Mises Wire

Grantham on Replacement Cost

Grantham on Replacement Cost

Famed asset manager Jeremy Grantham's essay Replacement Cost: The Bedrock of Value (follow link and then advance to page 7 of 9 in the PDF). Grantham writes as follows:

The total market must sell at about the total cost of replacement. It may be hard to calculate, but if we could know the true replacement value it would be the fair value of the market. If assets in the market sell away from replacement or fair value, an arbitrage takes place that is central to the effective working of capitalism. If the market sold at three times replacement value for example, companies would sell a billion dollars of stock, build a new billion dollar plant, and have it sell immediately at $3 billion in the market. Hugely encouraged, they would sell more stock and build more plant until they drowned in fiber optic cable, for example, at which point profits and stock values would crash back to replacement cost or below.

Conversely, if the market sold at half replacement cost, which company would build a greenfield plant when it could buy a competitor's plant in the market for half the price? No new plants would be built until eventually a shortage developed and then profits and stock prices would rise, until the new profits justified a new plant selling in the market at full price. If fair value in the stock market equals replacement cost, then it surely follows that: a) changes in short or long interest rates annot change replacement cost and are therefore irrelevant to fair market value, in contrast to the easy appeal of the "Fed Model" (surely the Fed doesn't actually believe this model?) that argues exactly the opposite.

Andrew Smithers takes a similar view in his book Valuing Wall Street. I believe that these analysts are mistaken in the following sense. If there were no fractional reserve banking, so every amount loaned to someone had to be an amount saved by someone else, then the interest rate would tend to reflect the degree of time preference in society. If there were a shift of some large segment of the population toward more future oriented preferences, all future goods would be re-valued higher relative to what they had been valued before, including all capital goods and all the factors required to produce them. Interest rates would be lower as well as they only reflect the time preference that prevails in all inter-temporal markets. However, if such a shift were to occur, then the capital structure would need to be realigned to reflect a longer time horizon. Some existing special-purpose capital would be less valuable under such a shift, while other capital goods might be more valuable. 

The original factors - land and labor - are considered to be more non-specific, so they would be free to shift to their highest and best use within the new capital arrangements. The upward re-valuation of all capital would be accomplished by narrowing the time-return spreads between inputs and outputs earned by capitalist producers at each stage of production. Under the fractional reserve system with central banking, the interest rate on the short end of the yield curve is set by government price controllers, and the banking system can create credit out of funds that were not saved by anyone, so yeilds can diverge from the social rate of time preference.

Other factors, such as foreign central bank purchasing of US debt securities can have an effect on the bond market. Financial asset inflation can push up bond prices to unrealistic inflated values. Higher bond prices are equivalent to lower bond yields. The bond market does not, in general, set interest rates. They are set by time preference, and the bond market must conform to it. However, if a financial analysts uses the bond market to measure interest rate — and these rates are primarily artificts of the dysfunctional monetary system — while time preference is fairly stable, then it is harder to say what the relationship is.

Of course Grantham is right on the arbitrage argument, no question there. The question is, do costs change when interest rates change. That is not touched by the Q issue. Antony writes here that Q is difficult ot measure. That is the core of the problem. If you could measure Q accurately, would you measure the change in replacement cost when time preferences change? Grantham seems to be saying that prices determine costs. As Austrians, we believe that costs determine prices, through imputation backwards from final demand. The imputation backwards through time is discounted by the social rate of time preference, otherwise known as the interest rate. The profit spreads between all stages of production must in the market correspond to the rate of interest. This comes about through price adjustments in capital goods and original factors.

Grantham by saying that interest rates cannot change replacment costs is denying that (in the case where interest reates reflect time preference) a change in time preference would result in imputed price changes through the revaluting of future goods relative to present goods. Of course modern economics does not seem interest rates as having anything to do with inter-temporal allocation. The interest rate is in the case of Keynes due to an arbitrage between holding cash and bonds, or in the minds of financila analysts, simply a magic number that is set by the Fed as part of "monetary policy".

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