New York Debtwatch Talk: Modelling Debt Deflation
on July 14th, 2010 at 8:10 pm
The blog now has over 5000 members, and about 40 of them crowded into a small room in the FlatIron district of New York to hear me give a talk on debt-deflation. Since I had the luxury of more time than you get at an academic conference, and an engaging and intelligent audience, I gave a lot more detail on my modelling approach. The questions were also superb, and would have continued for much longer if I hadn’t called quits at an opportune point (the whole caboodle of presentation and discussion is almost 70 minutes long). My answers come through loud and clear on this video; I just hope that the questions themselves can be heard by better ears than mine!
Steve Keen's Debtwatch Podcast
The presentation slides are linked here, and the paper here. The presentation is new and much more detailed than the one I gave at the Levy; the paper is the same as that linked to the Levy presentation.
I am still doing some development work on this model, including expanding it to include fiat as well as credit money (and I hope ultimately to fit it to the US data as well), but for now it’s the most complete single sectoral model of debt-deflation I’ve put together.
I’ve also linked an MP4 format file here, since the Flash Video compression seems to result in rather hard to read text on the slides.
PS I’ve just checked part of the video above, and after a while there’s a very large gap between the visuals and my commentary. This is probably due to my stuff-up when I got back from New York: I used an automatic backup program to transfer files from the camera to my computer, and then deleted the files from the camera–only to find that the New York material hadn’t been transferred!
An undelete program saved my bacon (thank you File Restore Plus), but in such operations there’s always some problem, and this is one of them. Nonetheless it’s better than losing the whole thing. So please put up with the disconnect.
bb
The comparison with CBA prior to the Australian private debt explosion that turbo charged bank profits is not valid.
A 7.5% post corporate tax yield from a quadopoly bank does not compare with an individual real estate asset yielding 2.5% pretax (roughly 1.75% after tax) especially when AAA bond yields are very low.
bb
Banks make profits from the spread on the total issuance of debt. The Debt/GDP ratio roughly doubled over the 1994 – 2010 period.
The driver of CBA bank profit and dividends 1994 – 2010 was the gowth in debt, 4.7% p.a. faster than GDP.
Are you suggesting that real estate rents (i.e. wages) will grow 4.7% faster than GDP over the next 15 years?
A bond investor at 10% in 1994 is also presently sitting on a 15 year to maturity 10% yield = also a reasonable 100% capital gain and a 10% yield.
You have the habbit of mixing and matching your examples to obfuscate the nieve.
That’s un-becomming from someone who is obviously intelligent.
bb
You are suggesting investing out of the rear view mirror as opposed to through the windscreen.
As you indicate, 1994 the yield on bonds was 10% the yield on banks shares was 7.5% and from memory the yield on residential real estate was 6%.
None of them high compared with 1990 nor low compared with today 2010.
A reasonable forward assumption over the next 15 years is that the yield on all three assets will be more than likely be somwhere in the mid range, i.e. yields similar to 1994.
The return on residential real estate would be the next rent 2.5% pretax (1.75% post tax) and the capital gain 0%
The yield on bonds 5% pre tax (3.5% post tax) and the capital gain 0%
The yield on term deposits 7.25% pre tax (5% post tax) and the capital gain 0%
Why would the capital markets be any more or less rational in 1994 as they will be in 2025?
bb@77,78
Let me put a time dimension into the formula
The original $8 is $8@1994
The $3 is $3@2010
yield@2010 = $3@2010 / $8@2010 = $3@2010 / $8@1994 * power( 1.045, (2010-1994)) = ($3@2010 / power(1.045, (2010-1994))) / $8@2010 = 10.5%
while you calc yield@2010 by
$3@2010 / $8@1994 = 37.5%
It is miss leading. But your IRR calculation sounds reasonable and reflect the risk premium. But I think you will know, IRR alone sometime give false indication.
correction on my typo
yield@2010 = $3@2010 / $8@2010 = $3@2010 / $8@1994 * power( 1.045, (2010-1994)) = ($3@2010 / power(1.045, (2010-1994))) / $8@1994 = 10.5%
Peter_W
Ok I’ll use another example…
In 1994 CSL listed at 76c per share. The dividend was 3.3c per share, or a yield of 4.4%. Goverment bond rates were +10%, and inflation expectations were +5% (which was why goverment bond rates were +10%).
Since 1994, CSL has paid $3.07 is dividends (4.0x the original investment). The current dividend is 80c per share. So the yield no on COST is +100%.
