WHATEVER HAPPENED TO RETURNS ON CAPITAL?
FOREWORD
If you own a portfolio of stocks whose value has risen over time, or a property whose market price has increased, you are at liberty to cash in those gains by selling your investment. This, though, does not apply to investors in the aggregate because, by definition, any sizeable selling activity drives prices down, thus reducing, eliminating or reversing prior capital appreciation.
Put another way, the tidal-wave of cheap money poured into the economy over the past fourteen years, whilst it may have enriched some, has created paper, notional or non-realisable gains for the majority of investors, including those ‘ordinary’, non-wealthy people whose savings are managed by institutions, and whose wealth is often based on inflated property values which, in the aggregate, cannot be turned into cash.
The principle is that, unlike incomes from dividends or rents, aggregate gains in asset prices cannot be monetized.
Though critical, this point is entirely missed by any media reporter who writes about the billions (or trillions) ‘gained’ by investors over a given period of time, and by those statisticians who, by multiplying the price of the average home by the number of properties, purport to put an aggregate ‘value’ on a nation’s housing stock. The multiplication of aggregate quantities – such as the numbers of stocks, bonds or properties – by marginal transaction prices creates valuations which are as meaningless as they are often impressive.
This needs to be borne in mind when we look at the gains supposedly made ‘by investors’ since the authorities adopted policies which, by driving down returns on capital, have created enormous increases in the market values of assets.
The subject of ‘investors’ has become almost toxic since the global financial crisis, when the authorities were accused of ‘rescuing Wall Street by plundering Main Street’. Inequalities of incomes and wealth have undoubtedly widened dramatically, and some governments have actually made this worse by ‘helping’ young people to go deeply into debt in order to shore up property prices to the benefit of their elders. There is nothing here that any reasonable person would try to defend.
Analytically, though, something fundamental has happened to returns on capital. Income returns – in the form of bankable cash – have been crushed, and replaced by non-bankable capital gains which, in the aggregate, can’t be monetized.
We know how this has happened, and we can be pretty sure about where it ends, which is in falls of varying (but generally severe) magnitude across the gamut of asset classes.
But why has the financial system behaved in this way? The view set out here is that an economy characterised by cosmetic “growth” has been forced to resort to replacing bankable investment returns with cosmetic, non-monetizable “returns” on capital.
What follows is not, in any sense ‘sympathetic’ to investors, still less a defence of the paper beneficiaries of the divergence between incomes and asset prices. Rather, the aim is to examine the abandonment of market and capitalist principles in the face of unacknowledged economic contraction.
INTRODUCTION
Time was when investors earned solid (and, for the most part, reliable) returns on their capital, in the form of cash incomes from stock dividends, bond coupons and property rentals. They would, of course, hope that these returns would be augmented by capital appreciation, but saving and investment remained viable so long as, over time, both incomes and asset prices at least matched inflation. The relationship between risk and return could be calibrated in these terms, with growth potential known to be in an inverse relationship with yields.
Latterly, yields – the rates of income earned on capital – have been crushed, making capital appreciation the primary form of return on investment. But there’s a fundamental difference between investment income and capital gains – whilst incomes are bankable, capital appreciation, in the aggregate, is not. As remarked earlier, the individual can sell his or her stocks, bonds or property in order to bank asset price appreciation, but investors collectively cannot do so.
In short, investors, as a class, have been stripped of cash incomes and fobbed off with paper capital appreciation that cannot, in the aggregate, be monetized, and may very well evaporate as markets back away from the frenzied pursuit of purely paper gains.
The mechanism by which this has happened is clear enough, and is traceable to the adoption and continuation of ultra-low interest rates in response to the global financial crisis (GFC) of 2008-09. But the rationale for this process is far from immediately obvious.
Critics allege that the motivation has been a desire to enrich a wealthy minority at the expense of everyone else, but this explanation, for all its apparent appeal, is faulty. This may well have been the intention but, to be effective, it would have to mean that the wealthiest people could turn all or most of their inflated wealth into cash, which is something that they cannot do at any significant scale. They can use their notional wealth as collateral, but this adds new forms of risk to the ever-present possibility that asset price slumps could diminish their wealth.
