Investment, the Engine of U.S. Prosperity, Is Underrated
Proponents and opponents of income redistribution differ greatly in their explanations for the success of the U.S.
Opponents argue that the discovery and commercialization of innovation are no different than any other investment. Investors must risk capital to fund failures. The potential payoffs provide the incentive to suffer the losses.
Those who favor income redistribution point to the steadiness of long-term economic growth as evidence that innovation bubbles up randomly in the normal course of business. They emphasize culture, claiming that Americans are eager to take risks regardless of the incentives, while Europeans and the Japanese are reluctant. Economists with these views see minimal costs from redistributing income from wealthy investors to poorer consumers.
Opponents of income redistribution worry that higher taxes water down incentives and that redistribution slows the accumulation of capital, especially risk-bearing equity.
-- Investment produces innovation: The more time and resources investors and entrepreneurs devote to searching randomly for innovation, the more likely they will be to find it. This requires time that the economy could devote to other endeavors. An increase in investment by one economy relative to another will likely affect their relative rates of discovery and implementation. When successful, risky investments in innovation will grow the economy faster than less risky investments that enlarge existing capacities.
Successfully commercializing good ideas is as important as discovering them and requires similarly risky investments. Even if Facebook Inc. (FB) and Google Inc. (GOOG) had randomly stumbled upon great ideas, they still had to invest inordinate amounts of money and overcome high levels of risk to commercialize them.
In “The Age of Turbulence,” former Federal Reserve Board Chairman Alan Greenspan reminds us that the U.S. economy has grown sevenfold in real terms since World War II, while physical inputs, such as steel and oil, have risen only twofold. Most of the growth came from intellectual capital. Cutting-edge economies like that of the U.S. invest largely by paying the salaries of talented thinkers who invent and design new products and processes.
-- Innovation expands the economy: Innovation benefits consumers through lower prices. Yet these can be hard to quantify, particularly when they show up in the form of higher- quality goods, which may sell at the same price but offer greater benefits than the products they replaced. Because of the difficulties of measuring such “quality-adjusted” prices, economists generally disregard the ebb and flow in the rate of these improvements.
Sometimes, workers capture the value of innovation and productivity gains through higher wages. Ultimately, higher wages and lower prices are the same because workers are both wage earners and consumers. With increased productivity, prices fall and real wages rise.
As tangible or intangible investment per worker increases, one might expect capital to capture an increasingly greater share of the output. But that hasn’t happened. Figure 1, attached, shows that as the U.S. economy has grown more capital- intensive, labor has continued to capture about 70 percent of gross domestic product as wages.
Consumers also capture the value of products over and above their cost. A car, for example, is worth much more than its price. Economists call this “buyers’ surplus.” GDP measures the value of goods at their prices, not at their value to purchasers. If consumers capture 70 percent of GDP as wages and 100 percent of the buyers’ surplus, they are capturing a very large share of the value created by investment -- perhaps 90 percent or more.
We see these dynamics in agriculture. As agricultural productivity has doubled since the 1940s, expenditures on food as a percent of GDP have fallen proportionately from more than 20 percent of disposable income to less than 10 percent today, see Figure 2, attached. In the U.S., these savings provided much of the resources needed to increase demand for manufactured goods. Today, similar productivity gains in manufacturing are driving growth in services.
The reduction in food expenditures displayed in Figure 2, attached, allows us to approximate the magnitude of the value captured by consumers relative to producers. Consumers captured the difference between 24 percent and 10 percent of disposable income -- income that is approximately seven times larger today than it was in 1950. Producers, on the other hand, benefited less. Their profits, after depreciation and before interest and taxes, remained stable at about 10 percent of revenues, or 10 percent of what consumers spent. The split of value (before corporate taxes) between consumers and producers created by agricultural innovation and investment is in the range of 20-to- 1 in favor of consumers.
This one-sided split of the returns from capital between investors and labor is the reason radical proponents of income redistribution, such as Paul Krugman, seek to regulate the allocation of capital through the political process rather than through free markets. They argue that many investments may be valuable to society but not to investors, so why let the small returns to private investors determine the allocation of capital critical to the welfare of mankind?
Proponents of free markets are concerned that regulations will reduce profitability and return on investment. Small reductions in profits and subsequent investment can have a big impact on wages, employment and the price of goods. This can unwittingly destroy more value than well-intended regulations create.
-- What is too much?: A broad range of investment continues to drive productivity because investment and risk taking, as a whole, are far below the optimal level. The work of Nobel Prize- winning economist Edmund Phelps presents empirical evidence that under optimal conditions capital would earn a real return equal to the growth rate of the workforce -- in highly developed economies, 1 percent to 2 percent per year.
Today, the U.S. has a surplus of debt. We are flooded with risk-averse savings. We face a shortage of risk-bearing equity to underwrite risk, rather than a shortage of capital more broadly. Equity in the U.S. and worldwide earns about 7.5 percent per year, indicating that equity and the risk taking it underwrites are well below the optimal level.
