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4th February 2022
The spectre of inflation has spooked stock markets since the end of last year with headline rates in the US for example above 7% – the highest since 1982. The Bank of England this week suggested that the UK will see a similar rate by April.
There are clear reasons why this inflationary impulse has occurred. Central banks around the world have supported a significant increase in deficit spending through the purchase of government debt and so we have witnessed the biggest Keynesian stimulus since World War Two. The Federal Reserve has more than doubled the size of its balance sheet since the outbreak of COVID-19. Moreover, this massive monetary expansion has been accompanied, for the first time in history, by government policies to shut down large sectors of the economy and impose working practices that have made it impossible for businesses to function as normal.
The outcome has been supply-chain disruption such as we have never seen which, as economies have opened, has led to both price and wage pressure throughout the system. Commodity and basic materials have seen prices up 20-80% from their lows and wages in some sectors, especially hospitality, have been rising at more than 10% p.a.
There are signs that some of this pressure may be about to ease. Industrial production is stabilizing back to pre-pandemic levels, shipping rates are now collapsing, and basic material prices are rolling over (except oil and gas). There are also signs that wage pressure isn’t compounding quite as much as feared as labour participation rates pick up.
We wouldn’t want to get too confident on the inflation front but if it is close to a peak, what would this mean for investors?
Although several interest rate hikes from the Federal Reserve are now priced in and bond yields have moved up this year, we still face the most negative real (inflation adjusted) yields since the 1970s.
Looking through a long lens in this chart going back to 1928, when negative yields have reversed it’s been because inflation has fallen sharply, not because bond yields have risen.
Once that reversal happens and real negative yields bottom out, it’s generally been a good time to buy the stock market with a long-term view. The grey bars on the chart show the ensuing 3 years market performance from the month that real rates turn.
29th June 2021
We have written a great deal over the last few years on the wealth polarising effect of monetisation. Given the significant increase in the Federal Reserve’s balance sheet through the COVID19 lockdowns, therefore, it should come as no surprise that the portion of net worth owned by America’s wealthy has increased again – nearly a third of all net worth in the US is in the hands of the Top 1% (see figure 1).
The most often cited cause of this is the Fed’s impact (although they largely deny this) on the price of assets held mainly by the well-off. There are, however, more subtle drivers too. The swings seen in asset markets, due to both COVID in 2020, and the longer-term effect rising leverage has on market volatility, has made it more difficult for the less-well off to hold on. In a bear market, as John Pierpont Morgan somewhat cynically pointed out, “stocks return to their rightful owners” and so if bear markets come more often and more sharply, then the rate of repatriation will only accelerate.
This might explain why, as shown in figure 2, the ownership of corporate equities and mutual funds in the US has become even more concentrated than for other forms of wealth. More than a half of all business equity, held either directly or indirectly, is held by the top one per cent of all owners. A trend that looks set to accelerate.
It may not only come down to the capacity to sustain losses, however. As in all western countries, good advice comes at a price. At Equitile we are not financial advisers but we talk to many advisers through the course of our business. As we see it, the crucial value of a good adviser is support and encouragement when the market has a set-back. A good adviser is in the best position to help investors overcome their natural behavioural aversion to loss, and to help plan their broader finances to make this easier. With good personal advice now scarce and expensive for those of lesser means, the ability to sustain losses floats ever upwards.
One intriguing move by the top 1% is their move away from bonds. Their holdings of debt assets (figure 3) has fallen from more than 60% to 40% of all debt assets in the last two decade - they sold aggressively throughout the COVID crisis.
With real interest rates in the US the most negative since the 1970’s, the potential for capital destruction through financial repression, for bond holders at least, is rising sharply. Perhaps the top 1% know this instinctively, or perhaps they are just better advised.
18th March 2021
Yesterday’s FOMC statement is important (March 17th 2021).
There are three points worthy of note:
1: “the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time”
This is a commitment to the ‘make up strategy’ whereby the Fed seeks to achieve higher future inflation to make up for previously having failed to achieve its desired 2% inflation target. From the FOMC’s perspective, this narrative provides the flexibility keep interest rates extremely low even if it becomes manifestly clear it is failing to maintain inflation at or below its 2% target. This is, as explained by the following passage, now the FOMC’s goal:
2: The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.
