Rhetorical numbers

Suppose you read the following statement: 

In 2006 the measured economic output of the entire world was around $47 trillion. The total market capitalization of the world's stock markets was $51 trillion, 10 percent larger.... Planet Finance is beginning to dwarf Planet Earth.

Are you impressed? You shouldn't be.

A year's output is the value of goods and services produced over that year, while equity values reflect the (discounted) value of all future streams of profits. If you are comparing the two, you must at least have a sense of what a decent benchmark for comparison would be.

So if, say, half of GDP originates in the corporate sector and profits are one-third of value added, the present value of profits discounted at a continuous rate of 8% amounts to 208% of GDP (=0.5x0.33/0.08).  This suggest that the value of stock markets should be more than double that of annual output, not the mere 10 percent extra that the above numbers suggest.  Planet Finance is not all that huge after all--at least given the numbers we are presented.

What is somewhat disconcerting is that the above statement comes from Niall Ferguson's new book, The Ascent of Money. Ferguson knows no doubt the difference between flows and stocks, or income and wealth.  But the way he sets this up is misleading nonetheless. 

Comments

[Morten]

If you add to your calculation that half of the corporate sector is not listed on the stock exchange, you are back to pretty much 100% 'of' GDP.

[gappy]

Point well taken. I should add that this same mistake is made when some newspapers claim that Bill Gates' net worth is greater than the GDP of, say the poorest 50 countries in the world. There is no doubt that Mr. Gates is a very rich fellow, but comparing stock and flow quantities misrepresents the size of his wealth.

[Asif Dowla]

He also provides a revisionist account of East Asian crisis suggesting that capital control in Malaysia was not successful. He pretty much agrees that IMF's policy prescription of raising interest rate during a recession and not bailing out domestic firms even though that is exactly what we are doing now in the US. He is famous for justifying British Empire in his earlier work. Overall, the book provides good historical background of bond, stock and insurance markets using an eurocentric narrative.

[j man]

Valuing the global economy based on GDP seems sort of like corporate valuation based on EBITDA - this is the amount of wealth we have, assuming that our capital has no cost, our equipment never decays, and we can keep everything we produce.

[Alan]

I think the keywords are : future streams of profits. And that's the problem. The stock market is trying to predict the future and as we all know there are always misses. Just think of all those quarterly earnings that stock analysts try to guess on a regular basis.

[Sandro Perricelli]

Dani,

One important Brazilian officer, allegedly a professor of economics, argues that world GDP is much greater given the size of financial flows, and calls financial flows unmeasured wealth that should and could be taxed.

It is hard to believe, but as far as I know, that same officer is capable of controlling his bowel movements.

Isn't that contradictory?

[Youri Kemp]

Hi Prof Rodrik,

I am not a quantitative genius, so it took me a little while to decipher the basics of the statement above.

But, you are right--it should be a better evauation of the estimation of the current spectre.

Good one and please, continue to put up these mind logging quant questions for us to ponder.

Best,
http://globalviewtoday.blogspot.com/

[eee_eff]

Dani:

I understand the theory you've presented, but there's often a disconnect between a mental construct and reality.

How about a graph showing the historical differential between these two amounts???

[eee_eff]

Dani:

I understand the theory you've presented, but there's often a disconnect between a mental construct and reality.

How about a graph showing the historical differential between these two amounts???

[Nils Torvalds]

I think it's a good point. But. If that had been the result of steady growth I wouldn't be as concerned (as I am). But it wasn't. What is, for instance, the amount of derivatives in that figure? So my comment would be a little like your comment on Martin Wolf in June 2007. ;)

[Richard H. Serlin]

There's very strong incentives and pressure to make your writing exciting and "stylistically good", even if it's more likely to mislead and less likely to teach well.

This is a a giant source of misleadingness and confusion. For more on this, see my very first blog post at:

http://richardhserlin.blogspot.com/2008/05/welcome-to-my-blog.html

[Per Kurowski]

I agree with Dani´s point but…. does not Planet Finance include much more than the market capitalization of the world's stock markets?

[Richard Salvucci]

Somewhere, in the film "The History Boys" there is a line to the effect of "Would you rather be clever or right?" It's pretty apparent that Ferguson made his choice some time ago--and that it's paid off handsomely.

[qiang]

Dear Prof Rodrik，
I am reading your books and papers, and really agree with most of your brilliant ideas.
The past and future history will give a strong support for your ideas.
Thank you.
Qiang

[Julio Huato]

I have a related question: When people give aggregate measures of asset values (say, Planet Finance's $51 trillion), are they properly consolidating the balance sheets? I mean, because, at the end of the day, all financial assets are claims over the existing total physical (and human) wealth in the global economy. Many assets and liabilities should cancel out when you consolidate the planet's balance sheet. You can create mountains of fiat money, debt, derivatives, etc., multiply financial assets ad infinitum, and keep them in individual balance sheets at face value, model value, or pull-off-your-hair value, and then add those figures to come up with some stratospheric sum, which doesn't really change the fact that actual wealth (the things that make human welfare increase) still needs to be produced the hard way, with -- you know -- labor + capital + natural resources. That's why I ask. It seems to me that there's an awful lot of double counting in those figures. Am I wrong?

[Andy Wright]

SO you are saying that the world stick markets were undervalued by 50% in 2006 - so they must be a bargain at now. Are you suggesting we should be buying stocks?
I wonder what the relationship was in 2000 when stocks were at their highest.

[Thorstein Veblen]

Thorstein Veblen is blogging!

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If you are thirsty for more posts by liberal economists, this is one place...

W/ apologies, Dani, for posting this on your site.

[anon]

It's slightly surprising that no one has questioned Rodrik's statement that stock prices reflect future profit streams into the future. Surely Keynes wouldn't say so: markets are largely based on current sentiment and largely follow the "herd". Is he implying that on some level stocks follow a collection of "market fundamentals"? And if so, isn't that kind of thinking what got us to where we are today?

[kharris]

I wonder if the comments from Per and Julio don't need further attention. Can't we change the outlook for the future net income stream by changing the debt load of publicly traded firms? The basic notion that our host offers is clearly right, but isn't it right within a broad range possible outcomes depending on financial structure?

[djohnson]

Anon: I was thinking the same thing with regards to future profit reflection. Sure, one can construct a theoretical world where stock values represent all future profit streams out to some arbitrarily distant point, but no one actually does that (not least because it would be impossible to do, lacking, as we do, knowledge of the future). In reality, it would seem to me that one could only expect the difference between Planet Finance and Planet Earth to represent what people are willing to regard as a reasonable expectation or level of future profit streams w/r/t the present value.

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[Christine Ngo]

It has been a long absence, Dani. There have been much going on at home and abroad. I am anxious to read your views. Hopefully you will write soon.

[edge]

Where is dani????

[Anonymous (thats actually my name]

Well I imagine he's busy since the new semester has started.

[Jurriaan Bendien]

Dani's math doesn't work by my reckoning. 0.5x0.33/0.08 = 2.0625. The value of financial assets such as stockmarket shares should be compared to total assets or total physical stocks. The gross profit component in GDP does not represent total business profits, only profits attributed to production. Both Dani and Niall get it wrong I think.

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