I – The Nominal and the Real
In economics, there are two kinds of problems: real problems and nominal problems.
The deforestation on Easter Island destroyed most of the Rapa Nui. When it was necessary to leave the island and start new lives in a new land with an environment able to support their people, there were not enough large trees left to build ocean-worthy vessels. Their population declined to 15-20% of their peak population within a century.
This is an example of a real problem. A real problem is a lack of natural resources, capital goods, land or labour, or when any combination of these factors of production sum to an inadequate value to produce enough to maintain (or better) the general welfare of a people.
A nominal problem is one which is contained in the abstract. They can result from frictions in capital structure, uneven distribution of income, or simply in the collective choices of participants in an economy.
The wealth contained in an economy is its capital stock: our oil fields, forests, farms, houses, offices, cars, computers, factories, data centers, software and construction equipment. Our potential is richly governed by the quantity of our workers, the durability of their work ethos coupled with their experience and education. This is the real economy.
Capital consists of raw materials, instruments of labour, and means of subsistence of all kinds, which are employed in producing new raw materials, new instruments, and new means of subsistence. -Wage Labour & Capital (Marx, 1847)
II – Marginal Capital Allocation
An economy with inadequate capital has firm prices and high capital returns. An economy with a glut of capital has soft prices and low capital returns.
Economic growth is the expansion of capital – and subsequent expansion of capital utilization. Investment creates capital. Capital is the accumulated labour directed by the formation of financial capital. This capital, or accumulated labour, represents capacity to sustain consumption.
High (low) capital returns don’t necessarily equate to high (low) capital prices. An outsized capital return likely indicates that additional investment will be induced, which could compete to drive the price of its output down.
Growth in employment hinges on investment. The utilisation of existing capital maintains the stability of existing employment, but new employment requires new investment. This is demonstrated with Figure 1, showing a very strong relationship between the health of the employment market and Investment net of Capital Consumption as a fraction of GDP.
Unemployment is largely a result of rentierism, which we’ve defined as the behavior of collecting economic rent from existing assets instead of creating new ones. The act of collecting rent is a preference executed on marginal free cash flow dollars, principally by the corporate sector. Corporate Management have three options, with increasingly expected yield requirements:
- Hold it as cash: this is a liquidity preference, which is pro-cyclical, and becomes decreasingly attractive as the embedded put option in cash becomes too expensive to hold while it decays, thus becoming less competitive with capital accumulation options that have a positive real expectancy
- Purchase existing capital: this can be either the purchase of used or previously existing fixed capital, such as machinery or real estate, or capital assets, including a firm’s own stock
- Invest in new capital: building a new factory or drilling a new oil well
III – The Marginal Rentier Opportunity Curve
J. M. Keynes (and Irving Fisher before him) furnish us with the Marginal Efficiency of Capital as the excess return of a piece of capital over its supply price. The supply price can be one of two values: the market price (buying used or existing capital) or replacement cost (new net investment).
I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price. This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general. The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over. -General Theory of Employment, Interest & Money (Keynes, 1933)
There in fact exist marginal efficiencies between all investment opportunities.
I propose, approximately illustrated in Figure 2, the Marginal Rentier Opportunity Curve, which offers a comparison between the principal investment opportunities available. The current yield is not the same as the Expected Return. We can, however, tease out the relative expected returns by spreading spots on this curve.
The investment opportunity set has ascending and encapsulating risk premiums: Attractiveness of new investment is measured against the sum of all premiums between it and the risk-free rate.
Thus, I further propose: The price of capital is the Net Present Value of Risk-adjusted Expected Return discounted from the Marginal Rentier Opportunity.
IV – Used Capital Competition
So far, I have postulated:
- The wealth of an economy, and the capacity for its income, is contained in the accumulated labour, or the capital stock, of its people.
- Economic growth, measured by real income, is the accumulation of labour and subsequent utilisation through net new investment.
- The marginal investment dollar purchases either existing capital assets, or the creation of new capital assets through net new investment.
- Marginal investment dollars that are not allocated into net new investment cause a reduction of income to the household sector, and increase unemployment.
Assuming the aforementioned postulates true, it can be observed that the rational business manager will, perhaps simultaneously:
- Increase liabilities from portion of the Marginal Rentier Opportunity Curve with the lowest expected return.
- Increase assets from the portion of the Marginal Rentier Opportunity Curve with the highest expected return.
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 capital is the Net Present Value of Risk-adjusted Expected Return discounted from the Marginal Rentier Opportunity, and the business manager finds the most attractive investment opportunities in the purchase of existing capital, we can conclude: the price of existing capital must be bid up high enough in order for new capital to be competitive.
V – Jobless Recoveries
The significance of existing capital available cheaply to allocators is that, until existing capital is expensive enough to make new capital competitive, net new investment will be muted, and so too will employment growth (figure 3).
The common understanding is stocks lead the economy at economic turning points. This is not always true. Coming out of the .com bust, the economy bottomed in 2001, more than a year before S&P 500 finally did. The explanation is expectations lead the economy, but I find this argument runs counter my observations in expectations around cycle turns. I offer an alternative: that which causes equities to (typically) bottom is also what causes the economy to recover.
The recovery after the .com bust recession was termed a jobless recovery, and for good reason: jobs took even longer than the stock market to bottom!
Using our understanding of job-growth as net-investment driven, we can clearly see why there were no jobs: there was no investment. The next observation we can make from Figure 4 is the lack of investment, even years after the recovery, until after the S&P 500 had bottomed. Finally, in later 2003, the Net Investment is elastic to the upward movement in the S&P 500.
For this argument, we approximate the S&P 500 as the aggregate price-level of existing capital.
The inference is that the jobless recovery of late 2001-2003 was the result of a net investment-less recovery, which was probably the result of existing capital being available more cheaply.
We can see the same pattern emerge, as demonstrated by Figure 4, in the present recovery.
Perhaps most incredibly, Net Investment went negative for the first time in history of the series going back to 1947 during The Great Recession (figure 6). Our capital stock was depreciating at a greater rate than we were replacing it.
The explanation that jobless recoveries result from a scarcity of net-investment because existing capital is too cheap for new capital creation to be competitive enjoys intuitive sense, as well some recent historical evidence.
VI – Contemporary Interpretation
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 CBO and BLS forecast around 0.7% annual labour force growth this decade, and just 0.5% in the 2020s. This means the growth of future requirements for fixed capital and accumulated labour that support workers — such as office buildings or automobiles — will be subdued, even more so than the production of goods consumed by all demographic groups.
Combined with productivity efficiencies in the Internet age that provide a declining Real Capital Intensity of Economic Output, we require less capital formation. This potentially explains why the price of real capital had been below its previous peak for so long, and consequently why net investment (and employment growth by proxy) has been limited.
With the S&P 500 (our approximate aggregate capital market value) closing once again near record highs, it seems likely that new investment will be more attractive.
Perhaps Conor Sen put it best: Wringing the risk premia out of existing capital is a necessary precondition for new capital formation (and hiring!).
I hope and believe we are there, and maybe we’ve learnt something new about the nature of jobless recoveries.