The FOMC’s goal is first to achieve a negative real interest rate of at least 2% and then to maintain that negative interest rate for ‘some time’. In other words, the FOMC would like to see the spending power of money, saved in the government bond markets, falling by at least 2% per year for the foreseeable future. In order to achieve this the committee is making an open-ended and asymmetric commitment to balance sheet expansion, arguably a euphemism for debt monetization:
3: Federal Reserve will continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee's maximum employment and price stability goals.
In our view, FOMC is being both honest and pragmatic, effectively admitting the cost of the economic lockdown policies of 2020 and 2021 can only be funded through the printing press. As a result, we believe we are already in the early stages of an uptrend in inflation which will likely last several decades.
We expect the inflation trend to be maintained and accelerated through monetary and fiscal policy coordination; governments will continue spending far beyond their means and central banks will continue ‘footing the bill’ with monetization and negative real interest rates. If so, the global government bond markets will cease to be a viable long-term savings vehicle for the private sector.
8th February 2021
Silvana Tenreyro, one of the external members of the Bank of England’s Monetary Policy Committee gave an important speech on January 11th titled Let’s talk about negative rates.
The content of the speech itself it not especially ground-breaking. As the title suggests it is a discussion of the pros and cons of the Bank of England pushing short term interest rates into negative territory. Nevertheless a few passages are noteworthy.
First there is a reminder that the Bank of England is already doing the work to ensure negative interest rates can be implemented in the British banking system:
“the Bank of England began structured engagement with firms on operational considerations regarding the feasibility of negative interest rates…Once the Bank is satisfied that negative rates are feasible, then the MPC would face a separate decision over whether they are the optimal tool to use to meet the inflation target given circumstances at the time.”
Then there is a longer section explaining how successful negative interest rates have been in other countries:
“the ‘financial-market channels’ of monetary policy transmission have worked effectively under negative rates in other countries …the evidence from experiences of negative rates in other countries suggests that ‘bank-lending channels’ of monetary policy transmission have also been effective at boosting lending and activity”
“· Financial-market channels appear to be unimpeded under negative rates, and some may even be stronger than usual.
We are not persuaded of the benefits of negative interest rates.
We remain concerned over the negative impact negative rates have on the banking sector. As Silvana Tenreyro notes negative interest rates were implemented in the Eurozone in 2014, since then the index of European bank stocks has fallen by approximately 45% in value. Over the same period a similar index of US bank stocks has risen by approximately 50%.
We are also unpersuaded negative rates help stimulate the real economy. Economists argue lower rates drive asset prices higher, boosting borrowing and thereby economic activity. We find this argument persuasive but only up to a point. In our view it is important to recognise much savings are effectively non-discretionary. The savings people put aside for the purpose of house purchases and to fund their retirement are driven by necessity rather than choice. To the extent lower interest rates boost the price of assets and lower the income from those assets the policy means people must divert more of their income toward savings and away from consumption, causing a drag on economic activity.
A simple thought experiment on the topic of negative interest rates is worth pondering:
Case A: You wake up one morning to find the bank has made a terrible error, paying you 100% interest. The money in your bank account has doubled overnight.
Case B: You wake up one morning to find the bank has made a terrible error, charging you 100% interest. The money in your bank account has vanished overnight.
In which of these two scenarios do you increase your spending? To economists focussing on capital market effects negative interest rates look like a stimulus. To savers, worried about banks withdrawing money from their accounts, negative interest rates look like the opposite of a stimulus.
The discussion of negative interest rates in the speech is entirely concerned with the effect on the private sector economy. In our view this misses the true purpose of negative interest rates which is largely to augment government finances.
The main beneficiary of negative interest rates are governments which can issue bonds with negative yields and get paid, by their central bank, with newly printed money, for doing so. In other words, negative interest rates could be viewed as a thinly veiled mechanism of enabling monetised deficit spending. Given the extraordinary level of government spending, caused by the economic lockdown, the pressure on the Bank of England to facilitate monetised deficit spending has grown dramatically in the last year.