The real explanation is simpler. It is that the economy can no longer afford to pay significant levels of bankable income to investors. As the economy has deteriorated, policy responses have, knowingly or not, prioritized the support of demand over returns on capital. What this in turn means is that the system of market capitalism has been abandoned, in all but name.
Let’s be quite clear about this. The fundamental, indispensable principle of capitalism is that investors receive real (above inflation) returns on their capital. A market economy, meanwhile, requires that markets are allowed to perform their critical functions – which are price discovery, and the pricing of risk – without undue interference.
An economy cannot be described as ‘capitalist’ once real returns on capital have been driven into negative territory, and markets cannot be said to be functioning properly when they have been subjected to massive intervention in the form of huge quantities of money created out of the ether.
Throughout its existence, capitalism has been opposed by ‘left wing’ thinkers and actors who have aspired to its destruction. The irony now is that market capitalism has been brought down, not by its enemies, but by its friends.
The obvious question is “why?”, and the true (though less-than-obvious) answer is economic deterioration. We are making do with cosmetic, ‘in name only’ capitalism for the same reason that we are deluding ourselves with cosmetic economic “growth”.
REAL RATES – LOCKED INTO NEGATIVE
In recent weeks, American markets have rallied – and the dollar has weakened – on speculation that the Federal Reserve might be softening its stance on monetary policy. There’s no evidence, in the Fed’s statements or actions, that any such softening is actually taking place or planned but, as the poet Alexander Pope almost put it, ‘hype springs eternal’.
Central banks use a range of inflation measures in the setting of policy rates but, for our purposes, the best yardstick for comparison is the headline rate of inflation in each currency area. On this basis, the Fed policy rate (4.0%) is 3.7% below inflation (7.7%). Real policy rates in Britain and the Euro Area are -8.1% and -8.0%, respectively (which, in a wiser world, might tell us all we need to know about both of those economies).
There’s a recognized connection which links deflation to economic recession, and this means that monetary policies intended to tame inflation risk inducing or exacerbating recessionary pressures. With this in mind, let’s think this situation through, imagining that, whilst the Fed does indeed, as expected, raise rates by a further 100bps, American headline inflation has retreated to, say, 6% by the time that this has been accomplished.
This scenario would leave US real rates at -1% on this basis of comparison. In such circumstances, would the Fed carry on raising rates? This seems implausible, not least because economic deterioration would prompt a chorus of demands for monetary loosening. In short, it’s unlikely that American policy rates will ever rise above inflation.
The situation is even more stark in the Euro Area and the United Kingdom. The only factor that is likely to tame European and British inflation is a severe and protracted recession, something which has already started to unfold. The British economy, in particular, shows many signs of shaking itself to pieces.
If headline inflation rates were to fall because of economic deterioration, would the European Central Bank or the Bank of England carry on raising rates? This is surely almost inconceivable. The British and European economies seem to be condemned to real rates remaining in deeply negative territory in perpetuity.
And ‘condemned’ is the mot juste. Negative real rates are not just anomalous, but extraordinarily harmful, yet, as the following charts show, they have been the norm since the GFC of 2008-09. Over that same period there has been a dramatic increase in the assets of the main Western central banks, which rose from $2.7 trillion at the start of 2007 to a recent peak of $26tn.
Fig. 1
MEANS AND CONSEQUENCES
As everyone presumably knows, rate repression was adopted during the GFC, and methods of implementation fell into two main categories. First, central banks slashed policy rates as part of ZIRP (zero) or negative (NIRP) interest rate policies. Second, they used newly-created money to buy huge quantities of fixed-interest securities, thereby driving prices up and yields down. QE can be regarded as complementary to NIRP and ZIRP, because it drives market rates down to levels consistent with policy rates.
Beyond methods and terminology, the overall effect was, and has remained, to keep nominal interest rates below inflation.
At the time, these innovations were described as “temporary”, to be operated only for the duration of the “emergency”. Adjectives do have a certain amount of elasticity, but negative real rates have now been with us for fourteen years, a period longer than the combined duration of the First and Second World Wars, and it’s too much of a stretch to describe this as “temporary”. The original intention, we might assume, was to restore the normality of positive real rates ‘as and when conditions allow’ – but this has simply never happened, and it’s become progressively less likely that it ever will.
