The six percent curse

I’ve been looking for root causes of the economic challenges facing the world. My answer is the assumed real return on capital, a risk adjusted 6%.

One of the main changes in global economics over the last forty years or so is how most capital now acts as one large pool. Beforehand, capital was a bit sticky, and it also flowed within many small pools. Moving capital between the pools was costly and often prohibited by capital controls. Only the very well connected could achieve it, people such as dictators, who became very rich indeed.

But now all that has changed. Capital controls have largely vanished, except in places like Venezuela, and to an extent in China. Technology has spawned a plethora of financial products to speed things along. And most investors have mingled together into a single mass, facilitated by banks, all looking to fish in the same pond. And more and more, investors include us: our pension, whether a company scheme or a 401K, forms part of the capital being invested.

To a large extent, the freeing up of global capital has been a good thing. Great projects can always find funding, including in the developing world. Innovative companies can improve everyone’s lives. Those dictators have a tougher time these days. Corporate bosses cannot get away with being lazy. Local bank managers can’t give loans to their cousins or golf buddies and ignore more deserving causes. Competition and scrutiny are everywhere, including on governments.

But a single pool of liquid, free to flow, must find a level, and that level has been 6% real for twenty years now, a level that has become a self-fulfilling prophecy. It is the big pension funds that set the level, for they need an assumption to balance their books. Now everything in the pool has to assume the same level, and most capital in the world is in the pool.

6% is a heroic rate by historic standards. Although the global population is growing at close to that rate, many richer nations now have declining and ageing populations that hold back growth. But 6% was set at a time of optimism. More cynically, banks and the US government were trying to promote 401K’s at the time (to benefit corporations and banks), and 6% made those seem more attractive.

The consequences of 6% have been huge. Most obviously, the rate builds in ever growing inequality. As Piketty claimed, usually r>g, and g, the natural real growth rate of production, now seems to be 2-3%. 6%, r, is the rate that capital, or existing wealth, grows. Summers’ theory of secular stagnation suggests that long term growth potential could be even less. So the rich get relatively richer compared with those without wealth. Without large compensating wealth, inheritance or property taxes, this cycle is set to continue, at least as long as r stays at 6%.

The next consequence is delusion, recklessness, bubbles and periodic crises. Anyone needing funds, so basically all of us, but especially companies, banks and governments, have to put forward a plan to achieve 6%. Meanwhile, the pension fund investors need to find plans that generate 6% to stay afloat. So everyone has a need to keep the plates spinning. So claims inflate, so does debt, and risks are overlooked as everyone crowds in. Then the bubble bursts; in the case of 2007-09 the asset class that collapsed was US housing debt. But such is the global dependence on the fiction of eternal 6% that governments chose to bail out banks, allow homeowners and jobholders to suffer, and even to make suffering worse by reducing their spending that was social rather than financial. After a while, the plates can spin again. We blame bankers, and the politicians in their pockets, but actually they had little choice, so long as the core assumption stayed unchanged.

The next consequence is starvation of investment. With a high discount rate, benefits in projects realised after more than 15 or 20 years count for little in financial evaluations. These tend to be the projects involving high up front capital or new technologies, and include things like roads and hospitals. It is no coincidence that infrastructure in developed nations has been hard to fund over the last fifty years. Projects such as social housing fit this category as well. The only people who can make such investments are in golden sectors like IT, where valuations can be sky-high, and in companies or places not reliant on debt financing. The most obvious example is China, and the Belt and Road initiative is the result.

While there are many factors behind the rise of populists, one root cause might be 6%. Mainstream social democratic parties have been sucked into the assumption, and been forced into policies to feed it and the class that benefits. Inequality rises, while poor citizens are lured into schemes built on inescapable debt. The rich spend less than the rest of us on average, so consumption overall is reduced over the mid term, a further argument towards secular stagnation. In this situation, someone promising escape while blaming foreigners has much appeal.

One other consequence of the flattening of global capital is the growing power of economic bullying. Trump does not need his mighty military as much as previous bullies, he can apply economic sanctions very easily, and with greater potency than before. In the long term the world will respond by stripping the US of its unique position as owner of the only reserve currency. At that point the US debt will leave the US itself at the mercy of China and other possible bullies.

If I am right, or even (more likely) somewhat right, and 6% is a root cause of so much damage, what can be done to reverse it? At first, this question seems simple, since it is just an assumption. Why not just change it to 4%?