In summary, we view recent comments by Bank of England officials as preparing the groundwork for negative interest rates. Investors and savers should take note and consider their own response. Although we disagree with the Bank’s sanguine assessment of the impact of negative interest rates on the real economy and banking sector, we agree such a policy is likely to cause further asset price inflation.
6th July 2020
As pubs and restaurants opened in the UK last weekend, we’ve heard mixed reports on how many customers returned. Either way, it doesn’t look like there was a mad rush back.
Most likely, they’ll see a repeat of the retail sector’s experience over the three weeks after they were allowed to open - things have picked up but not by much. Data from Springboard shows footfall in the high street is still less than 40% of what it was at the beginning of March. Retail parks are faring better but are still only seeing around 70% of the footfall they were before lockdown.
In George’s recent COVID-19 Insights piece he talked about the likely bifurcation in the fortunes of the very large companies and small ones, particularly in retail, hospitality and travel. It seems that his projection is playing out.
The Bank of England reported last week that, while SME’s had increased their net borrowing in May by £18.2 billion, large ones had paid off £12.9 billion of debt.
A recent ONS survey analysing the impact of COVID-19 paints a similar picture with the financial resilience of many small companies now being seriously tested. Of the 5,600 or so companies which responded, 14% were still not trading by mid-June. Of the 86% that were trading, 18% of their staff were still furloughed.
More worrying was companies’ assessment of their financial resilience. Of those businesses actually trading in mid-June, 44% said they have cash reserves to last less than six months. Including business that were still closed, close to half said they can’t survive more than six months given their current cash reserves.
The economy needs to pick up much more quickly if many of the UK’s smaller enterprises are to survive.
2nd July 2020
It doesn’t look like the permitted re-opening of retail stores in the UK has marked a rush back to the shops. One might have expected people to be cautious in the first week or so but even in week two the footfall in England and Northern Ireland was still down 53.1% on the same week the year before (Springboard). It’s hard to say how quickly confidence builds from here, especially in light of an impending sharp rise in unemployment once the government’s furlough scheme comes to an end. One thing is clear though - there’s no shortage of cash right now.
The Bank of England published data last week showing the sharp increase in retail bank deposits. There’s a startling build up of saving as those with an income spent more than 100 days, with the exception of Amazon and grocery stores, with no where to spend.
Wherever you look, there’s been a significant improvement in consumers’ balance sheet in aggregate. In fact, taking both consumer and companies together, saving has been significantly higher than borrowing for some weeks.
It can’t go on forever of course, Keynes’ so-called Paradox of Thrift can soon take hold. For now though, those left with an income have plenty of financial capacity to fulfil their pent-up demand.
21st February 2020
It looks like our argument in a recent blog - that LVMH shareholders were getting a free lunch – seems to have been understated. Bernard Arnault, the company’s driving force, might have made his most transformative deal yet and, moreover, have it mostly paid for by the European Central Bank.
Whereas our previous calculation (see our December 2019 comment) assumed 0.5% cost of debt funding for the Tiffany acquisition, the first EUR 9.5bn (of EUR14.5bn acquisition cost) has been locked in at even better rates through ECB’s Corporate Sector Purchasing Program. The issuance announced this week consists of five tranches; two of which carry negative yields. Even the longest maturity, an 11-year bond, has a coupon of no more than 0.45%. All in, this is around half of the price LVMH was expecting to pay when the structure of the deal was first laid out late last year.
So, what we thought would be an annual funding cost of EUR 73 million will now be somewhere between EUR 44m and 65 million. Trivial considering LVMH’s shareholders are accruing EUR 500-600 million of additional cash flow.
2nd February 2020
Within twenty-four hours of the Chinese authorities uploading the genetic code for the Corona virus to the internet, a San Diego based biotech company, Inovio, had digitally designed a vaccine and produced the first samples in its own lab. They started pre-clinical trials within a week and their vaccine, INO-4800, should to be tested on humans (assuming it’s found to be safe) by the early summer. Inovio is not the only company working on a vaccine - they are in healthy competition with, amongst others, Johnson & Johnson, Moderna Therapeutics and scientists in Australia.