Negative real rates have become ‘the new abnormal’.
As remarked earlier, a climate of negative returns on capital abrogates the fundamental principle of the capitalist system, whilst intervention at the enormous scale experienced since 2008 critically undermines markets’ ability to fulfil their essential functions of price discovery and the pricing of risk.
These might be regarded as purely theoretical objections, but there have been numerous adverse practical consequences of adopting an open-ended acceptance of negative real rates of return on investment, consequences which range beyond the dangers implicit in the creation of the ludicrous “everything bubble”.
Just one of these has been the driving of a wedge between the (generally older) people who already owned assets back in 2008-09 and the (generally younger) people who aspire to acquire them. It’s unlikely that the eventual bursting of the “everything bubble” will do much to assuage the resentment of the latter because, even if asset prices fall to levels they could once have afforded, their financial circumstances are likely to have deteriorated.
Another important consequence has been the stymying of the necessary process of creative destruction, whereby the failure of some enterprises frees up both market space and capital for new, more dynamic businesses.
Creative destruction cannot function when ‘zombie’ companies are kept afloat by ultra-low interest rates. Low rates further create an incentive for lenders to avoid declaring borrowers to be ‘non-performing’, a process which leads to write-offs and capital impairment. With rates at ultra-low levels, it becomes comparatively easy to avoid this, by adding ongoing interest to outstanding capital, especially when it’s recognized that ultimate loan repayment isn’t actually going to happen anyway.
QE AND INFLATION – THE MYTH OF NEUTRALITY
When QE was introduced, traditionalists warned that this was a latter-day version of ‘money printing’, and must result in inflation. Defenders of QE have since pointed to low headline inflation rates to support claims that QE ‘hasn’t caused inflation’. The irony here is that such claims are routinely made within the shadow of the “everything bubble” in all classes of assets.
What makes such claims possible is the convention which confines the measurement of inflation to consumer prices, and disregards rises or falls in the prices of assets.
The latter should, of course, be included in any measure of systemic inflation, for at least two main reasons. First, the scale of asset-related transactions makes it impossible, in practical terms, to disconnect the two – the day-to-day activities of insurers, lenders, agents, brokers and many others are directly connected to the prices of the assets that they insure, buy or sell. Second, asset price inflation has very real consequences, good or bad, most obviously for savers, retirees and young people who wish to purchase homes and acquire assets.
The SEEDS economic model has its own measure of systemic inflation, which is RRCI (the Realised Rate of Comprehensive Inflation). Some examples of RRCI, compared with the broad-basis GDP deflator, are illustrated in the next set of charts.
Fig. 2
Historically, as you can see, systemic RRCI inflation has tended to be higher than the GDP deflator in most years and in most locations. Based on the GDP deflator, compound global inflation between 2001 and 2021 was 1.6%, but this rises to 3.8% on the basis of RRCI. Over that same period, the RRCI rates of inflation were 3.6% (rather than 2.0%) in the United States, 3.4% (rather than 2.2%) in Britain, and 2.4% (rather than 1.6%) in the eight-country Euro Area group covered by the SEEDS model.
You will have noted that, had systemic RRCI been used instead of the GDP deflator in the preparation of economic accounts over the past quarter-century, a large proportion of the “growth” reported over that period would have been eliminated.
But the relevant point in the rate policy context is, of course, that the extent of negativity in real rates becomes even more pronounced when nominal rates are measured against systemic inflation. Though this may have been unintentional, there’s an element of sleight-of-hand in operating negative real rates which inflate asset prices, when this asset price inflation is then excluded from the inflation measure against which the extent of negativity in real rates is calibrated.
In short, the assurance that QE ‘doesn’t cause inflation’ is only valid when inflation is measured in a way which excludes the very kind of inflation that is created by QE. This is comparable to the adoption, during the early 1970s, of “core” inflation measures which excluded energy and food at the very time when the prices of both of these necessities were soaring. No wonder this was described as ‘inflation with the inflation taken out’.