So if somewone bought the shares using debt (which would also be historical cost), they would be paying circa 7% on the debt, but receibing +100% on the original investment.
So, I re-iterate the point I was making one last time…
****Just becase an investment does not provide a “Yield spread” on day one, does not mean one relys on capital gain alone in order to earn an attractive return****
This is not about whether housing is a good or bad investment, and I’m am certainly not trying to decieve anyone. I was simply trying to convey a very simple message about finance and investing.
@ MFO 36 – I agree,
I work in Sydney and there are number of wage slave investors on my floor. Not the smartest mob and most earning about the Sydney median – mid 60k mark.
One of them is about to buy another “investment” She’s always having issues with tenants, blah de blah, life tough..Yawn…
Another has just bought a house he can’t afford to live in himself, has it up for rent and has had to drop the asking price already.
I think the “shoe shine boy” investors will be the first to try to bail out…when they realise that they are going to lose all their money it will grind to a halt then slowly drop…
hq,
I understand the calculation but your logic is wrong.
Your caculation is 100% correct assuming a you wish to calculate a return relative to the opportunity cost of 4.5% per annum.
Where you get your logic wrong is after you inflate the denominator by the opportunity cost, you then compare the “adjusted yield” to the risk free rate which is another opportunity cost (see you post @ 74). You have therefore double counted the opportunity cost when assessing the investment performance of CBA.
The reason I use historic cost to calculate my yield is because I was comparing the yield to the cost of funding which is also historic cost. So it is not misleading at all!
This calculation was important in the context of the argument which started way back @ 51.
bb
The pre tax and after tax cashflows on real estate are more knowable in the future than the capital price of real estate and the cost of floating interest rate financing in the future.
This is less certain with individual company profits i.e. shares
That’s not true of a term deposit or a government bond, both of which pay 100% at maturity (one would hope the Australian government is good for the money).
Neither you nor I know with certainty what the yield will be on any of these assets in 5 years time. The future yield will be dictated by the market. What we do know is the range of historical yields over the long term past.
Presently the yield on real estate is very low by historical comparisons.
Whilst investors can obviously trade ownership back and forward betweeen themselves at higher or lower prices (and that will determine the yield at transaction settlement), investors in aggregate can only bank the aggregate future net cashflows (the yield)
bb
An ‘investor’ should be factoring in a range of future probabilities for net yields from residential real estate.
It’s more probable (based on history) that net yields are 50% higher 10 years from today than they stay the same or are 50% lower.
The more probable scenerio (based on history) is 2.5% net yield growing at ~4.5% with zero capital gain over 10 years.
The majority of investors are paying 7.25% interest on $333 billion hoping for a low probability outcome of capital gain over the next 10 years to compensate them for the funding cost.
Peter_W
We have change the discussion a little here back to pure real estate.
As I said in an earlier post, a 2.5% net yield + 2.5-3.0% inflation +1.5-2.0% real growth will provide a total return of c7%.
As you quite rightly point out, this is not a great return relative to funding. No argument from me.
But from an owner occupiers perspective, it is very attractive. Since cost of funding = total return, then equity return = 7% after tax.
Therefore, if one were to rent rather than own, the renter needs to generate a 7% after tax return on his/her equity to remain indifferent between buying or renting. Assuming you are a high marginal tax payer (say 40%), your need a pre tax return of 8.75% per annum from your investments (assuming all of your gain is capital).
I think this is a massive risk for a renter. 8.75% return is exceptionally high as my earlier post shows (real long term returns from equities = 6.0% over 150 years). It also requires alot of dicipline with all available money staying on growth assets through good times and bad. I know I couldn’t do that, nor could the average person.
All the while, your landlord can kick you out of your home.
I can understand why people chose not to invest in housing, but I can not for the life of me understand why people chose not to Own and Occupy if they can afford it.
bb@87
Disagree
$1@1994 is not same as $1@2010, thus calc today’s yield based on historical cost is misleading.
This is similar to real estate agent claims house price double every 10 years.
Sounds a lot, right? Yes, it is 100% on the original investment based on your evaluation method. However, it is actually 7.2% p.a. I guess there a lot of term deposit current offer around 6.5%
It must also be remembered that it is the house that yields income and not the land. A vacant block of land yields nothing.
A vacant block of land will grow in value over time should it experience an expansion in infrastructure, facilities, becoming leafy etc.and all the sudden people want to live there. As long as things like a freeway aren’t built at your back fence, then the value should go up relative to the size of the paypackets of those who want to live there.