It’s a great example of how exponential growth in computing power is leading to a revolution in drug development. During the SARS outbreak in 2003 it took nearly two years before a vaccine was ready for human trials, for the Zika virus of 2015 this was down to six months – this time it will be a matter of weeks.
Digitally designed molecules to fight pathogens might look like the stuff of sci-fi but as processing speeds continue to double every eighteen months, the ability to design and test drugs without ever entering the lab is now normal.
I’ve been following the development of a US based private company, Schroedinger, which has industrialised molecule design on a grand scale. Whereas traditional approaches to drug discovery might have synthesized 1,000 compounds each year, Schroedinger’s platform can evaluates billions of molecules “in silico” per week with only the most promising molecules reaching the lab – some within the company’s own drug development programs. It’s not possible for us to buy shares in the company but their shareholder base is further testament to the convergence of computing power and bioscience – one of the company’s early investors was no other than Bill Gates.
The connection between processing speeds and drug development is especially clear in genetic science. The cost of sequencing the human genome has fallen from $100,000,000 in 2001 to a little over $1,000 today. It’s no surprise, therefore, that patent filings for gene-based therapies are growing exponentially.
Whether a vaccine for the Corona virus will be available in time to stop it becoming a pandemic - or more likely before it burns itself out - is yet to be seen. The battle between silicon and pathogens, however, is in full swing.
One can speculate on where this might lead. Along with ubiquitous computing power, smartphone health monitoring, home testing kits and so on, small companies and individuals can now innovate in a way that was previously the preserve of large corporations. And so, if there are any hobbyists out there who fancy their chances, here are the first 1,020 nucleotides out of 29,904 that make up the RNA of the Wuhan-Hu-Q. Good luck.
18th December 2019
SHARES Magazine's 2020 Outlook edition has an article explaining how we invest at Equitile.
2nd December 2019
A visit to Tiffany’s would, to most of us, prove an expensive affair but the breakfast Antonio Belloni, Group Managing Director at LVMH, had with Tiffany’s CEO early in October will be the most lucrative one he’ll have this year. The European luxury conglomerate will overtake Switzerland’s Richemont as the leading player in high-end jewellery after it completes a EUR 14.6 billion takeover of Tiffany in 2020 – building on its position as global leader when it comes to fashion & leather goods, fine spirits and luxury boutique hotels.
The deal becomes most interesting, however, when one looks at the funding of it.
LVMH will acquire Tiffany by issuing corporate bonds at ultra-low rates. With their current 2024 bond yielding minus 12bps, the opportunity for the company to lock in long-term funding costs of close to zero is clear. Even bonds issued by LVMH with a 10 or 15 year maturities will yield next to nothing. Despite the low yield, they won’t struggle to find demand however - the company issued a EUR 300 million tranche with a negative yield in March this year and the deal was six times oversubscribed.
Even if longer-term funding costs were, say, 50bps - realistic in a world where USD 10 trillion of debt has negative yields and the combined entity will still only have net debt/EBITDA of 1.6x – LVMH will pay EUR 73 million annually to bondholders in return for Tiffany’s annual estimated operational cash flow of EUR 500-600 million.
In effect, the bondholders who are paying for Tiffany are bound to lose money, in real terms, while the shareholders of LVMH will extract a net annual cashflow EUR 430-530 million. And that’s before the growth - there are already material plans to expand in China and Japan, markets where LVMH has proven success (Tiffany has remained largely an American brand).
LVMH’s customers, of course, are the sort of people who own shares in LVMH. As central banks keep interest rates close to zero, assets like Tiffany can be bought at virtually no cost to the acquirer’s shareholders who, in turn, have more to spend on expensive handbags and jewellery.
It’s a textbook case of how wealth polarization works in practice in the current monetary environment. As an investor, in this case at least, it’s a chance to be on the right side of it.