This could be done, but it would instantly create another financial crisis. All invested wealth would suddenly be worth less. In particular, any pension fund or other fund that pays out in the future would immediately have an unmanageable deficit. That ropes in the largest investments, nearly all national governments, and cities, starting with those like Chicago and Detroit, where the most financially stressed regular people live.

Still, recognising the problem remains the first step to solving it, even if admitting it creates a crisis. That is the nature of such problems. The key is to have a solution to the crisis ready at the same time.

Short of solving the problem, some steps can help to reduce its effect. It is probably not of benefit to go back to a world of capital controls, but the water can be made stickier. Start with a Tobin tax, designed for exactly the purpose of slowing down the most speculative flows. Then reverse incentives for debt. As part of the plate spinning, many advanced economies have favoured debt, through measures like mortgage tax relief and other tax advantages.

Then take a deep breath and change the assumption, led by governments and mandating banks. But have the safety net ready, not for corporations but citizens caught up in the mess. That implies printing money for debt relief and pension shortfalls. It would be like the last bailout, but this time targeted to change the assumption rather than prop it up. Its effect would be like a short burst of high inflation – writing down almost all wealth. And, having reduced inequality at a stroke, the new assumption would mean it would only build up again more slowly.

Lastly, take the opportunities that the reduced assumption provides. States can categorise investments with social or longer-term payback, without falling into the traps of nationalisation or picking winners. It is simply using the extra leeway to steer capital to the benefit of society rather than bubbles.

Most likely, only another crisis will enable this shift to happen. Perhaps that is fair enough. But this time, if I am a little bit right, economists can be preparing for the crisis in advance, and use it for lasting benefit.  

Solving Economics

One of my few regrets is that I did not study economics at college. I was a bit of a maths prodigy so slid into that discipline, but I loved economics at school, and once I got to college I could still succeed at the maths but found little passion for it. So I flirted with changing, but ultimately stuck with the safe option. Who knows how things would have turned out, but a part of me still thinks I made a mistake.

I loved economics because it was live, empirical, unsolved, complex, but showed signs of being solvable, with a mixture of theory and experimentation. Since my school course in the 1970’s, text books have had to be re-written at least twice, and the discipline has learned a lot but arguably remains as far from lasting solutions as it ever was.

My guess is that this will change over the next twenty years. My belief is that there have been two big inhibitors to progress in the discipline.

The first has been in the nature of the subject: because so many variables are interacting all the time, and because most of these cannot be controlled (and others cannot be ethically controlled because they have too much influence on human well-being), the mass of available data has always had too much noise to be able to reach definitive conclusions. But this limitation might be vanishing, thanks to big data and machine learning. Economics is precisely the sort of field where this can help, and I believe the science will march forward as a result.

But economists will have to overcome the second limitation, that of lazy bias. Too many theories are set up to serve vested interests, usually the corporations and sponsors wishing to maintain their wealth. This had held up progress in many disciplines, for example healthcare and environmental knowledge, but in economics it has been everywhere, and politicisation of the subject has held back progress.

As an optimist, I am hopeful that once big data starts to make a difference, the political side will find it harder to resist more robust ideas. If The Economist is any guide (and I think it probably is) there are already promising signs. Over the last couple of years, the magazine has been more open to casting off tired shibboleths. Until recently, they thought that every problem in education could be solved by firing teachers, that trade was always good and that trade unions were always bad. Nowadays things are more nuanced, and the magazine also has a good new habit of posing open questions.

I would love to know more about the subject, to be able to understand more of the debates in the Economist and elsewhere and also to challenge and hone my own opinions. The complexity has increased with globalisation but so has the potential to create really robust models that can drive policy and progress.

Within the most recent edition, many articles were thought provoking and not dogmatic. The lead article looked at finance ten years after Lehman; the Britain section mused intelligently about low wage growth; there was a fascinating debate out why Turkey and Argentina seemed to be getting the same results from diametrically opposite policy stances, one of which the Economist would typically have lauded; and Larry Summers’ thoughts about secular stagnation were reopened. My hope and my guess is that in twenty years time all of these challenges will appear much more simple and open to attainable remedies.

One potentially useful tool in all of this is something that programmers, doctors and project managers use all the time; root cause analysis. A good example may be in understanding the causes of the Great Recession. It is too easy to blame the greed of bankers. I tend to agree that most bankers are greedy frauds; this week I enjoyed the movie The Big Short, which confirmed my bias but also set me thinking about possible deeper causes. Perhaps I will read Crashed, but yesterday in Barnes and Noble I flipped through its 600 pages and I am not sure my love for Economics goes that deep.