By way of illustrating of the working of QE, let’s imagine that a latter-day Isaak Walton – the author of The Compleat Angler – had been put in charge of monetary policy during the GFC, and had started handing QE largesse, not to the markets, but to fishermen. The prices of rods, reels and all other items of angling paraphernalia would have soared. Rivers, lakes and beaches would have been crammed with zealous – and affluent – people in pursuit of the denizens of the deeps.
This, of course, isn’t what happened, and QE money was directed, not to anglers, but to investors. The same principle of selective inflation applied, but it was the prices of stocks, bonds and property, rather than those of floats, flies and lures, that adopted exponential trajectories.
The point is that QE does cause inflation, but does so at the point at which new money is injected into the system. By a quirk of economic history, rises or falls in the prices of assets are not included in headline measurements of inflation, but are part of the systemic pricing picture nevertheless. The convention of limiting the definition of inflation to consumer prices thus enables commentators to state that QE ‘isn’t inflationary’ at a time of rampant inflation in asset prices.
Between the GFC and 2019, the bulk of the QE enacted by the central banks was poured into the markets, creating huge inflation in asset prices. With the onset of the pandemic, though, this pattern changed. Essentially, governments started running enormous fiscal deficits to support households (and employers) affected by lock-downs, and these deficits were funded by central bankers, who used QE to purchase existing government bonds.
For the first time, to any significant extent, QE was now flowing, not just to investors, but to consumers. This was followed, as surely as night follows day, by surges in consumer prices.
What this demonstrates is that the statement that QE ‘doesn’t cause inflation’ needs, at the very least, to be modified to ‘QE doesn’t cause consumer price inflation, so long as it doesn’t flow to consumers’.
THE REASON WHY – ECONOMIC DETERIORATION
The central contention made in this analysis is that investors have been deprived of adequate income returns – and fobbed off with non-monetizable capital gains instead – because of a fundamental deterioration in what is affordable for the economy. Regular readers will be familiar with the issues involved – and a comprehensive analysis of the economy is planned for forthcoming publication – but a brief synopsis is appropriate here.
Because nothing that has any economic value at all can be supplied without the use of energy, material economic prosperity is a function of the quantity, value and cost of energy available to the system.
Another way to put this is that the economy is a dissipative landfill system, in which energy is used to extract raw materials and convert them into products whose ultimate destination is disposal. The rapid growth in the size and complexity of the modern economy has been made possible by the use of fossil fuels, with the result that climate-harming gases are a sizeable component of the waste heat which is the outcome of the energy dissipation process.
Over time – and as we have seen – there has been remarkable consistency in the rate at which primary energy is converted into economic value. The absence of efficiency gains in the conversion process may be a product of the depletion of non-energy resources. But the end result has been that economic output has increased or decreased in line with the quantities of energy consumed.
Critically, though, output isn’t the same thing as prosperity, in much the same way that total and disposable incomes are not the same thing. The difference between the two is cost and, at the macroeconomic level, the cost involved is the Energy Cost of Energy. The principle of ECoE is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This is a deduction from output, because energy value consumed as ECoE cannot be used for any other economic purpose.
Once the cost-reducing processes of geographic reach and economies of scale had been exhausted, depletion became the principal driver of the ECoEs of fossil fuels. These – and the overall ECoE of a system dominated by oil, natural gas and coal – have been rising exponentially, undermining prosperity.
This process first began to make its presence felt during the 1990s, when it created the economic drag which was then labelled “secular stagnation”. This term referenced a non-cyclical deterioration in growth, though orthodox economics has never made the necessary connection between economic deceleration and rising ECoEs.
Because GDP is a measure, not of material value but of transactional activity, we have been able to inject cosmetic “growth” into the system through an expansion in credit, with each $1 of reported increase in GDP being accompanied by more than $3 of net new borrowing over a period stretching back to the 1990s. Economic historians of the future are likely to date these processes from the 1990s, and to identify the GFC of 2008-09 as the first demonstration of the reality that using liability expansion to create synthetic “growth” is not a workable solution. The subsequent sequence has involved supplementing “credit adventurism” with “monetary adventurism”, leading, inevitably, to the second and larger crisis which looms on the near horizon.
The problem, of course, is that a rapid expansion of debt dictates an equally rapid rise in the cost of servicing that debt. This is the equation that forced us into crushing rates – debts had become so big that we could no longer afford to service them as we had in the past.