30th November 2019
I have been asked to re-post four articles origionally written in April/May 2014 about the ideas of Thomas Piketty in his book Capital in the Twenty First Century: The Magical Mathematics of Mr Piketty Part 1 and Part 2, Credit in the Twenty First Century and The Horrible History of Mr Piketty
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The Magical Mathematics of Mr Piketty Part 1
To my mind the best quote from Thomas Piketty’s new book Capital in the Twenty-First Century is: “To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics…” p32
I could not agree more. But this does not mean we should dispense with mathematics entirely. Some problems in economics are easily formulated in mathematics, for those the equations can be a useful tool to test the validity of the underlying logic. This is true for the ideas in Piketty’s own book.
There are only three important mathematical relationships in Piketty’s book but I am having trouble reconciling them, especially in the low growth world that Piketty wants to analyse.
The three relationships are:
“This fundamental inequality, which I will write as r > g (where r stands for the average annual rate of return on capital, including profits, dividends, interest, rents, and other income from capital, expressed as a percentage of its total value, and g stands for the rate of growth of the economy, that is the annual increase in income or output), will play a crucial role in this book. In a sense, it sums up the overall logic of my conclusions.”
r > g
“I can now present the first fundamental law of capitalism, which links the capital stock to the flow of income from capital. The capital/income ratio β is related in a simple way to the share of income from capital in national income, denoted α. The formula is
α = r × β
Where r is the rate of return on capital.
For example, if β=600% and r = 5%, then α = r × β = 30%.
In other words, if national wealth represents the equivalent of six years of national income, and the rate of return on capital is 5 percent per year, then capital’s share in national income is 30 percent.”
“In the long run, the capital/income ratio β is related in a simple and transparent way to the savings rate s and the growth rate g according to the following formula:
β = s / g
For example, if s = 12% and g = 2%, then β = s/g = 600%.
In other words, if a country saves 12 percent of its national income every year, and the rate of growth of its national income is 2 percent per year, then in the long run the capital/income ratio will be equal to 600 percent: the country will have accumulated capital worth six years of national income.”
In summary the three key relationships in Piketty’s mathematical framework are:
The inequality r > g
The first fundamental law of capitalism: α = r × β
The second fundamental law of capitalism: β = s/g
Of these Piketty’s inequality has captured most attention. Piketty is at pains to emphasise that, r, the return on capital is always greater than, g, the growth rate of the economy. He also maintains that r is more or less a constant at around 4 to 5% and he expects growth to head lower toward around 1 to 1.5%.
We can explore what happens to these relationships as the rate of economic growth falls toward zero.
To keep the examples simple I will assume a constant return on capital of 5% and a constant savings ratio of 10%. This leaves the growth rate, g, as the only free variable in the system.
The following table shows the key variables under different growth scenarios.
| Growth rate | g | 4% | 2% | 1% | 0.50% | 0.25% | 0.125% |
| Savings Rate | s | 10% | 10% | 10% | 10% | 10% | 10% |
| Return on Capital | r | 5% | 5% | 5% | 5% | 5% | 5% |
| Capital/Income ratio | s/g | 2.5 | 5 | 10 | 20 | 40 | 80 |
| Share of national income going to owners of capital | r x(s/g) | 12.5% | 25.0% | 50.0% | 100.0% | 200.0% | 400.0% |
| Share of national income going to workers | 1-r x(s/g) | 87.5% | 75.0% | 50.0% | 0.0% | -100.0% | -300.0% |
As growth falls capital values rise pushing up the share of national income accruing to the owners of capital – one of Piketty’s key concerns. However as growth falls toward zero it becomes apparent that all is not well in this model. The capital/income ratio eventually rises to a point where more than 100% of the national income goes to the owners of capital - clearly an impossible scenario.
The problem arises because Piketty’s second ‘fundamental’ law of capitalism β=s/g contains a singularity , a divide by zero, which sends the value of capital toward infinity as the economy stagnates. When coupled with Piketty’s assertion that the return on capital remains above g, at around 4 to 5%, this sends the income from capital to infinity – another impossibility
Piketty’s equations simply cannot hold true in the low growth environment which he is trying to analyse.
