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.