The charts in Fig. 3 illustrate some central aspects of this process. The use of rapid monetary expansion has driven a wedge between aggregate prosperity and reported GDP (see Fig. 3A), whilst average prosperity per person has trended downwards as ECoEs have risen (3B). At the same time, the real costs of energy-intensive essentials have been rising, imposing a progressively tighter squeeze on living standards (Fig. 3C). Along the way, efforts to create “growth” using exponential expansion in debt and broader liabilities have introduced worsening instability into the financial system (Fig. 3D). Incidentally, the forward projections shown in Fig. 3D assume the continuity of current practice, though it’s very probable that we are now at, or very near, the point of inflexion.
Fig. 3
WHERE NEXT?
It’s not entirely true to say that the implications of crushed returns on investment have gone wholly unnoticed. The new context was addressed in an important report on pension prospects published by the World Economic Forum back in 2017.
Looking at the United States, the WEF stated that annual real returns on equity investment were likely to be 3.45% in the future, compared to a historic 8.6%. More tellingly – because of the lesser scope for capital appreciation included within total returns calculations – real returns on bonds were likely to fall to just 0.15% in the future, from 3.6% in the past.
The inference to be drawn from this is that paper capital gains – being, by definition, non-monetizable in the aggregate – cannot be used to pay pensions. This is partly why the WEF report, which looked at eight countries, warned that a pensions “gap”, then measured at $70 trillion, was likely to expand to over $400tn – at 2015 values – by 2050. For reference, global GDP in market dollars was $75tn at that time.
A summary of where our investigation has taken us is that, as the underlying economy has decelerated towards contraction, so cash returns on investment have been replaced by cosmetic capital gains, ‘cosmetic’ in the sense that they cannot, in the aggregate, be turned into cash by investors. This has not, remotely, been coincidental.
This ties in with the “wealth effect”, in that increases in paper wealth have two effects. The first is to make people more relaxed about taking on additional debt. The second is that it disinclines them to ask awkward questions.
The issue now is when belief in the supposed reality of purely notional gains will be replaced by hard-headed assessment – or, perhaps, outright fear – which takes over from the long-standing penchant for irrational hope over solid fact.
Thus far, the effects of dawning reality have largely been confined to the wilder fringes of “tech”, where we’ve been witnessing collapses in the absurd market values once ascribed to cash-burning businesses in a frenzy of IPO and SPAC activity.
But we cannot assume that investors are going to stop asking questions at the point where only the most obvious froth has been blown off the markets. The search for substance isn’t going to end with the discovery that it cannot be found in a bright idea, adept marketing, leased office space and a mailing list.
As we know, there are a number of salient features of the economy that have been ignored during a long period of what we might term ‘the voluntary suspension of disbelief’.
Observers may come to recognize that there are limits to how long we can proclaim “growth” on the basis of the injection of cheap credit and cheaper money into the system. The divergence from economic reality is reflected in the first of the following charts (Fig. 4A), which plots the disequilibrium that has come to characterise the relationship between the ‘real’ economy of material prosperity and the ‘financial’ economy of transactions, of which an ever larger proportion neither creates nor represents material value. If we apply percentage equilibrium downside (calculated here at 40%) to the sheer scale of financial exposure (Fig. 4B), we can identify truly vertiginous levels of financial risk.
Even if this point is not recognized quite yet, market participants must surely be aware by now that standards of living are trending downwards, creating an affordability squeeze which puts at risk, not just discretionary (non-essential) consumption, but also the reliability of financial flows from households to the corporate and financial sectors.
What we can now anticipate is the replacement of starry-eyed gullibility with hard logic, inclining investors to get into a competitive retreat from the unrealistic. Portfolios will be weighted increasingly towards non-discretionary sectors, those with solid material value, and those which do not depend on income streams from increasingly hard-pressed households. Other asset classes, including residential and commercial property, will be part of the decline that sets in as ‘keeping up the payments’ gets ever harder, and as investors start to turn against anything exposed to affordability compression.
And it’s axiomatic that, when investors rush for the exit-doors, those doors get smaller.
Fig. 4
Surplus Energy Economics 