The question is how to fix them. The most logical approach is to accept that the yields on assets fluctuate to reflect the growth rate of the economy. If growth is cut in half then asset prices will double but their yields will also be cut in half, a condition met when r = g.
If the scenarios are re-run with r = g we get the following results shown in the table below.
If we accept that the real return on assets floats with growth, r = g not, as Piketty claims, r > g, then there is no conflict with either of Piketty’s two fundamental laws of capitalism.
I expect the r = g assumption will make more intuitive sense to investors who have seen the real yields on, for example, inflation protected bonds collapse as growth has fallen. It also helps explain why pension funds are struggling to meet their funding targets and why the UK government has recently relaxed the requirement for pensioners to buy annuities – because annuity yields have fallen in line with economic growth.
However the r = g assumption causes a significant issue for Piketty’s case for a wealth tax. If r = g prevails in a low growth world then Piketty’s 2% wealth tax could push the return on capital into negative territory potentially crushing entrepreneurial activity.
In conclusion – Piketty’s own fundamental laws of capitalism appear at odds with the inequality on which much of his book is based. This is especially true in the low growth world he is concerned about.
| Growth rate | g | 4% | 2% | 1% | 0.50% | 0.25% | 0.125% |
| Savings Rate | s | 10% | 10% | 10% | 10% | 10% | 10% |
| Return on Capital | r=g | 4% | 2% | 1% | 1% | 0.25% | 0.125% |
| Capital/Income ratio | s/g | 2.5 | 5 | 10 | 20 | 40 | 80 |
| Share of national income going to owners of capital | r x(s/g) | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% |
| Share of national income going to workers | 1-r x(s/g) | 90.0% | 90.0% | 90.0% | 90.0% | 90.0% | 90.0% |
30th November 2019
I have been asked to re-post four articles origionally written in April/May 2014 about the ideas of Thomas Piketty in his book Capital in the Twenty First Century: The Magical Mathematics of Mr Piketty Part 1 and Part 2, Credit in the Twenty First Century and The Horrible History of Mr Piketty
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The Magical Mathematics of Mr Piketty Part 2
The philosopher Friedrich Nietzsche wrote: “There is no more dangerous error than confounding consequence with cause: I call it the intrinsic depravity of reason.” In economics the problem of confusing cause and effect is rife and frequently leads to disastrous policy mistakes.
The more I think about the logical framework of Thomas Piketty’s Capital In The Twenty-First Century, the more I become concerned that Mr Piketty has fallen into Nietzsche’s trap. I fear that Piketty has got his causes and effects the wrong way round.
To explain where I think the problem lies, I am going to use a simple thought experiment:
***
Consider an isolated island kingdom. Half of the island is covered in productive farmland and half is covered in unproductive land which is too rocky to farm. The island is a perfect feudal society. The King owns all of the land and therefore all of the capital of the island. All of the island’s inhabitants work for the King.
Fortunately the island’s farmland is fertile enough to produce more food than is needed to pay the wages of the farmworkers who tend the crops. As a result, in each year, the King enjoys a surplus value of food which he uses to pay the wages of additional workers. The King employs these additional workers to clear the rocky-land thereby turning it into new productive farmland.
It so happens that each acre of farmland requires exactly 9 people to farm it, yet in each year it produces enough food to pay the wages of exactly 10 workers. It also happens that it takes exactly 20 years of labour to turn each acre of rocky land into productive new farmland.
The upshot of these convenient numbers is, for each twenty acres of land owned by the King he is able to employ enough workers to convert exactly one additional acre of land into new productive farmland each year. As a result the King’s farmland, and therefore the island’s economy, grows at a steady rate of 1/20, or 5%, per year.
It also so happens that the King’s hobby is accountancy – stay with me! The King likes to idle away his time tallying his earnings and wealth. For convenience he chooses to do this by accounting for everything in units of ‘years of labour’.
The King notes that, each year, each of his acres of farmland produces enough food to purchase 10 years of labour. He also notes that, in order to receive this 10 years of labour, he must spend 9 years of labour to pay the wages of the farm workers. He therefore considers that each acre of land generates a profit to himself of 1 year of labour.