Want yield then stick a house on it and rent it out. With a house earning less than 5% yield whilst depreciating at 2% a year, at this stage of the cycle, term deposits offering between 6 – 7% are looking pretty good.
bb@90
“I can understand why people chose not to invest in housing, but I can not for the life of me understand why people chose not to Own and Occupy if they can afford it.”
Taking taxation in to account, this is probably a fair statement.
hq
“$1@1994 is not same as $1@2010″
Agree
“thus calc today’s yield based on historical cost is misleading”
Not if you are comparing the yield to the debt which is also at historic cost, which was my point. Your calculation was an exercise in double counting.
“This is similar to real estate agent claims house price double every 10 years”
No its not. This is an emotive response in an attempt to try and catagorise me as a naive real estate agent.
“Sounds a lot, right? Yes, it is 100% on the original investment based on your evaluation method. However, it is actually 7.2% p.a. I guess there a lot of term deposit current offer around 6.5%”
You are now getting confused between compound returns and current yield on cost.
and yes – I understand the concept of compound returns. Do we want to really play games can say a 7.2% return is really just a 6.9% logged return – which is more technically correct since it solves for kurtosis…
Pick up any first year finance text book and you will learn there are dozons of ways to express a return. No one way is right or wrong, they just express the results in different ways.
The important point is to express the return which is relevant to the point…in this instance, relative to the historic cost of funds.
Please re-read my posts from 101 onwards and you may understand why I expressed the return the way I did.
mfo @ 92
That is a very good post, and I agree with most of it.
Land in Sydney has historically increased by 6-7% per annum, but off course offers no yield
The 6-7% per annum, makes sense since this is roughly in line with nominal GDP, and is consistent with benefitsing from higher incomes across a fixed number of people for a given area.
The 6-7% land price growth has been consistent since about 1850 and can be sourced from land title records in your local state.
The improvements do depreciate, but your 2% is a generalisation an could be either widely optimistic or pessimistic.
Depreciation does not occur in a straight line. A brand new house does not change much from year to year, but a house that is 50 years old deteriorates at a much faster rate.
Property economists use the “inverse sum of years method” for depreciating real estate. If you studied accounting you will know that is the age of the property divided by the sum of year of its expected existence (ie: if a building was to last 50 years, the denominator is 1+2+3+4+….+50 = 1275).
So in year 1, the depreciation rate is 0.1%. In year 50 its 3.9%.
Most houses are in pretty good nick and would be the equivilant to 10-15 years old given the upkeep. So a depreciation rate of 0.7-1.2% is closer to the mark.
Of course improvements make up around 50% of the value of a house. So applying the depreciation to the entire property would give you 0.35%-0.6% per annum in depreciation.
mfo 92
I agree with you and am doing just that. However good investment comes also to those that BUY right. The secret is in the buying especially with housing and I guess most attending this blog would agree that housing ain’t going nowhere at the moment Money in the Bank will give one the flexability to invest whenever the market decides to go up or down.
bb
You say…
“But from an owner occupiers perspective, it is very attractive. Since cost of funding = total return, then equity return = 7% after tax.”
bb I’m not sure I follow that logic.
If I put down 0% deposit and borrow 100% there is no return on equity, there is an economic loss of 0.25% of the total asset p.a. from now until eternity (or until interest rates fall to below the return on asset).
If I put down a 10% deposit and borrow 90% at 7.25% and the asset returns 7% then the return on equity is a 0.25% loss at 9:1 leverage. That’s not a 7% return on equity its an economic loss of 2.25% (7 – 2.25) = 4.75% return on equity (pre tax).
If I were to rent the asset I pay 3.5% (the gross rent) and presumably I can walk down to the local bank and invest the other 3.75% at 7.25% pre-tax for 5 years in a AAA bank term deposit. The 7.25% term deposit rate suggests to me that banks believe that the mortgage rate will be 7.25% or higher over at least the next 5 years.
bb
The interest rate risk for an owner occupier can be mittigated for a while by using a fixed rate loan! Presently the 5 year fixed rate is 8% and 10 years 8.2%
If the asset return is ~7% and the fixed rate funding cost is 8% then the return will be the 7% asset return on the deposit (equity) minus the funding cost (1% loss) times the debt/equity leverage.
