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When the long-term interest rate is much lower than the growth rate, it is the severity of the liquidity (debt) constraint that determines asset prices
We are looking at the current situation where the long-term interest rate, even increased by a “normal” risk premium, is lower than the long-term growth rate. In this configuration, the discounted sum of the future income generated by holding an asset is infinite: the fundamental value of an asset no longer exists, there is no longer any restoring force towards the fundamental value. In other words, in this configuration, it is optimal to take on unlimited debt to buy assets. The rise in asset prices therefore continues as long as savers can obtain funding to buy assets; it stops when savers cannot take on more debt (face a “liquidity constraint”). In this situation, it is therefore savers’ borrowing capacity that determines asset prices, not the fundamental value of assets.
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Natixis
Based across the world’s leading financial centers, Natixis CIB Research offers an integrated view of the markets. The team provides support to inform Natixis clients’ investment and hedging decisions across all asset classes.
Patrick Artus
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