He also notes that it takes 20 years of labour to turn an acre of rocky-land into productive farmland and therefore considers that each new acre of land costs 20 years of labour. Once cleared of rocks the new farmland is no more nor less productive than the old farmland. He therefore considers old and new farmland to be of equal value and accounts for each of his acres as being worth 20 years of labour.
As each acre of land produces a surplus value of 1 year of labour and is valued as being worth 20 years of labour the King considers that he receive a return on his farmland of 1/20 or 5% per year.
The King notes that the yield he receives on his farmland, r, and the rate of growth of his acreage, g, are both equal, r = g, at 5%.
The King is so intrigued by the coincidence between the 5% return on his farmland and the 5% rate of growth of his acreage that he commissions two of his most venerated priests to investigate the phenomenon. The two priests, Karl and Adam, set about their task of investigating the r = g conundrum.
After years of research the two priests are summoned to present their findings to the King’s court.
Karl presents his report first. His is an enormous work running to hundreds of pages and is packed with charts and tables.
Karl begins speaking: “My lord, I have researched the r = g conundrum and I can conclude that it is just an incredible coincidence, there’s no natural force behind this incredible coincidence of pushing the growth rate of the economy toward the rate of return on capital.”
The King is clearly disappointed by this finding but Karl continued: “Nevertheless, my studies have lead me to discover new and important laws and relationships governing the workings of our island’s economy. I have studied all the records of this land, through all of its known history, and I can tell you that the return on farmland has always been 5% per year. So reliable has been this rate of return I am forced to conclude that a 5% return on capital must now be considered to be something close to a universal constant of economics.
Furthermore, I have discovered the ratio of the value of the capital of the economy relative to the value of its annual production is governed by a new fundamental law of capitalism. This law states that the ratio of capital to income is the same as the ratio of the savings rate to the growth rate of the economy.”
The King looked rather more pleased with these exciting new findings but his enthusiasm was soon dashed by the terrible news that Karl delivered next: “Unfortunately, my Lord, these new findings lead me to conclude that the island is about to suffer a terrible famine.”
At this point Karl pauses for dramatic effect and to give time for the assembled audience of high priests to nod and mutter their approval. One of the high priests becomes too excited to contain himself. He leaps to his feet and declares: “If you think you have found an obvious hole, logical or empirical, in Karl then you’re very probably wrong.”
Karl continues: “I have been up to the north of the Island to survey the rocky-lands that are yet to be cleared. The news is very dire. I can report that this land is much rockier than any we have cleared so far. I estimate that the cost of clearing this land will be not 20 years of labour per acre but 40 years of labour.”
Again he pauses for effect as the priests gasp at this terrible news.
Karl continues:” Once we are forced to start clearing the very-rocky land I am afraid to say the whole island will be plunged into a dreadful famine.”
At this point the King, who is becoming increasingly bemused, interjects with a question. The King asks: “You are saying that today we are able to feed ourselves quite amply and also able to clear the less rocky land but that in the future, when we start clearing the rockier land, there will suddenly be famine. How can this be so? Will the island not still have the same farmland that it had before?”
Karl responds: “Let me explain. It is my new laws of capitalism which show the inevitability of this famine. Clearing the rockier land will take not 20 but 40 years of labour. As a result the price of purchasing each new acre of land will double. Once this happens we will be forced to revalue the rest of Your Majesty’s capital. The value of your capital will double, to reflect the new higher cost of purchasing new land.
It is this higher valuation of capital that will cause the dreadful famine. Due to my newly discovered law, showing that the return on capital is always 5%, your income will double so that you will now receive not 1 but 2 years of surplus value per acre. This doubling of income being necessary to keep the yield of your land at 2/40 or 5%.
As a consequence there will be just 8 years of labour available to pay for the 9 farmworkers required to tend each acre of land. Incomes will fall sharply and sadly people will starve.”
At this point the King, loses his temper and turns to the second priest demanding: “Adam, is this true? Are the farmers facing famine?”
Adam, who was becoming increasingly agitated during Karl’s presentation, hands the King his own report – a single sheet of paper marked with just one expression “r ≡ g”.