My pet root cause for much that goes on in the world of commerce and finance is 6% real. That has become the target rate of return for capital.

Fifty years ago, capital was managed in small pools. There were barriers to capital crossing borders. Individual firms could pursue their own strategies and goals. Governments could also mix policy objectives. Investors acted somewhat independently. Now all that has changed, and most of the world’s capital acts as one large pool. And like water it flowing downhill, capital seeks out its best risk-adjusted return. Any investment offering less than the average is starved.

This has happened because most barriers between states have been dismantled. Further, investors have merged towards a single block and have become tied up with governments. The largest investments are now pension funds, linked to regular citizens and of great interest to governments. Remaining investors have become like lemmings too, often using index-tracking funds, and, if not, getting data so frequently as to expose any portfolio offering below average returns.

In this environment, the financial world has become flat, and its level is at 6% real. Pension funds must assume a rate of return to balance actuarial inflows (today) with outflows (in many years time). At a time of boom, they chose 6%, and to change that now would require unaffordable write-downs. Governments would be on the hook for public sector funds and under pressure for private ones too. In a way, it is not that banks have become too big to fail; it is that almost the whole system has become too big to change its base assumption.

There are a few exceptions. Sovereign wealth funds could choose a lower target, though citizens might ask why. Privately held companies can also opt out, so long as they don't need to finance much debt. And governments can opt out too, choosing to impose capital controls and print money. Venezuela shows where that policy ends up. Argentina does too, as well as what happens when a country opts back in. Increasingly, there is no escape. One victim has been social democratic political parties, finding that in power, fiscal discipline constrains their actions, and then damages their brand and reduces trust among their possible voters.

Compared to historical averages, 6% real is a huge return to achieve sustainably. In one way, it has been good that the target is set so high, because it fosters innovation and hence human progress. Silicon Valley might have been less exciting if the 6% target had been lower. But the downside has been disastrous.

Companies have had to become reckless to continually produce plans to investors that flag 6% real returns. They diversify into risky financial products and pursue ambitious acquisitions. They rely on dodgy consultants and internal gurus and pay them far too much. They offshore and outsource. They sacrifice any thought for secondary goals such as fairness to customers, environment, legacy and workers – it is not callousness that has destroyed real wage growth, it is employer necessity. They buy back shares rather than investing, and especially avoid long-term, less certain investments. They pump up debt. Each quarter they announce earnings and a new plan to keep the plates in the air a little longer. If the plan is not deemed credible, they fire the CEO and find a better snake charmer. They also might collude, and certainly they lobby - even blackmail - governments fiercely to reduce regulation and corporate tax rates.

As a result, we have an economy permanently on steroids but filled with risk. Banks are just companies with even stronger steroids. Governments cannot escape either.

2007-8 is one obvious consequence. So is relentless growing inequality. There are other consequences as well, that I’ll look at next time I blog. Then I’ll also consider if there may be any paths out of the mess. 

Too little, too late

Consider this job description. The headline is a community counsellor. The responsibility is to be available to anyone within a defined boundary to offer comfort, advice, hope and suggestions. You are offered legitimacy in the role by the support of an international hierarchy of such counsellors, and by undertaking fixed rituals, including regular speeches. Those you are counselling come to believe that this backdrop gives you power to support and heal, to forgive and even to offer life after death. Your legitimacy is further boosted by some darker powers over anyone who does not follow some rules or your guidance. Pay and lodging is provided, and you will be well looked after even if you are unlikely to grow rich.

This is quite an interesting job description, is it not? Imagine it appearing in a local paper. Who might be interested? Who might turn out to be good at the role?

About who might be interested, on the plus side, they would likely be kind and have a benevolent wish to do good for others. The global hierarchy and the consequent possibilities for career advancement, despite that rather poor pay, might attract some of ambition, which might be good or bad. More risky is all that stuff about power – this might attract those with a need for control and who feared they might lack the skills to acquire it without the uniform or rituals.

As for who might be good, well the job would require massive patience, empathy, optimism and resilience. They must be good listeners. Some sort of psychology training would help. The empathy would be aided by a wide experience of life, suggesting people old enough to have such experience but not so old as to be out of touch. Ambition and control would need to be tempered – these people must lead through service. Like many caring and supporting jobs, on balance women might typically be better suited than men.

If might be tough, but if society decided to create such a role, maybe it could be filled by qualified candidates and do some good. But, sadly, there is more, none of it positive.

