Monday, January 19, 2015

The Inexorable Growth of Wealth

There is truth in the oft quoted phrase “It takes money to make money.”  A more relevant manifestation of that sentiment might be “It takes wealth to make wealth.”  Everyone sees money flow through their hands, but it is only those who can accumulate more than they need to cover the fundamental needs of food, clothing, and shelter who are in a position to create wealth and use it to create more wealth.  What is not immediately obvious is that wealth seems to grow even faster as it becomes larger, allowing significant fortunes to increase in an unbounded manner.

This dynamic is explained in Thomas Piketty’s book Capital in the Twenty-First Century.  Piketty has made his charts and tables available here.  He defines capital as anything that has a market value, making the terms wealth and capital synonymous.  His basic conclusion is that the rate of earnings from capital has always exceeded the growth in income (equivalent to the rate of growth in GDP) except in unusual circumstances where high rates of taxation were in effect.  Consider this chart of the return on capital (pretax) in Britain over the past few centuries.

The “real” rate of return differs from the “observed” by Piketty’s estimate of the cost of managing the assets earning income.  What is startling is the constancy of this value of about 5% over time.  At early times, wealth was mostly in the form of land when agriculture was a dominant component of the economy.  Over time, agriculture diminished in importance and was superseded by real estate and financial instruments such as stocks and bonds, yet the rate of return remained relatively constant. 

The anomalous period was the era of the Great Depression and the two world wars.  Much wealth was destroyed in that calamitous period, but what wealth there was was highly valued.  It was immediately after this era that periods of high economic growth were observed as regions devastated by war rebuilt themselves.  High growth in GDP translates into high growth in incomes, allowing more people to pass that transition point where they earned enough to be able to save and accumulate resources.  It can truly be said that this was the period in which a middle class began to be formed.  Home ownership became more widespread and that became the dominant contributor to the growth of wealth in this middle class.

The growth of a middle class is the positive aspect of Piketty’s economic history.  The negative aspect arises from the historical fact that high rates of growth of GDP are an historical anomaly.  Up until World War I the rate of economic growth was on the order of 1-2%.  The higher rates that we have become accustomed to in the postwar years are apparently returning to the historical norm.  Given that income growth will fall far behind growth in wealth from the higher income from wealth, we face a situation where the wealthy will become ever wealthier while the rest get left behind.

Consider this plot of the top income groups in the US over time (top 1%, top 1-4%, top 5-10%).

The volatility is in the income possessed by the top 1%.  It peaks dramatically just prior to the stock market crash and the great depression, falls significantly during the high-tax and highly-regulated era associated with World War II and its aftermath, and then around 1980 the top 1% begins to again grow rapidly with time.  There are a number of things operative that explain this increase: taxes were lowered, policies were put in place that favored the wealthy, and the rate of growth began to slow. 

Remember that the media quotes total GDP whereas the number of interest is per capita GDP.  If population grows by 1% and the quoted GDP grows by 1% there is no actual growth in average individual income.  Consider this plot of per capita GDP growth in Western Europe and North America over time.

Western Europe with its high taxes and high social benefits has been, and still is, creating income at a greater rate than the more economically “liberated” new world.  Note that the high-growth postwar years appear to be replaced by an extended period where growth is descending back to the historical norm.  

Given this data we would expect to see growth in income inequality.  In fact, it turns out the growth in inequality is even worse than one might imagine.  Piketty tells us that not all wealth is equal.  He concludes that the larger the amount of wealth possessed, the faster it will likely grow.

Piketty looked at two sources of information on how the investments of the very wealthy performed over time.  The first involves the magazine Forbes and its annual ranking of the wealth of the world’s billionaires.  This is an imperfect source of information for detailed analysis, but it does allow him to draw a conclusion:

“….the largest fortunes grew much more rapidly than average wealth.  This is the new fact that the Forbes rankings help us bring to light, assuming they are reliable.”

Piketty provides a few specific examples.

“Between 1990 and 2010, the fortune of Bill Gates….the very incarnation of entrepreneurial wealth….increased from $4 billion to $50 billion.  At the same time, the fortune of Liliane Bettencourt—the heiress of L’Oréal, the world leader in cosmetics…..increased from $2 billion to $25 billion, again according to Forbes.  Both fortunes thus grew at an annual rate of more than 13 percent from 1990 to 2010, equivalent to a real return on capital of 10 or 11 percent after correcting for inflation.”

“In other words, Liliane Bettencourt, who never worked a day in her life, saw her fortune grow exactly as fast as that of Bill Gates, the high-tech pioneer, whose wealth has incidentally continued to grow just as rapidly since he stopped working.  Once a fortune is established, the capital grows according to a dynamic of its own, and it can continue to grow at a rapid pace for decades simply because of its size….money tends to reproduce itself.”

There is nothing mysterious about this growth in wealth.  It is simply due to the fact that the very wealthy have the resources to expend in wisely managing their wealth—another variation on the thesis that it takes wealth to make wealth.  To make this point more clear Piketty looks at a more robust source: financial reports from university endowments—which range in size from the merely large to the astonishingly large.

“….US universities publish regular, reliable, and detailed reports on their endowments, which can be used to study the annual returns each institution obtains.  This is not possible with most private fortunes.  In particular, these data have been collected since the late 1970s by the National Association of College and University Business Officers, which has published voluminous statistical surveys every year since 1979.”

Picketty’s analysis of this data is summarized in this table:

Piketty draws two conclusions from this table.  The first is that the rate of return for university endowments is considerably higher than that of wealth in general, and is consistent with the picture obtained from the Forbes surveys of personal wealth.  The second conclusion is that the larger the endowment, the larger is the likely rate of return on investment.

“The higher we go in the endowment hierarchy, the more often we find ‘alternative investment strategies,’ that is, very high yield investments such as shares in private equity funds and unlisted foreign stocks (which require great expertise), hedge funds, derivatives, real estate, and raw materials, including energy, natural resources and related products (these too require specialized expertise and offer very high potential yields).”

“Concretely, Harvard currently spends nearly $100 million a year to manage its endowment.  This munificent sum goes to pay a team of topnotch portfolio managers capable of identifying the best investment opportunities around the world.”

Piketty also arrives at this interesting conclusion about investment risk and return on investment:

“….the year-to-year volatility of these returns does not seem to be any greater for the largest endowments than for the smaller ones….In other words, the higher returns of the largest endowments are not due primarily to greater risk but to a more sophisticated investment strategy that consistently produces better results.”

The very wealthy also have options available to them to protect their wealth from both taxes and foolish children who might squander it, and thus preserve it for generations.

“….wealthy people are constantly coming up with new and ever more sophisticated legal structures to house their fortunes.  Trust funds, foundations and the like often serve to avoid taxes, but they also constrain the freedom of future generations to do as they please with the associated assets.  In other words, the boundary between fallible individuals and eternal foundations is not as clear-cut as sometimes thought.”

We seem to have entered a long-term period of low growth which translates into small gains in income—at best—for the majority, while large fortunes have accumulated that are in a position to grow without bound.  Piketty fears, as we should also, that this disparity in wealth will be a destabilizing factor in society. 

Large fortunes have become nearly immune to taxation because most of the income is derived from capital rather than wages.  Piketty’s long-term solution would be a small progressive tax on wealth, one that would still allow wealth to grow, but not in so robust a fashion.  If average income is to grow at 1-2% per year, it is hard to justify a situation where large fortunes—particularly inherited fortunes— grow at 10% per year.

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