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r > g, but only if they don't take it from you!

  1. Capitalism
    iStock_nuvolanevicata
    The Byre

    The Byre UKBF Ace Free Member

    Posts: 5,353 Likes: 2,135
    8 |

    Ten years ago this week, Stan O'Neal, the first African-American CEO of a major Wall Street investment house was trembling. His newly re-appointed risk assessment officer had just handed him a piece of paper, outlining what he had found out over the past couple of weeks. His company, Merrill Lynch had invested heavily in a new product called Collateralised Debt Obligations (CDOs) and these were beginning to fail.

    Merrill Lynch was in the hole for billions, but nobody was really sure just how big the hole really was. In the end, it turned out to be $8bn, but that was going to be chicken feed compared to what was happening in the rest of the market. A forest fire was about to engulf the world's banking industry.

    So, whereas everybody and their mothers-in-law are fretting over Brexit, I suggest that we have more important things to fret over - in particular, the reason I went into business in the first place all those years ago. Namely, that the number five is considerably larger than the number two.

    Not only that, but the number three-hundred and thirty-two is far larger than eighty-one. But I shall come back to that important fact later on! It is also this huge difference between the number 81 and the number 332 that stops me from borrowing money!

    But back to this week, ten years ago: it usually takes a collection of factors cause a financial 'Forest Fire' and the 2007-8 crisis was no exception.

    At the heart of the 2007-8 crisis was a device known as a 'collateralised debt obligation' and these were all sorts of debts bundled together (student loans, mortgages, company debt, car financing, anything and everything) into c.a. $1bn bundles. These were then sold off in $10,000 shares. And yes, one of them was indeed called 'Forest Fire'. 

    Borrowers may have assumed that they were paying off the car, house or cheap furniture to a finance company, but that money was sent straight to the account of the CDO that bought the debt.

    The result was, (in most cases, but not all) the body that lent the money, got its money back within weeks - so there was no real incentive for them to give a hoot, who the hell they lent to. If you were warm and could sign your name, you could get a $300,000 mortgage on a house worth less than half that. Mortgage brokers were being paid hundreds of thousands of dollars every week. Only regulations can force them to demand proof that you can pay. Take that regulation away and your dog could get a £50,000 loan, using his dog-basket as collateral.

    (One enterprising Polish woman went to the US and took out dozens of mortgages on total shacks, splitting the money with the very happy house owners! She then vanished!)

    CDOs on their own didn't do it. Derivatives and synthetic CDOs (a peculiar side-bet on a CDO) didn't do it. Inflated house prices didn't do it. Banking deregulation on its own didn't do it. Mounting private debt didn't do it. Wild commission levels for financial instruments and trade didn't do it. Refusal to take proper risk assessments at trading houses and investment banks didn't do it. But put all of those factors together and you got one giant Ponzi scheme - and what happened was inevitable.

    It was the day the banks fell for their own Ponzi scheme.

    But now we have an even bigger Ponzi scheme building up. It is the Ponzi scheme of fiat currencies. Governments around the world are paying today with numbers that represent nothing. It was Adam Smith, who said that all money is a matter of faith. But faith is being stretched to the limit.

    Just as we no longer believe that the world is six thousand years old and that there is a bearded man in the sky, we are not only losing faith in money, but in the very mechanisms behind money.

    The physical things we have and use are finite. There is a finite amount of land and the amount per person is decreasing as populations expand. There is a finite number of trees to build houses. There is a finite amount of fresh and clean water and air. Some things we can build more of - we can always build more and better cars, houses, roads, breed more cattle and eat more meat. But the numbers of cows, cars and houses are not infinite.

    But governments, with the eager collusion of the banks, are generating more money and the banks, by lending against the extra money generated, are accelerating that process, by generating more money from the more money generated. 

    A fiat currency, like software and smartphone apps, is infinite. A government can put any large number in the right-hand margin and that becomes the new money supply. The only thing that stops them from inflating away their debts and obligations, is the extremely destabilising effects of inflation, if/when it gets out of control and achieves a momentum all of its own.

    So far, all this just happily goes over the heads of 99.99% of the population. Who cares?? Drunk for a penny, dead drunk for tuppence! Today that is drunk for £10, dead drunk for £20! 2,400 times as much! A house for £20 - a house for £200 - a house for £2,000 - a house for £20,000 - a house for £200,000 - a house for £2m - a house for £20m - where do we stop? Do we even need to stop?

    Can we stop? Do we need to worry?

    We call that fall in the value of money - inflation and as has been pointed out, here, there and elsewhere, a little inflation is regarded by most as being a good thing. It helps spending and helps currencies to circulate faster. Banks just love a bit of inflation. It also discourages saving and increases profits!

    BUT

    May I introduce you to the second law of capitalism - (I'm working backwards today - live with it!)

    Capital = savings/growth.

