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Whew! We can finally talk
about something besides banks -- though I'm sure we'll go back there pretty
soon. This is quite the historic moment in the financial sector.
Instead, we'll talk about
something else: the idea of the Capital/Labor Ratio. I call it an
"idea" because there's no real ratio, as in a number with several
decimal places. If there was, or someone made one, you should probably ignore
it anyway.
Ever since the beginning
of the industrial revolution, in the late 18th century, people have wondered:
it's great that one person, with a steam-powered spinning machine, can do
what took a dozen people with spinning wheels used to do, but what happens
then to the other eleven people? Do they become unemployed?
Possibly. But, on the
other hand, if they all had steam-powered spinning machines, then they would
all be employed, and the total output of cotton cloth would be twelve times
more than it was before. And, there being twelve times as much cotton cloth
produced, people could thus use 12x more cotton cloth, or sell it for
something else they wanted, or what have you. Thus, we see greater
productivity leading to greater wealth. There is also the question of who
gets what. Do the workers get salaries equivalent to 12x as much cotton
cloth, or do they get no more than what they got when they used spinning
wheels, and the factory owner gets the benefit of all the surplus production?
Let's say that, in one
case, one person operates the steam-powered spinning machine, and 11 people
are unemployed. They are no longer able to compete against the machine-made
cotton with their spinning wheels. If they don't have spinning machines of
their own, maybe they end up as floor-sweepers, ditch-diggers and
prostitutes. Low-value, low-paid, non-capital-intensive activities. How much
does a broom cost? In short, they are underemployed.
What's the difference
between the somewhat sunny scenario where there are lots of spinning machines
(12 people with 12 machines), and lots of productivity, leading to higher
wages and wealth, and the more dismal scenario where there is one person with
a spinning machine, who is underpaid because of the great surplus of labor,
and 11 underemployed people?
The difference, it seems,
is the other 11 spinning machines. Spinning machines are "capital,"
specifically capital expenditure. When there is lots of capital,
then labor is in demand and is well-used. When there is not
enough capital, labor is in surplus and is underused. Also, let's
say that the cotton cloth business is very profitable. There is a high return
on capital. Thus, more capital pours into the sector. This capital is useless
unless combined with labor to operate the machines. The value of labor thus
goes up. Wages rise -- to the point at which they reduce the profits of
capital, and investment becomes less attractive. Thus, when there is plenty
of capital, two things happen: 1) labor is well utilized (lots of good jobs)
and 2) labor is well paid, which is to say, a greater degree of the
additional productivity resulting from the capital investment is paid to
labor.
What if you had capital
to produce 20 machines, but there were only 11 people available in the labor
pool to operate them?
One of the problems in
the US right now, for example, is that there is an effective surplus of labor
as immigration rules are rather lax, and there has been a huge amount of
effective labor introduced via India and China for example. (You don't hear
much talk about how the high tide for the middle class in the US, which was
really the 1950s and 1960s, were a time of restricted immigration.) At the
same time, capital investment and capital creation is rather low.
"Capital investment"can take many forms. There is the
traditional "big company buys a big machine" sort of capital
investment. However, any investment that results in "greater
productivity" can be considered a capital investment. If a cook sets
aside time and effort (capital) to become a better cook, then his product
(food) may be tastier. This is greater productivity. Both Wolfgang Puck
(celebrity chef of yore) and the burger-flipper at McDonald's spend about
eight hours a day cooking. However, Puck is vastly more productive
(considered simply as a chef rather than a media figure and restaurant
entrepreneur), which can be considered a result of his capital investment in
building cooking skills. This greater "productivity" may result in
a higher income as well. Many "capital investments" today are in
the form of education and training, formal or informal, which doesn't really
show up on any statistics as "capex."
From this, it can be
readily seen that high levels of capital investment are beneficial, and
indeed even necessary because the effect of increasing productivity is that
it typically takes fewer and fewer people to do something. This means more
and more "surplus labor" that needs new capital. The increasing
productivity of agriculture, to take one of the longest-running examples, has
resulted in fewer and fewer people needed in the industry. In some sense,
capital investment (in agriculture for example) creates the need for more
capital investment (what to do with the people no longer needed in agriculture).
Ideally, you want this
process to be "proactive," such that people that are no longer
needed in one industry are enticed to higher-productivity activities by
higher wages ("I'm dumping this bogus nonsense to get a good,
high-paying job in the city") rather than via depressed wages and
unemployment. ("Factory closed, now what am I going to do?").