Investors can make poor choices and take imprudent risks in one sector -- housing and mortgage risks, for example -- without the economy as a whole extending beyond the point of optimality.
Government subsidies can also drive risk taking beyond the point of optimality by over-allocating investment to one sector -- subprime housing, for example -- at the cost of underinvestment in other sectors.
-- Monetary policy: Printing money doesn’t magically stimulate the economy. Instead, monetary policy allows risk taking to grow when it is hampered by a lack of credit, and the economy has excess capacity available to produce the increased growth. An owner of future cash flows (assets) may seek to increase the amount of risk he is taking by splitting his future cash flows into tranches so that he can exchange the low-risk first-to-be-repaid tranche (debt) for a risk-averse saver’s income. Putting that hoarded capital to use expands the economy.
If credit is restricted, risk takers may be unable to tap those savings. Constraints on credit may occur if banks have already loaned all the available deposits, or if they have used all their equity to meet capital-adequacy requirements for existing loans. Lower short-term interest rates increase the spread that banks earn by borrowing short-term savings and making long-term loans. This increases bank profits and grows their equity, which reduces constraints. Relieving credit constraints will grow the economy, but only if the economy has the capacity to produce the increase in demand and an appetite for risk.
Increases or decreases in optimism tend to create self- reinforcing feedback loops that monetary policy can either allow or restrict. As risk takers grow increasingly optimistic, asset values rise. This makes investors and consumers grow increasingly willing to take risks. As risk taking grows, the economy expands, increasing the amount of investment and the value of assets relative to the economy.
-- Investment is understated: Our antiquated 1940s manufacturing-based accounting rules expense the salaries of creative thinkers and leaders as intermediate costs of production, rather than capitalizing them as investments. Only recently have accounting rules allowed the capitalization of software-development costs, for example. Accounting rules demand highly restrictive measures of investment to ensure comparability between results. A fast-growing company with higher profit margins that is pouring more money into investment than its competitors looks more attractive to investors and garners a higher stock price. Accounting rules prevent this lack of comparability by erring on the side of expensing rather than capitalizing costs, especially employee-related costs.
Survivor bias exacerbates this masking effect and further obscures the link between investment in risky innovation and its return. One breakthrough may require hundreds of failures. Failed investments in intellectual capital are expensed and forgotten, decoupled from the cost of the resulting success. Without clear linkages between the value of success and the hidden cost of failure, investment appears dramatically understated.
Conservative measurements such as those employed in a 2006 Federal Reserve study, “Intangible Capital and Economic Growth,” show significant increases in intangible investments. According to the Fed, intangible investments rose from about 7 percent of non-farm business output in the late 1970s to 10 percent in the early 1990s to about 14 percent today, see Figure 3, attached. These investments rose dramatically in the 1990s when productivity accelerated.
Over the same period, traditional business investments in factories and machinery grew from about 5.5 percent of GDP after World War II to about 8 percent today. Adding both tangible and intangible investments shows that business investment grew from 15 percent of GDP after the war to a level approaching 25 percent today.
It is likely that these simple estimates understate investment, and that the expenditures that increase the productivity of the most talented employees are much broader. Almost everyone engaged in finance, for example, thinks about the value of future cash flows and how to maximize them. They make decisions about the allocation of assets that set the prices for various risks. These prices influence the allocation of investment. Again, economic statistics expense all these costs.
There are other forms of overlooked investment. The most talented U.S. workers now spend more time working while the hours of their European peers have declined.
The productivity of the most talented workers is also growing faster than the U.S. economy as a whole. With 5 percent of the workforce producing more than a third of the output, increases in this group’s productivity have a big impact on the economy overall.
Pundits often wonder why median wages have failed to rise in proportion to increased levels of productivity, as they have in the past. The answer is obvious: The median wage is the highest wage of the lowest 50 percent of workers, and productivity growth has occurred predominantly at the top of the wage scale. Above the median, the wage premium for the most talented workers grew, despite a surge in the productivity- enhanced supply of knowledge workers, see Figure 4, attached. An increase in supply should drive down wages, but pay rose because the value from deploying this talent was greater than their pay.
We can also see the increase in intangible investment in the changing composition of U.S. jobs since the mid-1980s. Again, half of all the new jobs created over the last 25 years have been in thought-oriented professions. Such jobs made up only a quarter of total employment in the 1980s.
It’s also clear why the income of the top 1 percent is growing faster in the U.S. than in Europe and Japan. U.S. innovators produced Intel Corp. (INTC), Microsoft Corp. (MSFT), Google and Facebook. The rest of the world contributed next to nothing.
(Edward Conard was a partner at Bain Capital LLC from 1993 to 2007. This is the second of two excerpts from his new book, “Unintended Consequences: Why Everything You’ve Been Told About the Economy Is Wrong,” available now as an e-book to be published in hardcover on June 7 from Portfolio, a member of Penguin Group (USA) Inc. The opinions expressed are his own. Read Part 2.)
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