Stumbling and Mumbling

Capitalism's self-preservation society

Here are three recent items:

 - E.On boss Michael Lewis calls for “very substantial" government help with fuel poverty.

 - CBI Director-General Tony Danker says the government must “help people facing real hardship now”

 - Some “patriotic millionaires” want higher taxes on the rich: #taxmenow

These people are not revolutionaries nor even moral crusaders, despite Danker’s words. Instead, they see that egregious rates of exploitation, inequality and poverty are not in the interests of at least parts of capital. They want some redistribution and a solution to the cost of living crisis not because of a fit of morality but because they are a self-preservation society.

One reason for this lies in the simple fact of the circular flow of income. Lewis, I suspect, doesn’t give a damn about fuel poverty; if he did he would cut prices himself. What he does care about – because he is paid to – is that increasing numbers of his customers are in arrears and cannot pay their bills. “Very substantial” help for them means very substantial help for him; it improves E.On’s cashflow.

And not just him. Supermarket sales are falling, and discount retailers are gaining market share. That’s another effect of falling real incomes. Anything that boost incomes will help to slow or stop this trend and hence support the profits of retailers. Welfare benefits aren't so much a payment to claimants as a payment through claimants. Which is one reason why Justin Webb isn’t entirely right to claim that a windfall tax on oil and gas companies will hurt pensioners because it will reduce the share prices of Shell and BP. Maybe it will, to an extent. But the revenues generated thereby will be spent in the wider economy, thus supporting profits and dividends elsewhere.

But there’s a second reason why smarter capitalists favour redistribution. It’s that, as James O’Connor pointed out in his famous book, The Fiscal Crisis of the State, capitalism requires more than economic conditions favourable for profits. It also requires legitimacy, which requires that the system be regarded as fair.

This isn’t just because without such a feeling there is a threat of revolution – although it might be no accident that inequality in capitalist countries declined after the Russian revolution and increased after the collapse of Communism. It’s also because inequality can generate political uncertainty – and as Nick Bloom has shown, this depresses what he calls investment and what Marxists call capitalist accumulation. What’s more, a sense of unfairness is likely to undermine respect for property rights. It’s no accident that retailers are reporting increased levels of shoplifting.

For both these reasons, capitalism sometimes requires a degree of equality not because of romantic notions of justice, but because it is in the interests of capital. Two big facts tell us as much.

One is that in the UK the era of social democratic capitalism was for years better for many capitalists themselves than what followed. UK non-financial company profits rose by 4% a year in real terms between 1948 and 1973, compared to just 2.3% a year between 1979 and 2019.

The other is that the most egregiously unequal nations have rarely been happy places even for investors. Back in 1996 Roland Benabou pointed out that South Korea’s economic performance had far exceeded (pdf) that of the more unequal Philippines. The point broadens: several very unequal countries (such as South Africa, Brazil or Argentina) have delivered poor long-term returns for equity investors because high inequality (pdf) can retard accumulation.

Of course, this is not to tell some just-so story about how capitalism and a degree of fairness can be compatible.

For one thing, the extent of this compatibility depends upon economic conditions and so varies from time to time and place to place. If profit margins are squeezed by worker power and militancy (as they were in the mid-70s), capitalism requires an attack upon workers’ living standards, not support for them.

And for another thing, the interests of capital can themselves conflict. Whereas customer-facing businesses sometimes want decent incomes for the masses, finance capital’s priority is more often low interest rates. Social democratic capitalism might have been good for Ford, but extractive neoliberalism better suits Goldman Sachs.

Which is the context for the Tories’ divisions over the cost of living crisis. Whilst some of them do see that capitalism needs shoring up with redistributive measures, others (and their corrupt cronies) regard capitalism in the same way that looters regard a burning supermarket: they don’t want to put the fire out, but just grab what they can before the roof collapses. 

Stealing a living

Now I am retired, I can safely make a confession: for years, I was stealing a living.

I say so because the general financial advice any retail investor needs is actually very simple:

 - Minimize taxes and charges. Avoid expensive fund manager fees. Don’t trade very much. Make full use of Isa and Sipp allowances.

 - Make the power of compounding work for you, not against you. Start investing as early as you can. And remember that fund managers’ fees compound horribly over time; an extra half percentage point in annual fees can easily add up to over £2000 for every £10,000 invested over twenty years.

 - Diversify sensibly. Hold equities for growth, and non-equity assets (which might just be cash or your earning potential) to spread risk.

 - Invest regularly, via monthly direct debits. The habit of savings is important.