At 7:1 leverage (15% deposit) the equity return becomes ~zero.
bb
By my rough maths (real rough)
If real estate yields rise 4.5% p.a. and the capital gain is zero for the next 7 years then net yields will rise from 2.5% to a more historical yield of 3.4%
If a potential buyer with a 15% deposit and the ability to save 3.75% p.a. (the difference between the mortgage rate and the rent) were to continue to rent rather than buy and borrow at 7.25% whilst they undertake the discipline of saving into term deposits at 7.25% they should have close to a 50% deposit by year 8
The only risk the renter faces is that interest rates fall and real estate rises at 4.5% or more as a consequence, or rents rise faster than wages, therby undermining the savings rate.
I don’t see these as big risks
bb
“No its not. This is an emotive response in an attempt to try and catagorise me as a naive real estate agent.”
I am sure you are not and that’s why I didn’t understand why you need to using historical cost to have your point conveyed.
“You are now getting confused between compound returns and current yield on cost.”
I aware the difference. But it is not the analogy I want to express. The part “double value every 10 years” is my main point.
“Pick up any first year finance text book and you will learn there are dozons of ways to express a return. No one way is right or wrong, they just express the results in different ways.
The important point is to express the return which is relevant to the point…in this instance, relative to the historic cost of funds.”
Not denying there are many way to express return, but whether the way your using is most appropriate in this blog? I think most of us are not “naive real estate agent” either, and are interested in the true return and comparison instead of numeric/nominal return. This is my main argument.
Since our discussion is far off the main topic, I will just stop here and not making any more distraction.
But in general, I am very much like your comments. I think Seven’s model is over simplified and out-of-touch of the reality. But in the end he is just a economist, his model may predict the outcome, but not the timing(no offense, I still think you are great!). Keep going, mate.
bb re 46
http://www.news.com.au/business/breaking-news/australand-half-year-net-profit-up-127pc/story-e6frfkur-1225897343890
New York Debtwatch Talk: Modelling Debt Deflation | Steve Keen’s … « Macro Observations
Okay, it’s a surreal video.
Ours is a surreal economy in a surreal world.
Keen argues that economic models must earn their keep: reflect reality rather than the potential employability of economists who claim (or pretend) to use them.
Classic macro- modeling and theory attempts to justify the ‘waste based’ economy that profits by metering the flow of finite material resources (capital) into landfills. it does so by falsely categorizing and mispricing inputs and then lying about the mispricing. The mispricing and the lying are features, not bugs. That these features are impossible to sustain and are causing The Great Credit Unwinding does not deter the establishment which requires its institutions to defend them. Economists aren’t incompetent so much as compromised.
Professor Keen uses analysis tools like those the ‘real, PhD’ economists use who work for the Federal Reserve. He crafts a model based on Hyman Minsky’s Financial Instability Hypothesis;
… chaotic dynamics … should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm” ((Keen 1995, p. 634)). That storm duly arrived, after the lull of the “Great Moderation”. Only a Fisher-Keynes- Minsky vision of the macroeconomy can make sense of this crisis, and the need for a fully fledged Minskian monetary dynamic macroeconomic model is now clearly acute.
http://economic-undertow.blogspot.com/2010/07/analysing-waste-based-economy.html
Oops, that’s a failure!
http://economic-undertow.blogspot.com/2010/07/analysing-waste-based-economy_28.html
Steve,
I am a big fan of your general economic work. However, i must completely disagree with the ‘limited life share’ concept.
I would argue that a better solution to the problems of speculation would be limited purpose banking. Restrict banks to the activities that actually aid the economy rather allow them to become parasitic (as you have shown them to be) and I would expect you would achieve the desired outcome. I also think that (although based on my limited understanding of austrian economics) interest rates should not be manipulated/determined by a reserve bank, but rather set by market forces. In this way the ability to lend would naturally be reduced in boom times as funding would be constrained and interest rates would rise, while lending would be easier in times of low economic activity as higher rates of cash being saved push the interest rate down.
Regardless of which ‘change’ above was made, stock market bubbles would still occur due to positive feedback loops and speculation. However, limited purpose banking would insure that large slabs of debt are not built up against bubble wealth.
Also, I am curious if you are familiar with Michael Pettis.
http://mpettis.com/2010/07/do-sovereign-debt-ratios-matter/
When I read this blog post, the nation of Australia jumps out to me as hugely at risk, as we have a classic inverted balance sheet. I am very curious to hear your thoughts on his work.
Keep up the good work.