First, only men are accepted. Next, the training is long and theoretical and arduous and applicants must consider that the role is for life. The hierarchy is absolute, the doctrine restrictive, but there is almost no scrutiny from outside the hierarchy. Finally, no sex is permitted – no flirting, no masturbation, no sex at all.

Who will be interested now? Rather fewer people. And while they will still have a benevolent streak, they are far more likely to be motivated, at least in part, by the stuff about power, probably ladled with a strong fear of intimacy and the opposite sex. If recruited at thirty or below, they seem very likely to be under strong influence from a mother figure and to have some slow-developing and confused ideas abut sex and sexuality. As for whether this profile would turn out at good at the job, well, there will be some happy successes, but few would be able to overcome the handicap of lacking worldly experience, and for a minority the combination of power, absence of scrutiny and mixed up thoughts about sex could be highly dangerous.

Of course I have been trying to describe the job of Catholic priest, admittedly using corporate type language that those of a spiritual nature might dispute. But looking at it in this stripped-down, corporate way seems to me to go a long way to explain the mess the Church has got itself into, even its inevitability.

What surprises me about the most recent revelations is that anyone should be surprised. The lid was taken off this scandal years ago, and exposed further by wonderful movies such as Spotlight and Philomena. The Church responded as defensively as you would expect from an institution of such arrogance, wealth, vulnerability and freedom from external scrutiny. To its credit, it has put procedures in place to make a new generation of priests far less likely to fail.

But it was inevitable that more abuses from the past would come to light. Previous revelations required brave whistle-blowers to defeat entrenched positions so were sure to be only a tiny part of the story. Even now, there must be a lot more to follow. Why should Pennsylvania be unique? And think about a place like the Philippines, where all the temptations will have magnified and the scrutiny even less.

Only now have priests in the USA been allowed to publicly express their anger and shame, and it is to their credit that my local ones have been clear, and even cautiously proposed some controversial reforms. While I was impressed and moved by this statements, my overwhelming feeling was one of “too little, too late”. Where was the focus on victims ten years ago? Where was the urging for reform? Where was the condemnation of cover-up? It was all missing, following the lead of a callous and divided Vatican. Sadly, asking us to believe in these people to reform now is not really credible.

It is sad because the Catholic Church remains a force for good, perhaps the most effective global NGO and sometimes a stalwart for human values. Even on the values, the track record is blemished, both past and present; the Church can seem like a single-issue lobby group at times, following its prime source of money rather than its conscience. How can a Trump administration be tolerated by anyone grounded in the gospels?

So an institution providing hope and practical charity is perhaps holed below the waterline and beyond self-repair. The previous time a pope visited Ireland, 2.5 million souls turned out to greet him; last weekend the tally was 130,000. The current pope is clearly hemmed in by entrenched interests. Beyond prayer and personal advocacy, can anything be done?

I believe it is time for states to stand up to the unacceptable face of religion. Most religions have a dark side. Jews are taught to believe that they are God’s chosen people. Evangelical Christians are divisive and tribal. Radical Islam harms its own adherents, especially women, while preaching hate. Hindus perpetuate the caste system. Buddhists cheer on persecution of Rohingya. Nearly all religions hold back women’s rights, and gay rights.

The solution is obvious; end all legal carve-outs for religions. Already universal human rights declarations mandate religious tolerance. But most states actively or passively tolerate practices that would be illegal were they not based on religion. Most of the root causes of the Catholic mess would be eliminated, as would many dark effects of other religions. Yet charity, promoting respectful values, and non-abusive private rituals of hope and comfort would be supported and can continue.

The effect would be transformative. Obviously, the abuses would largely stop. But I suspect the main beneficiaries would be religions themselves. The Catholics cannot reform alone, but if forced to reform they could provide an attractive haven for recruits, both adherents and celebrants (of all genders, living healthy lives) . The same would be true of many other religions. And as individuals we would have less reason to hate others, while ignoring our own hypocrisies.

Will this happen? Not in my lifetime. But a quiet movement might create some valuable osmosis. If they are smart, reform-minded Catholics should be in the forefront. And because Christianity is the religion in most trouble and is the established religion of the rich world, perhaps that world might be able to lead.

In the meantime I will continue to attend mass and support my local churches and their leaders. I will continue to try to hold my own religion to the same human standards that I try to judge other religions by. And no doubt I will be saddened, but not remotely surprised, by the next torrent of human failing in the name of religion that hits the news.