Granted, we can finesse this. History suggests we can use market timing; equity returns have been partly predictable by consumption-wealth ratios, the dividend yield, ten-month moving averages or simply the time of year. And two types of stock have beaten the market on average over the long-term: defensives and momentum: yes, most stock market anomalies are illusory (pdf) or short-lived, but not these two.

But retail investors don’t need these add-ons, not least because we’ve no guarantee that past relationships will continue to exist. Many people can safely invest in tracker funds and cash and get on with their lives. You needn’t bother with portfolio optimization. It can’t be done. Simple (pdf) diversification works. Satisficing is the best we can do.

Everything useful that needs saying about investing can thus be written in a few words. Beyond this, there are sharply diminishing returns and I suspect even negative ones. Which is why I say I was stealing a living.

And so too have been thousands of finance professionals:

 - Equity analysts. “corporate growth rates are random” concluded Paul Geroski in one study (pdf). “There is no persistence in long-term earnings growth beyond chance” found Chen Karceski and Lakonishok in another (pdf). “Firm growth is characterized by a predominant stochastic element, making it difficult to predict” concluded Alex Coad in another survey. All of which means that, insofar as equity analysts are paid to forecast earnings (and in fairness they do other things) they are getting money for nothing. The big price falls we’ve seen recently in Netflix and Peloton (along others) shows the dangers in relying upon forecasts for earnings growth.

 - Economic forecasters. Prakash Loungani has shown that these have consistently failed to predict recessions around the world: they are better at forecasting GDP growth in normal times, but that’s when we don’t really need forecasts. If you want to know the chances of recession, just look at the yield curve.

 - Fund managers. These, said the Financial Conduct Authority in a recent report, “did not outperform their own benchmarks after fees.” The “vast majority” of them, said David Blake and colleagues in another “were not simply unlucky, they were genuinely unskilled.” Such findings corroborate evidence which we’ve had for years (pdf) in the US (pdf). Granted, there’s some evidence fund managers can pick stocks, but the benefits of this are dissipated by their need to hold more shares to reduce liquidity risk, or by their poor selling strategies.

Many people in finance, then, are simply quacks, snake oil salesmen.

I use the analogy for a reason. Quacks and snake oil salesmen thrived for decades: the market does not always weed out charlatans. Our latter-day snake oil salesmen prosper because they use similar techniques to their 19^th century counterparts, described (pdf) brilliantly by Werner Troesken. They use product differentiation (such as the launch of new funds, be it small cap ones in the 80s, TMT ones in the 90s or ESG ones today); exploit wishful thinking and the public’s ignorance or distrust of experts; and they rely upon people not distinguishing between skill and luck.

The analogies between the finance and patent medicine industries aren’t perfect, however. One difference is that the finance industry is less competitive. Thomas Philippon (pdf) and Guillaume Bazot (pdf) have shown that the costs of financial intermediation (such as fund managers’ fees or spreads between borrowing and lending rates) haven’t changed for decades. The IT revolution has done nothing to lower costs for customers.

Huge swathes of the finance industry are therefore failing their customers. This is not because of mis-selling or crime. It happens in the legal everyday operation of the industry. Adair Turner was bang right to describe much of the finance industry as "socially useless".

Which is true in another way – the financing of business. For every £1 banks have lent to UK manufacturing companies they have lent £34 in personal mortgages. And in 2019 (the last normal year before the pandemic) banks’ net lending to non-financial companies was just £11.5bn compared to household savings of £72.2bn. The idea that banks use household savings to finance business isn’t just wrong in theory (savings don’t create loans): it is wrong as a matter of numbers. Banks are property lenders with a casino sideline, rather than financiers of industry.

The financial system, then, does not serve its customers well.

There’s another way in which this is true – financial innovation.

As Robert Shiller has shown (pdf) – based on Arrow and Debreu’s work in the 50s - financial products could in theory protect individuals from big economic risks. If we could trade securities which were claims on GDP or occupational earnings, people worried about or exposed to downturns could protect themselves by going short. This is especially useful because, given the impossibility of predicting recessions, monetary and fiscal policies are not sufficient protection.

In fact, though, we don’t get such useful innovations – or at least not on the scale we need. Instead, we get scams and gimmicks such as ICOs or NFTs.

There’s a reason for this. The innovation we get depends upon whether innovators can capture a sufficient fraction of their benefits. They can do so for (say) NFTs, but not for Shiller-type products.

It’s tempting to infer from this that we have a financial system which is not fit for purpose. Such an inference is wrong. It is superbly well-equipped for purpose – if that purpose is to funnel wealth from clients (and wider society) to itself.

You might think this claim is a radical one. Maybe, maybe not. It is, however, one that is rooted in wholly conventional economics. You don’t need heterodox thinking to challenge the existing order.

