Wick­sell and cap­i­tal mis­al­lo­ca­tion

Financial Mirror (Cyprus) - - FRONT PAGE -

Un­for­tu­nately, given the mon­e­tary pol­icy set­tings that have pre­vailed since 2010, we are not con­vinced the ac­cepted wis­dom is cor­rect. Sure, in the Key­ne­sian doxa, the stan­dard idea is that if in­ter­est rates are held low enough for long enough there will be a cap­i­tal spend­ing boom. How­ever, the Wick­sel­lian idea is to­tally dif­fer­ent: if rates are kept low enough for long enough, it will lead to a fi­nan­cial boom fol­lowed by a fi­nan­cial bust, and at the end of it all the econ­omy will be poorer. If this view is right then in­vestors have good rea­son to be ap­pre­hen­sive ahead of the Fed’s de­ci­sion next month.

Let us as­sume that the ex­pected av­er­age mar­ginal re­turn on newly in­vested cap­i­tal is 6% per year. We all know that out of ten new projects, nine will re­turn much less than ex­pected and the tenth will de­liver ten times the re­turn pro­jected in the busi­ness plan. In short, there is a huge el­e­ment of risk in­volved in in­vest­ing in new ven­tures in cap­i­tal­ism.

Fur­ther, let us as­sume that the re­turn on in­vested cap­i­tal for ex­ist­ing in­vest­ments is 4%. If the T-bill yield is at zero, and the in­ter­est rate at which the “nor­mal” in­vestor can bor­row is at 2%, then in­vestors have a choice: ei­ther in­vest at 6% with high un­cer­tainty, or in­vest at 4% with al­most no un­cer­tainty. Un­sur­pris­ingly, risk-weighted cap­i­tal will be chan­neled to­wards buy­ing ex­ist­ing as­sets, rather than to­wards cre­at­ing new as­sets.

As a re­sult, the price of ex­ist­ing as­sets will go up and the ROIC for a new buyer will fall — say to 3%. But as long as the bor­row­ing rate re­mains at 2%, some in­vestors will be will­ing to lever­age up to buy ex­ist­ing as­sets, be­cause the lever­aged re­turn is above zero. The mu­sic will only stop when the ROIC on ex­ist­ing as­sets falls to 2%, and the ex­pected re­turn on the lever­aged play drops to zero. Sim­i­larly, any listed com­pany with an in­ter­nal ROIC on its ex­ist­ing as­sets greater than 2% has a pow­er­ful in­cen­tive to is­sue debt with which to buy back its shares and re­tire eq­uity, as in­ter­est pay­ments are taxd­e­ductible, while div­i­dends are not.

The up­shot will be an in­crease in debt ac­com­pa­nied by a big rise in the value of ex­ist­ing as­sets. But there will be very lit­tle in­vest­ment in new as­sets. As a re­sult, pro­duc­tiv­ity will fall, the struc­tural growth rate of the econ­omy will go down, the Gini co­ef­fi­cient will go up, and Key­ne­sian econ­o­mists will write the­sis af­ter the­sis on the “new nor­mal” or “sec­u­lar stag­na­tion”. Their so­lu­tion, of course, will be more gov­ern­ment in­ter­ven­tion to share out an ever-dwin­dling pot of goods and ser­vices.

And as we all know, the gov­ern­ment has two arms: one very long to take peo­ple’s money, and one much shorter to re­dis­tribute it — which im­plies that if you are not close to the gov­ern­ment, you don’t ben­e­fit. For­tu­nately for the Key­ne­sians, most are close enough to the gov­ern­ment not to worry. Alas, how­ever, more gov­ern­ment in­ter­ven­tion sel­dom leads to more growth.

Now let’s con­sider what hap­pens if the T-bill rate is at 3%, and the ac­tual bor­row­ing rate is at 5%. Now there is no in­cen­tive to bor­row in or­der to buy ex­ist­ing as­sets yield­ing 4%. Any­one who wants to get rich has to build new as­sets and has to run the risk of fail­ure. What’s more, com­pa­nies yield­ing less than 5% can no longer ac­cess cap­i­tal and must even­tu­ally fold. There is no more lever­age and no more zom­bie com­pa­nies. This state of af­fairs leads au­to­mat­i­cally to an in­crease in the stock of cap­i­tal, to­gether with ris­ing pro­duc­tiv­ity.

So Wick­sell’s the­sis is sim­ple:

if you want growth, you need to keep in­ter­est rates above the av­er­age re­turn on ex­ist­ing as­sets, and be­low the ex­pected mar­ginal re­turn on new as­sets.

The band be­tween the two is the “nat­u­ral rate” band. If you main­tain the mar­ket rate way be­low that band, then in­debt­ed­ness and as­set prices will go up and the re­sult one day will be debt-de­fla­tion, as de­scribed by Irv­ing Fisher. This debt-de­fla­tion will start when lever­aged re­turns fall be­low zero, which can oc­cur ei­ther be­cause the ROIC is fall­ing be­cause growth is low, or be­cause the ROIC is now com­puted on the prices of as­sets which have gone up a lot, or be­cause the cen­tral bank raises rates, or be­cause of a com­bi­na­tion of the three.

So, con­trary to what many peo­ple be­lieve, if the lever­aged re­turn is at zero as we speak,

a 25bp in­crease in the cost of money could have a dev­as­tat­ing im­pact

on many po­si­tions, turn­ing them into neg­a­tive cash flow night­mares in no time at all. In short, it is not that an even­tual in­ter­est rate in­crease from the Fed­eral Re­serve should be dis­missed as an event with lit­tle im­pact in the real world.

Not only does this line of rea­son­ing make in­tu­itive sense, there is plenty of sta­tis­ti­cal ev­i­dence to sup­port it. The chart above shows US history since 1965. The un­shaded ar­eas rep­re­sent pe­ri­ods in which real short rates were above 2%, their me­dian from 1960 to 2002. Ev­ery one of th­ese pe­ri­ods showed strong pro­duc­tiv­ity and strong growth. The re­verse is equally true. The ar­eas shaded green rep­re­sent pe­ri­ods in which real rates were be­low 2%. Each was marked by a col­lapse in pro­duc­tiv­ity, and there­fore by a col­lapse in the struc­tural growth rate of GDP per capita.

The dif­fer­ence be­tween th­ese two sets of pe­ri­ods is that in the first — when real rates were higher than their his­tor­i­cal me­dian — cap­i­tal was used by en­trepreneurs, while in the sec­ond cap­i­tal was used by the gov­ern­ment and by ren­tiers. The re­al­ity is that if you waste cap­i­tal on bid­ding higher the prices of ex­ist­ing as­sets, you can­not have growth. The idea that growth can be gen­er­ated from a rise in the prices of in­ef­fi­cient old as­sets is a myth. The amaz­ing thing is that some­thing so ob­vi­ous should still be con­sid­ered con­tro­ver­sial.

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