Yesterday, I examined a possible reason why we are seeing fewer startups is because the return to capital is higher than growth. Matt Busigin writes an astonishing post that examines this idea with far more rigor and says:
“This necessarily implies that, if the risk-adjusted expected return is not highest in net new investment, the business manager will instead invest the marginal dollar into existing capital.
If the price of existing capital has been rising, and Net Investment has been muted, we conclude that the price of creating new capital is not competitive with existing capital.
The great irony is that, the richer the country has become, there is less work to be done, which leaves workers with less income. This is our great nominal problem.”
The post is a must read, really. When countries get rich, they have lots of good, existing capital. It’s entirely rational for people to evaluate new business opportunities against just buying older business capital and letting those appreciate.
For example, how did Warren Buffett get rich? He bought some existing capital, and let those businesses knock it out of the park on that existing capital. These businesses have grown tremendously, but a huge portion of the capital they required to grow was already in place when Buffett purchased those companies. The money portion was secondary to the other real capital these companies had built prior to the purchases. He got rich because he thought for the companies he purchased, the return to existing capital would be higher than investing in new companies, and he was correct.
On a wider scale, this is what Matt Busigin is saying: Business managers evaluate the return from existing capital against the expected return from new capital. So what if this is true for the entire economy? We’re all acting like Warren Buffet now because returns to existing capital has the highest expected payoff.
How does all of this work? Matt does not go into reasons why or how this situation might come about – but here is one possible reason – this situation is due to the low rate environment created by using monetary policy to stimulate the economy.
Assets are priced roughly by the reciprocal of the risk free rate. The fed model famously uses the 10 year rate as the divisor for earnings to figure out a “fair value” for the stock market.
So what happens when we get close to zero risk free rates? Well, asset prices reach some level close to their maximum. At some point, people begin to think we are reaching the maximum pricing allowed, given the risk in the markets, so asset values come approach something like a steady state.
And yet…the assets are not at their maximum value. Small decreases in the used risk free rate can cause absolutely astronomical increases in asset values. Moving from a 3% RF rate to the 2% RF rate causes asset prices to increase 50%. Decreasing from 2% to 1% causes asset prices to go up 100%
Remember, everyone is always evaluating existing capital against investing in new capital. Minor changes in the discount rate cause massive price swings in existing capital when the discount rates are low. Of course, everyone knows this – and this is factored into the expected returns from existing capital.
Expected return is the sum of (the return in each possible world times the probability of that world happening). When there is a world where it is possible for rates to go down 100 basis points and for you to double your money, that possibility gets factored into the expected return to existing capital.
This is what new investments need to compete with in order to make investment sense. Is your new investment going to generate income with an existing customer base, and give an upside possibility of 100% asset appreciation. Probably not.
The problem becomes significant to new businesses entrants, because the return hurdle is so much higher than it was when RF rates were at 6%. Then, changes in the discount rate used to value the capital of the company would not result in massive payoffs.
We’re seeing “lots” of investment in lottery style payoff companies (think tech companies), where a few million bucks might end up making billions because this is what it takes to outperform the possibility existing capital seeing a 100 basis point reduction in its discount rate.
Yet, *lots* of investment in tech companies is not the even close to something like a massive build out of millions of miles of roads over 50 years, or running millions of miles of wire for telephones. What were are not seeing is people investing $5 billion in order to make 10% returns over 10 years. This is where the massive quantity of new jobs *must* come from, as Matt points out in his piece. This is our nominal vs. real problem we experience in our economy.
I blame lots of this on the low rate environment, which is a policy choice. We use monetary policy to stimulate our economy. As Godley pointed out long ago, if we want the economy to grow nominally to match the real wealth we are creating, some ratio must get larger. We’ve chosen using private credit as the tool to match the nominal economy to the real economy. The price of doing this with private credit is to create an environment where at some point, the large scale investments necessary to keep full employment do not make economic sense because you expect to make more money investing in existing capital due to the returns from minor decreases in the discount rate used to value capital.
Matt might have a different take on it, but this is at least one way to interpret the data he’s presented. Note, this is a critique of Piketty (started by Matt B) because it explains much of what we see in our world without making a claim r > g forever, and one which suggests solutions entirely different than imposing a tax on wealth.