Adam begins speaking: “My Lord, I fear that my most esteemed colleague, Karl, is talking poppycock. There will be no famine. The problem is, he has got his cause and effect the wrong way round.”
The priests in the gallery, who sense their beautiful crisis slipping away, start hissing and catcalling.
Adam continues: “The relationship between growth and the return on land is not a coincidence. The two are tied together by nothing more nor less than your own accounts, My Lord.
Each acre of land produces 1 year of surplus value and each acre of land is valued at the price, in years of labour, of clearing a new acre of land. It follows that yield of your land is simply 1 divided by years of labour needed to clear new land. However that same calculation also gives you the fraction of each new acre that can be cleared with the surplus generated from each existing acre. You are choosing to calculate the yield on your existing land from the cost of purchasing new land and so the two numbers, r and g, are the same.
Let me explain with some examples.
If it takes 10 years of labour to clear an acre of land, each acre will be worth 10 and will have a yield of 1/10. And each year of labour will pay for 1/10th of a new acre of land. The yield and the rate of growth will be 10% in both cases.
If it takes 20 years of labour to clear an acre of land, each acre will be worth 20 and will have a yield of 1/20. And each year of labour will pay for 1/20th of a new acre of land. The yield and the rate of growth will be 5% in both cases.
If it takes 40 years of labour to clear an acre of land, each acre will be worth 40 and will have a yield of 1/40. And each year of labour will pay for 1/40th of a new acre of land. The yield and the rate of growth will be 2.5% in both cases.
In all cases r will be equal to g simply because, My Lord, you are choosing to value your existing capital at the same price as the cost of acquiring new capital.
I have heard rumours that, in distant lands, this practice is referred to as the no-arbitrage condition or the law of one price and is considered by some to be a fundamental law of capitalism.”
The King pauses for a moment before asking: “And what of the famine and my surging income and asset prices?”
Adam replies: “The price of your land will double, when accounted for in years of labour, but each acre will still produce the same 1 year of surplus value, so the yield on your land will be halved. Your incomings and outgoings will remain unchanged and your workers will be paid just as before. However the rate at which you accumulate new land will be halved.
There will be no famine.”
***
I may be missing something obvious in how I am thinking about Piketty’s thesis. He is arguing we face a low growth future. To my mind, this means that we are faced with a situation where it becomes more expensive to purchase additional economic activity. That is to say the return on new investment must be lower. Yet at the same time he is also saying that the return on the existing stock of investment will remain high even in this new low growth world. I am struggling to understand how the markets will not arbitrage away the different returns available on new and existing capital.
The question I am asking myself is: Does Piketty’s thesis require the impossible situation of having two different prices for interchangeable, fungible, assets?
Clearly the story above is not a model of a modern developed economy. Nevertheless it is a useful aid to assist thinking about the relationships between: return on capital, economic growth, savings rates and capital valuations. Hopefully it helps to demonstrate that it is unreasonable to consider these variables as being independent of one another.
Piketty is of the view that r, the return on capital, and, g, the rate of economic growth are quite independent of one another – to quote: “There’s no pilot in the plane, there’s no natural force that will make this incredible coincidence of pushing the growth rate toward the rate of return happen, and so we need to find another plan in case this does not happen.”
Reasonable people can take a different view on this. Piketty warns of a future low growth world with much higher levels of capital and as a consequence capital’s share of income rising significantly: “experience suggests that the predictable rise in the capital/income ratio will not necessarily lead to a significant drop in the return on capital… With a capital/income ratio of seven to eight years and a rate of return on capital of 4-5 percent, capital’s share of global income could amount to 30 or 40 percent, a level close to that observed in the eighteenth and nineteenth centuries, and it might rise even higher.”
My questioning of Piketty’s thesis is not an attempt to defend the status quo. I have myself written on the flaws in economic theory and offered suggestions on how we may go about reforming the science of economics. Both our economic policies and our economic theories have failed us terribly in recent years. The science of economics needs a radical overhaul, but leaping from one flawed theory to another, without thoroughly testing its logic, is not the way to proceed.
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