House prices: who wins, who loses

I grow my own kale and never buy any from the shops. If the price of kale rises, do I therefore win or lose?

The answer is: neither. On the one hand, I could profit if I were to sell the kale I grow. But on the other, the cost of eating my own kale – the money I would make if I were to sell it – has also risen. Net, I’m neither better or worse off.

Some of you might not care very much about the kale-growers of Rutland. What’s true of kale, though, is true of something many of you do care about – house prices.

Just as I am self-sufficient in kale, so I’m self-sufficient in housing. As an owner-occupier, I’m a supplier and buyer of housing services in equal amounts. What’s true of kale prices, therefore, also applies to house prices. A rise in my house price would make me richer if I were to sell. But to the same extent it increases the cost of me occupying the house – the money I’d make if I were to sell. Net, it’s a wash. For me, house prices are not wealth. And what’s true for me is true for many other owner-occupiers. As Mervyn King said (pdf) back in 1998:

A rise in house prices leads not only to an increase in wealth but also to an increase in the cost of housing services. Or, to put it another way, if the price of your home goes up, you will not be able to spend more on other things if you wish to carry on living in your home.

(See also this pdf by Willem Buiter)

Who, then, does gain from higher house prices?

Plenty of people. Those who are sellers, or who expect to be. These include owner-occupiers planning on trading down, say because their house is part of their pension, or landlords looking to cash out. It also includes people expecting bequests of their parents’ or grandparents’ houses.

But of course, if prospective sellers benefit from higher prices prospective buyers lose.

High house prices, then, are a transfer not so much from young to old – many of us oldsters don’t give a damn about house prices and many more shouldn’t – but from many young people to a subset of owners and inheritors.

But is it a zero-sum transfer, or a positive- or negative-sum one?

In some cases, it’s positive-sum. Rising house prices also benefit those planning on using their house as collateral to borrow for consumption, home improvements, to start a business or to use home equity release schemes to top up their pension. These are winners without corresponding losers. In fact, to the extent that higher house prices encourage business start-ups (and there’s evidence (pdf) at least from the US that they do), everyone gains from increased aggregate supply and competition.

On the other hand, though, it can be negative-sum. Insofar as they increase household debt, higher house prices increase economies’ vulnerability (pdf) to financial crises. And there are several channels through which they depress productivity. In increasing commuting times and distances workers are more likely to become stressed and absent. Insofar as they encourage construction booms they divert economic activity into less productive sectors of the economy. If people are spending huge sums on housing costs – either mortgages or rent – they’ve less to spend in dynamic sectors or upon the goods and services supplied by new companies, all of which deters entrepreneurship. And high and rising prices divert potential entrepreneurs towards rentier activities such as landlordism whilst also channelling savings away from business and towards property.

Net, rising house prices are a bad thing.

Boris Johnson, however, has other priorities. He said recently that if the government does more to help people with the cost of living “that will mean that people’s interest rates on their mortgages go up, the cost of borrowing goes up, and we face an even worse problem”.

There’s a germ of truth here. Anything that supports aggregate demand would tend to raise inflation (relative to what it would otherwise be) and hence raise interest rates.

But why would this be “an even worse problem” than hunger and fuel poverty?

My chart shows why. It shows that the rise in house prices relative to incomes since the 1990s has been closely associated with the long-term downtrend in interest rates. This is because houses are an asset, and the price of an asset is the discounted value of future incomes – be they rent or the rent you save by being an owner-occupier. Lower interest rates mean a lower discount rate and hence a higher asset price. There is therefore widespread agreement that house prices depend heavily (pdf) upon interest rates. And indeed, on the rare occasions when interest rates have risen (such as in the late 80s or mid-00s) house prices subsequently fell soon after.

Which is why the Tories are so scared of rising interest rates. It’s because they would lower house prices. Which is nasty for that minority who do depend upon high and rising prices, such as those hoping for a bequest or landlords. It is these – whom Phil rightly describes as the most backward, uncompetitive and socially regressive sections of capital - who are Johnson’s client base.

And their interests collide with those of three other groups. One is those who most need help with cost of living. In refusing to support these for fear of higher interest rates, the government is sacrificing them to protect landlords and those hoping for a big inheritance. The second group are renters and wannabe buyers. And the third group comprises many entrepreneurs and potential entrepreneurs – those whose businesses are being stymied their potential customers are handing cash over to utility companies and landlords instead of spending it with them. If we had an intelligent opposition, it would be trying to form a coalition of these interest groups.

Of course, house prices are a deeply political issue. But let’s be clear what the division of interests is. It is not young versus old, but rentiers versus the rest of us.