders do not even want to consume their current income, but to save part of it for their retirement. The European baby boomers who are very active now will be in their mid-sixties in 15 years and will thus want to begin to consume their wealth as pensioners.
If the ECB has returned to normal interest rates not abandoned its low interest rate policy by that point, these baby boomers will realize that the value of their shares and real-estate has also returned to its normal level – and that they do not have the cash at their disposal that they expected due to lost revenues from interest.
In other words, the ECB's low interest rate policy increases the initial value of their assets, but lowers their ultimate value.
The valuation paradox also poses risks to the stability of the financial markets. For, as is usual in the case of asset bubbles, the banks and other financial institutions will use the surge in the market value of their assets to carry out credit-financed increases in dividend payments; and will thus use-up their actual reserves.
As soon as share prices fall again, it will become clear that many formerly functional financial institutes are no more than empty shells.
Taxpayers will ultimately be left with no alternative other than to pump more funds into these institutes, or to take them over de facto (which is what happens when politicians nationalize ailing banks).
All of these effects can be seen as the collateral damage of a well-intentioned monetary policy. Asset holders and taxpayers, in the meantime, would be well-advised to approach the ECB's policy decisions with a large dose of skepticism – instead of to laboring under the illusion of the valuation paradox.
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