The AEG baseline

Dec 04 2013 07:55
*Edward Ingram
ONE reason why today's financial services leave everyone in despair of making a good life plan is that the financial services industry uses a so-called risk free rate of interest, based upon the interest payable on government bonds. There is no allowance for inflation.

Others, like the Austrian School, think that the most ‘neutral’ rate of interest is one that keeps pace with price inflation. I strongly disagree with both benchmarks.

The benchmark which I have used in my mathematical treatise on safe mortgage finance is the rate of average earnings/incomes growth (AEG% p a). Let me explain.

Firstly, mortgages are repaid out of incomes, not prices.

On the savings side, the thinking is that the average incomes/earnings growth, AEG, of a nation is related to the rate of growth of the total (or aggregate of all) domestic spending. Aggregate spending is what determines the price of everything.

If total spending does not change, prices fall. If total spending rises, the price of everything becomes higher than it would be otherwise. This is a form of inflation.

For investors, any property which does not increase in value at this AEG% p a rate has some special or local factors influencing the price. Similarly, any company whose turnover and profits do not rise at this rate is lagging behind the push given to it by rising spending; or, as I said, what economists call rising aggregate demand.

So AEG% p a is a kind of proxy for aggregate demand and a baseline for what goes on in a domestic economy. Of course, external investors disturb this scenario, but I want to leave that aside for now.

Apart from giving us one more measure against which to assess the performance of our investments, everyone’s pension fund needs to keep pace with AEG/average incomes.

The fact that there are no ‘wealth bonds’, on offer – bonds that are index-linked to AEG have already forced pension funds to back-track on offering defined benefit pensions and they are now offering defined contributions instead – in short, they have no investment which protects the wealth/income that has been invested with them.

And consider this: a person or a business that can borrow money at an interest rate which is less than AEG% p a can invest that money in property or equities or its own business, and on average, can expect to make a greater return than the cost of borrowing.

For example, borrow 100 000 and add interest of 5% for AEG = 5%. Properties rise by 5% as long as no special factors are operating, and there is rental income on top. 100 000 invested in property becomes, say, 105 000 of capital plus 2 000 of net rental. Total is a 7% return before tax.

I looked to see how interest rates for housing have behaved in the past. I selected these periods because they were long, and they were before the distorted low interest rates seen since around 2002. Here are the graphs for the UK and South African housing finance.

South Africa is based on prime rates less 2%, as I was advised. The marginal rate of interest above AEG% p a is called the true rate of interest:


Source: SA Reserve Bank True rate in yellow. Prime -2% in blue, AEG in brown.

In both cases the true interest rate averaged about 3%. This is saying that interest rates were 3% above AEG. In the UK, this was probably 5-6% above price inflation.

When you look at the difference between this way of valuing and costing everything and the usual alternatives, like the money cost, or the ‘real cost’, the calculated figures can leave you with your mouth wide open in stunned surprise.

Everything looks very different.

Only if your investment keeps pace with the push coming from rising aggregate demand (rising incomes/AEG% p a) will your investments keep pace with everything else. Only in that way can your pension fund keep pace with average incomes and deliver some kind of defined benefits.

AEG% p a is the natural growth rate for all investments. AEG is my benchmark.

 - Fin24

Next week I will explain how AEG can be used to track the movement of wealth.

*This is a guest post from Edward Ingram, a leading specialist in mortgage finance and macro-economic design for sustainable growth who is involved in studies in macro-economic reforms.

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