We are told that equities are claims on very long-term cashflows, but we also accustomed to equity values fluctuating based on very short-term news (even when interest rates are low). 1/
One explanation for that is path dependence: The effects of immediate-term events accumulate in ways that compound over time, rather than the firm reverting to the prior path. 2/
I think current market action suggests a different explanation: 3/
Equities are claims on long-term cashflows CONDITIONAL on avoiding over the interim an insolvency event that either ends the cash-flows or detaches them from current shareholders, awarding them to other stakeholders. 4/
So, in ordinary times, short-term news can have outsize effect on equity value via a probability of insolvency channels. 5/
During the present crisis, the intent and effect of Treasury/Fed interventions has been to basically take solvency concerns off the table. 6/
Insolvency is theoretical, hypothetical, so long as a firm is liquid. interfluidity.com/posts/11976536… Policymakers have made it clear they intend to keep major public firms liquid on very indulgent terms. 7/
In an environment of low interest rates, and absolved from fluctuations in value due to the possibility of liquidity crises and the sometimes existential costs shareholders might be required to endure should they transpire... 8/
shares start to behave like simple models of claims on very long-term value after all, to "look through" current events, to be much less in the thrall of the drama of the news cycle. 9/
is this good or bad? i don't know. does the discipline of the margin call improve or damage shareholders' and firms' incentives to conduct real economic activity that creates value and promotes development? 10/
American finance types used to mock Japanese firms for facing "soft budget constraints" because cozy banking arrangements kept liquidity forthcoming where hypothetical US financiers would be hard-nosed. 11/
It's pretty clear that American exceptionalism on that account has been replaced, post 2008 and especially now, by a heap of humble pie. 12/
It's not clear, in retrospect, that "soft budget constraints" ever did Japanese firms any harm, nor is it clear that they didn't, that in a counterfactual world more conducive to creative destruction, better things wouldn't have resulted. 13/
In any case, for better or for worse, we have all turned Japanese now. /fin