    If a country saves 12% of its national income and the economy grows by an average of 2% per year, then, in the long run, the capital/income ratio will be equal to 600%. i.e. the country will have accumulated capital worth six years of national income. This of course, only applies to capital that we can accumulate. If a nation sits on large natural resources, then (like Donald Trump) we can have wealth without having to go to all the trouble of earning it and saving it up.

    Which brings me neatly to the first law of capitalism - the most fundamental law of any investment and one that we make almost daily.

    Wealth = rate of return x capital.

    (We have a great deal of horse manure at our place. Unfortunately, the rate of return on horse manure is rather low, about zero, I would guess. So having all this horse manure has failed to make me wealthy! So for anybody looking for an investment to make them wealthy, avoid horse manure and buy some land instead!)

    For a nation, it looks like this: if national wealth is worth the equivalent of six years of national income and the rate of return is 5%, then capital's share of NI is 30%. Simples!

    Now, for those of you who are especially sharp this morning (like Jeeves, no doubt, the result of eating fish) you will have noticed two things about the two laws of capitalism and my examples for a nation. I have used very typical numbers for rates of return and growth - 5% and 2% respectively! 

    And those of you who put yourselves outside of a kipper this morning, you will realise that 5% is much more than 2%. (You see! I told you that I'd come back to it!) This rather stark and dangerous fact is what French economist Thomas Piketty calls:

    "The Central Contradiction of Capitalism: r > g"

    Now we add that one thing in our lives that all flesh is heir to: time. 

    "Time, like an ever-rolling stream, bears all its' sons away. They fly forgotten as a dream flees at the break of day."

    It also does something else: it turns 2% into 81% in just one generation (30 years) and 5% into 332%. That is the same as saying the wage earner gets 1.81 times as much, but the capitalist (aka business person) gets 4.32 times as much.

    If we now make that 100 years and we hand down our businesses to our grandchildren, then we no longer multiply our wealth by paltry single figures, but by over 130. Our grandchildren can expect to be over 130 times as wealthy, whereas the grandchild of the wage earner is just seven times as well-off (assuming that war or economic disaster has not done something nasty to growth and therefore to the lot of our wage earners in the mean time!)

    When you start to think about these numbers, then you realise how small family shops, turn into multinational retail chains and one man and a printing press can become a multi-billion media empire! But only if they don't get that wealth stolen!

    But be warned - there are thieves about! 

    These thieves manage to steal nine out of ten cars sold today and they even steal nearly all modestly-priced houses. They can take the deeds to your house and play every trick in the book to not have to give them back. They steal thousands from nearly every household every year! You probably call them banks. 

    Well, it's banks and just about everybody else who seems so drop-dead keen to lend you money - do you really need a flash company car, payable over four years and at 'just' 3.9% interest, with an optional £10,000 buy-out at the end? Did they happen to mention that your dream car for £30,000 only costs about £4,000 to build and that the damn thing is almost certainly not going to be worth £10,000 after four years?

    If you are paying a typical 7.5% interest rate on a private loan from a bank, then you are sitting on the wrong side of the table. In ten short years, your loan that you hope will start your business will have earned the bank 40%.

    But the thief that is compound interest is targeted at one end of the market and hardly gets to steal a penny at the other end. Cars for £30,000 are sold on credit, but cars for £300,000 almost never. Nobody is likely to take out a mortgage on a castle in Scotland, but a two-up, two-down in a Scunthorpe back-street - almost always!

    But let us return to Professor Piketty and the undeniable fact that r > g, or as I stated at the top, 5 is a bigger number than 2.

    The consequences for the long-term distribution of wealth and thereby the stability of society, are potentially terrifying, especially when we remember that the return varies with the size of the initial stake and the resultant divergence in wealth distribution is taking place on a global scale.

    Unfortunately, the higher growth rates that history tells us can happen, only happen in when economies are catching up, for example, Europe after the War or China and Third World countries today. For mature economies at the forefront of technology, there is good reason to believe that 1 - 2% growth in real terms is all we can achieve, no matter which policies are adopted.

    Pressure is building. 

    Some may argue for a progressive tax on capital, but this would require a level of international cooperation and coordination that can only be achieved within trading blocs large enough to dictate terms beyond their borders. That is the European Union, North America and China.

    And none of those seems interested in any such idea, probably because the idea would fall at the first hurdle: practicality. Capital will always find a way to make the number 5 bigger than the number 2.
     

    #0
  2. Francois Badenhorst

    Francois Badenhorst Deputy Editor Staff Member

    Posts: 91 Likes: 18
    These last two paragraphs seem to adopt a somewhat hopeless position, The Byre? What do you think is the solution? Or is there even one?
     