Where does this
"capital investment" come from? Mostly it comes from current
income, or "savings." We are familiar with household savings, but
corporations "save" as well. In short, they have surplus cashflow, which is channeled into investment. On a
physical level, it means that people spend time and effort (capital) on
investment-type activities, whether education and training or building the
machines and other physical capital that people will use in the future to be
more productive.
The capex
of the developing Asian economies is phenomenal. For China today, and places
like Japan or Malaysia in the past, you could often see capex
on the order of 50% of GDP, and super-high savings rates to match. When there
is this much investment in higher productivity, is there any surprise that
higher productivity results -- accompanied by higher wages and high demand
for labor?
Thus, it would make sense
for a government to promote capital accumulation. This was a very basic idea
a hundred years ago, but it seems rather foreign to governments today. How do
you promote capital accumulation? Mostly, the government should avoid
discouraging and preventing capital formation. Investors are naturally
anxious to accumulate capital anyway, if they are not prevented from doing
so.
One of the biggest
impairments in capital accumulation, it seems to me, is the corporate income
tax. On the corporate level, capital investment (in excess of capital
consumption, ie depreciation) is financed primarily
via profits. Higher taxes = less profits = less capex.
It's not too much more complicated than that. Plus, taxes introduce a
distortion, namely that returns on capital are impaired, so that not only is
there less capital to work with, but it tends to be channeled into
less-productive uses (muni bonds?) due to tax
considerations. Thus, a double impairment to productivity.
Even if a corporation
uses outside capital, in the form of debt or equity, that capital also has to
come from somewhere -- typically excess cashflow of
some other corporate entity. Likewise, capital (profits) that are not
invested at one corporation are most likely invested at another.
If a corporation isn't
paying out 40% in taxes, that money goes somewhere else. In practice, it is
either reinvested, in a new factory for example, or paid out to shareholders
as a dividend, where it is typically then reinvested in another company that
wants to build a factory but is short of cash. (We have to talk in these
50-year old "build a factory" terms, even though maybe factories
aren't what is needed today, and instead someone will rent an office and
spend $100m on software R&D.) When you have a new factory , then of
course you have new demand for labor to work at the factory, which means more
jobs and higher demand for labor.
Capital gains and
dividend taxes have much the same effects, impairing the process of capital
accumulation. Of course, personal income taxes create similar effects. Also,
when taxes are low or nonexistent, the incentive to invest, i.e.
"save" or accumulate capital, is greater. Otherwise, the income is
"consumed," creating no future productive advantage.
In effect, these taxes channel
cashflow to the government, instead of into more
capital accumulation. The government also makes capital investments of its
own. Typically the "public works" type projects are the most
economically useful. Indeed, the government can often get things done here
that would be difficult in the private realm, particularly as regards
rights-of-way for highways, building ports, etc. However, rather little
government spending today is directed into productive capital investments.
Mostly it is waste, via corporate subsidy, military spending, etc. Transfer
payments, namely Social Security and Medicare, don't do much for capital
accumulation either, although they may be important for other reasons.
Thus, with these
principles, if you wanted, for example, to improve the situation for
America's middle class, you would encourage the formation of capital. This
means lower taxes on capital, particularly corporate taxes, capital gains
taxes, taxes on dividends, interest income etc. The US today has some of the
highest taxes on corporations and capital in the developed world. Is it any
surprise that the US also has one of the sickliest middle classes in the
developed world? Hardly. You might also limit the supply of labor, at least
within the US, perhaps by enforcing existing immigration laws. It is typical
of the capitalist class to prefer low taxes on capital and capital
accumulation, but also policies that create a surplus and excess of labor, as
this tends to maximize the share of production that is enjoyed by capital.
(In short, low wages.)
