The Marginable Capital Theory of Asset Prices

Given its failures to explain the macro economy in recent years, specifically why QE did so little to spur bank lending and thus underlying inflation, many are looking to alternative models to the classic "loanable funds" story taught for nearly 80 years in economics textbooks. Indeed, simple institutional features of the banking system, well understood by people in the financial sector and MMT friendly economists, make the loanable funds model very questionable to begin with. Specifically, banks never need to get money in order to lend. They always have access to cash because their central bank makes sure of it. The limit on bank credit is not the quantity of reserves in the banking system, in fact, loans create deposits, deposits do not create loans. The constraint on bank credit is the availability of profitable loans and the net worth (capital) requirement imposed on banks by regulators. 

Banks are fundamentally in the cash flow business. They purchase future cash flows from customers who sell them in exchange for deposits which can be spend immediately. This phenomenon, known as maturity transformation, is not limited to banks. 

A humongous market for cash flows exists in the form of all kinds of securities. A bond is just a  stream of coupon and principle payments and large financial institutions invest in bonds using leverage. Much like the institutional framework between banks and the Fed, large players in the US bond market always have access financing because of Fed policy. The constraint on their ability to invest in bonds is thus not constrained by some finite pool of liquidity, but rather market imposed capital constraints such as haircuts on repo transactions. 

These firms face a simple choice when entering the market. If they meet market imposed net worth requirements and long bonds offer enough spread over short rates to compensate for duration risk, they should borrow short and invest. Much like banks, the limiting factor is capital and the availability of investable securities, not liquidity. 

 Thus, when thinking about asset price formation, we must move away from the simple supply and demand framework which works well in the market for cell phones or toothbrushes.  A well capitalized finance sector can easily absorb reasonable increases in the supply of Treasurys without yields rising (that is, bond prices falling). 

This brings me to what I call the marginable capital theory of asset prices. As long as financial capital exists which can be offered as margin to get loans to invest in assets with predictable cash flows, an increase in the supply in those assets won't affect prices. It will only draw in existing leveraged investors into the marketplace. A well capitalized investment banking sector will always do its job and engage in maturity transformation in the securities market! 

The financial sector could suffer a large net worth shock, such as in 2008. This could limit the the ability of bond dealers to enter the market as new assets are emitted, and thus long term interest rates could rise relative to short rates, as well as credit spreads and other risk premia. If the normal activity of the financial sector can no longer absorb the incremental supply of new assets, yields would have to rise so that the asset market clears. 

Alternatively, a massive surge in new issuance, maybe on the order of 10T or greater in a very short period, could force yields up because investment banks simply wouldn't have the capital to absorb the new supply at current prices. This scenario is academic however, the Fed could easily intervene, or the Treasury could avoid the situation all together by issuing at the short end of the curve. 

 In any event, supply is really only an issue in extreme and/or dysfunctional markets. Assets are cash flows and its usually profitable to invest in them with leverage. In the case of bonds, prices aren't set by supply and demand, they are set by expectations about the present value of the underlying cash flow, or in other words, expectations about interest rates. Mechanically, well capitalized firms are easily able to access the leverage they need to absorb new issuances without pushing prices down. The issue isn't supply or loanable funds. It's marginable capital.