    Posted: Aug 2, 2017 By: Francois Badenhorst Member since: Aug 25, 2015
    #2
  3. The Byre

    The Byre UKBF Ace Free Member

    Posts: 5,353 Likes: 2,135
    Professor Piketty discusses the basic laws of capitalism over 570 pages in his latest book 'Capital in the Twenty-First Century'. So you see, this is not a man who glosses over his subject!

    His conclusions are written from pages 571 to 573 - which is his way of saying "No, I don't know either!"

    He suggests taxing capital, but all attempts at that (e.g. death duties) just sees capital move to where it cannot be taxed. Not only that, but those who organise such things, heads of state and similar bods, tend to either get sticky fingers, or screw up, overdo things and crash the economy.

    My 30 cents worth -

    1. Be on the 5% side of the table.
    2. Avoid borrowing money whenever and wherever possible.
    3. If you do manage to multiply your capital by over 300 times, keep that fact to yourself!
    4. Just remember the French Revolution! Poor and living is better than rich and headless!
     
    Posted: Aug 2, 2017 By: The Byre Member since: Aug 13, 2013
    #3
  4. Francois Badenhorst

    Francois Badenhorst Deputy Editor Staff Member

    Posts: 91 Likes: 18
    Been meaning to read this book for a while: https://en.wikipedia.org/wiki/Progress_and_Poverty

    It's written by a really interesting character called Henry George. After reading your article, I might pull the finger out and read it because apparently, it deals with these exact themes. Namely, how to create a more equitable tax system.

    George was a major exponent of taxing land. Not property - but literally the land. It's way more complex than that (hence I wanna read the book!), but his argument rested on the fact that you can't shift land overseas or conceal it. I mean you could try - but you'd look like an idiot.

    I can't help but think bringing taxation back to a physical asset like land would be better. Capital these days is so easy to shift and move, and money is often just numerals on a screen.
     
    Posted: Aug 2, 2017 By: Francois Badenhorst Member since: Aug 25, 2015
    #4
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  5. atmosbob

    atmosbob UKBF Ace Free Member

    Posts: 2,707 Likes: 614
    I was at a seminar of creative people a few years ago. Some of them were famous in their fields. Chatting between sessions a group of us made an interesting discovery. Those who financed their lives and businesses by paying cash whenever they could, not getting in to debt, not buying the latest camera, car, mixer deck etc until it was absolutely needed, were doing better than the ones who borrowed from the banks.

    I learnt that tightening your own belt is the cheapest finance a person can get.
     
    Posted: Aug 2, 2017 By: atmosbob Member since: Oct 26, 2009
    #5
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  6. The Byre

    The Byre UKBF Ace Free Member

    Posts: 5,353 Likes: 2,135
    Posted: Aug 2, 2017 By: The Byre Member since: Aug 13, 2013
    #6
  7. Noah

    Noah UKBF Regular Free Member

    Posts: 140 Likes: 14
    Very interesting article - thanks. I have many related thoughts, but for now (and forgive me as I am not checking any facts directly befoe posting this - because I like to live dangerously - so I may be talking utter twaddle) : German businesses are traditionally very averse to debt, and as a rule expand when they can afford to buy assets outright rather than borrowing. This leads to slower but cheaper (and therefore more stable) expansion than borrowing. The benefits of this model can be seen in e.g. Aldi and Lidl who (and this is where I may be wrong) buy their stores outright, and hence have lower overheads hence can offer cheaper prices.

    An example closer to home (if you don't consider Yorkshire a foreign country) is the Samuel Smith pub estate, where all pubs are owned outright by the brewery (and have been for generations), one of the reasons why they can sell beer so cheaply.
     
    Posted: Aug 5, 2017 By: Noah Member since: Sep 1, 2009
    #7
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  8. mtools

    mtools UKBF Regular Full Member

    Posts: 382 Likes: 41
    100% agree! Easier to cut costs than increase sales (in the first instance)
     
    Posted: Aug 6, 2017 By: mtools Member since: Mar 27, 2013
    #8
  9. The Byre

    The Byre UKBF Ace Free Member

    Posts: 5,353 Likes: 2,135
    You are not talking twaddle (though you can if you want to!)

    Aldi and Lidl are private companies owned by the Albrecht and Schwartz families respectively. They have been expanding in the UK at a steady rate, but have to finance their store building out of current profits. That is why the expansion in the UK has taken so long.

    We see a similar development in Radio. One woman owns and controls nearly half of all the private radio in the UK. Yes, there are other companies like Global and News Corps with a few stations and many, many little stations like Jackie and Radio Caroline, but Yvonne Bauer and her company Bauer Media has the rest and a dominating 34% market share. http://www.bauermedia.co.uk/brands

    And yes, you've guessed it - Bauer Media is another privately owned and operated German company.

    The key to these companies is lack of debt and extreme long-term planning. They have realised that £x today at 5% is over £300x for their grandchildren!
     
    Posted: Aug 6, 2017 By: The Byre Member since: Aug 13, 2013
    #9