At this point, the more
environmentalist type cringes in horror at the thought of ever-greater
empowerment of the concrete-pouring, suburb-building, Big Box-shopping,
fossil fuel-burning element of the economy. Indeed, I suspect that, at some
collective level, certain populations have determined that "enough is
enough," and have accepted a certain amount of economic stagnation
(France for example) in return for a slowdown of environmental destruction
and general cultural demolition. However, this is in large part a measure of
choice. There is nothing that requires "capex"
to take the form of a superhighway or a strip mall. If the highest return on
capital was to opera singers, instead of Big Box stores -- which is another
way of saying, people are paying for opera singers rather than Big Box
retail, such that one is more profitable than the other -- then we would have
an economy rich with opera singers and few Big Box stores. Or, to put it
another way, we would spend lots of our money at the opera and little at the
Big Box Mart. What if 20% of people's total income was spent on art and
artists -- jazz clubs, paintings, dance and so forth. Then 20% of the economy
would be artists. (GDP is basically a measure of spending.) So, for those
with such environmental or societal concerns, I say: put your money where
your mouth is. Don't shop at the Big Box. Don't buy a McMansion
in the 'burbs. "But it's cheaper
there!!!!" comes the whine. Of course it is. So what. Just don't
participate in the collective delusion. Pay up for the small, independent
store, if it is the sort of thing you would like to see multiply and prosper.
Pay up for the organic food, the custom tailored (or otherwise well-made)
clothes, the artisan-made housewares, the independently-owned
restaurant. Vote with your wallet, instead of complaining why other people
don't vote with theirs. You see, people have to be shown how to do things
that are different than what they are being told to do by their television
sets.
* * *
Bailout Watch: The Fed has hired Blackrock to manage its portfolio
of mortgage-related securities. Manage? That's a funny thing to do on
collateral on 28-day loans.
* * *
T2 Partners has put out a
big Powerpoint with interesting info on how the
mortgage situation is developing. It is available at http://www.valueinvestingcongress.com/. Basically, it's worse
than you think. I suspect that this spring/early summer selling season will
see some "give up" among sellers, and further reluctance among
buyers (as the last round of "dip-buying" buyers gets whacked),
producing a significant drop lower in prices. Just think of how things have
changed since the last spring/summer selling season, April-July of 2007. More
bubbly areas, like California and Florida, could see another 20%-30% downmove, while more marginal areas could see weakness
due more to a weak economy. Prices are still too high. Prices have to get
down to the point where the monthly cashflow costs
of buying and owning a house -- on a 30yr fully-amortized mortgage -- are
less than the cashflow costs of renting. Because:
nobody has more cashflow than that --
most renters spend as much on rent as they are capable -- so where would the
extra money to pay the mortgage and expenses come from? Besides, banks aren't
going to loan you the money anymore unless you can document the ability to
pay it back, so how are people going to document that they can pay more than
their rent? That's a maximum price, it seems to me, and realistically the
number of people who want to buy a house, and are able to put up the 20% downpayment, are rather scarce. Probably, prices would
fall well below that. I still see 50x a month's rent as the probable floor of
our crash crater. We can imagine the effects on the mortgage-finance sphere.
I've thought for a while that inflation (declining dollar value) would help
prop up housing values, but none of that inflation has been making it into
people's incomes yet. I think incomes (ability to pay) will be the primary
determinant of nominal prices for now. Prices in terms of gold oz. may
collapse to astounding levels.
* * *
Silver Shortage: Retail bullion dealers
reported "the busiest day in forty years" when silver fell recently
below $18/oz. on the Comex. It appears that dealers
are sold out across Canada, and available silver in the U.S. is very spotty.
I've heard that dealers are even bidding $0.50 over Comex
for 1000oz. good-delivery bars. The markets for metal and paper (the
heavily-manipulated Comex) are beginning to
diverge. Indeed, a couple large funds could take delivery on the entire Comex inventory, which would probably put an end to that
charade. If you have any form of "paper silver" -- pooled accounts,
certificates, ETFs etc. -- I'd consider going to bullion except perhaps for a
trading position. For accounts of less than $2m or so, Goldmoney.com provides
a good alternative. While holdings via Goldmoney
are "direct held" in a legal sense, in a practical sense one is
still somewhat reliant on the custody and trading framework Goldmoney provides. Still, it looks better than the many
alternatives, if you don't want to take personal delivery.
* * *
Surf's Up: Some of you with
beachfront houses may have noticed a bit less beach over the past six months
or so. You're not the only one. Word on the "scientific
underground" is that sea levels worldwide rose about 6" over the
past 12 months, with 80% of that coming in the last four. Some estimates
point to an additional 1-3 feet of sea level rise by the end of 2009.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset management.
Lewis has written for the Financial Times, the Wall Street Journal Asia, the
Japan Times, Pravda, and other publications. He has appeared on financial
television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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