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Figure 1
Federal Reserve Bank of St. Louis
Figure 1: U.S. Labor’s Share of Income.
Figure 1: U.S. Labor’s Share of Income. Source: Federal Reserve Bank of St. Louis
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Figure 2
U.S. Department of Agriculture
Figure 2: U.S. Food Expenditures Relative to Disposable Income.
Figure 2: U.S. Food Expenditures Relative to Disposable Income. Source: U.S. Department of Agriculture
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Figure 3
Corrado, Hulten, and Sichel, “Intangible Capital and Economic Growth,” 2008
Figure 3: U.S. Intangible Investment Relative to Non-farm Output Adjusted to include intangibles.
Figure 3: U.S. Intangible Investment Relative to Non-farm Output Adjusted to include intangibles. Source: Corrado, Hulten, and Sichel, “Intangible Capital and Economic Growth,” 2008
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Figure 4
Figure 4: U.S. College High School Graduate Wage Premiums. Sources: Claudia Goldin and Lawrence Katz, The Race Between Education and Technology, PP. 290, reprinted by permission of The Belknap Press of Harvard University Press, Cambridge, MA. Copyright © 2008 By the President and Fellows of Harvard College.
Figure 4: U.S. College High School Graduate Wage Premiums. Sources: Claudia Goldin and Lawrence Katz, The Race Between Education and Technology, PP. 290, reprinted by permission of The Belknap Press of Harvard University Press, Cambridge, MA. Copyright © 2008 By the President and Fellows of Harvard College.
Proponents and opponents of income
redistribution differ greatly in their explanations for the
success of the U.S.
Opponents argue that the discovery and commercialization of
innovation are no different than any other investment. Investors
must risk capital to fund failures. The potential payoffs
provide the incentive to suffer the losses.
Those who favor income redistribution point to the
steadiness of long-term economic growth as evidence that
innovation bubbles up randomly in the normal course of business.
They emphasize culture, claiming that Americans are eager to
take risks regardless of the incentives, while Europeans and the
Japanese are reluctant. Economists with these views see minimal
costs from redistributing income from wealthy investors to
poorer consumers.
Opponents of income redistribution worry that higher taxes
water down incentives and that redistribution slows the
accumulation of capital, especially risk-bearing equity.
– Investment produces innovation: The more time and
resources investors and entrepreneurs devote to searching
randomly for innovation, the more likely they will be to find
it. This requires time that the economy could devote to other
endeavors. An increase in investment by one economy relative to
another will likely affect their relative rates of discovery and
implementation. When successful, risky investments in innovation
will grow the economy faster than less risky investments that
enlarge existing capacities.
Successfully commercializing good ideas is as important as
discovering them and requires similarly risky investments. Even
if Facebook Inc. (FB) and Google Inc. (GOOG) had randomly stumbled upon
great ideas, they still had to invest inordinate amounts of
money and overcome high levels of risk to commercialize them.
In “The Age of Turbulence,” former Federal Reserve Board
Chairman Alan Greenspan reminds us that the U.S. economy has
grown sevenfold in real terms since World War II, while physical
inputs, such as steel and oil, have risen only twofold. Most of
the growth came from intellectual capital. Cutting-edge
economies like that of the U.S. invest largely by paying the
salaries of talented thinkers who invent and design new products
and processes.
– Innovation expands the economy: Innovation benefits
consumers through lower prices. Yet these can be hard to
quantify, particularly when they show up in the form of higher-
quality goods, which may sell at the same price but offer
greater benefits than the products they replaced. Because of the
difficulties of measuring such “quality-adjusted” prices,
economists generally disregard the ebb and flow in the rate of
these improvements.
Sometimes, workers capture the value of innovation and
productivity gains through higher wages. Ultimately, higher
wages and lower prices are the same because workers are both
wage earners and consumers. With increased productivity, prices
fall and real wages rise.
As tangible or intangible investment per worker increases,
one might expect capital to capture an increasingly greater
share of the output. But that hasn’t happened. Figure 1,
attached, shows that as the U.S. economy has grown more capital-
intensive, labor has continued to capture about 70 percent of
gross domestic product as wages.
Consumers also capture the value of products over and above
their cost. A car, for example, is worth much more than its
price. Economists call this “buyers’ surplus.” GDP measures the
value of goods at their prices, not at their value to
purchasers. If consumers capture 70 percent of GDP as wages and
100 percent of the buyers’ surplus, they are capturing a very
large share of the value created by investment — perhaps 90
percent or more.
We see these dynamics in agriculture. As agricultural
productivity has doubled since the 1940s, expenditures on food
as a percent of GDP have fallen proportionately from more than
20 percent of disposable income to less than 10 percent today,
see Figure 2, attached. In the U.S., these savings provided much
of the resources needed to increase demand for manufactured
goods. Today, similar productivity gains in manufacturing are
driving growth in services.
The reduction in food expenditures displayed in Figure 2,
attached, allows us to approximate the magnitude of the value
captured by consumers relative to producers. Consumers captured
the difference between 24 percent and 10 percent of disposable
income — income that is approximately seven times larger today
than it was in 1950. Producers, on the other hand, benefited
less. Their profits, after depreciation and before interest and
taxes, remained stable at about 10 percent of revenues, or 10
percent of what consumers spent. The split of value (before
corporate taxes) between consumers and producers created by
agricultural innovation and investment is in the range of 20-to-
1 in favor of consumers.
This one-sided split of the returns from capital between
investors and labor is the reason radical proponents of income
redistribution, such as Paul Krugman, seek to regulate the
allocation of capital through the political process rather than
through free markets. They argue that many investments may be
valuable to society but not to investors, so why let the small
returns to private investors determine the allocation of capital
critical to the welfare of mankind?
Proponents of free markets are concerned that regulations
will reduce profitability and return on investment. Small
reductions in profits and subsequent investment can have a big
impact on wages, employment and the price of goods. This can
unwittingly destroy more value than well-intended regulations
create.
– What is too much?: A broad range of investment continues
to drive productivity because investment and risk taking, as a
whole, are far below the optimal level. The work of Nobel Prize-
winning economist Edmund Phelps presents empirical evidence that
under optimal conditions capital would earn a real return equal
to the growth rate of the workforce — in highly developed
economies, 1 percent to 2 percent per year.
Today, the U.S. has a surplus of debt. We are flooded with
risk-averse savings. We face a shortage of risk-bearing equity
to underwrite risk, rather than a shortage of capital more
broadly. Equity in the U.S. and worldwide earns about 7.5
percent per year, indicating that equity and the risk taking it
underwrites are well below the optimal level.
Investors can make poor choices and take imprudent risks in
one sector — housing and mortgage risks, for example — without
the economy as a whole extending beyond the point of optimality.
Government subsidies can also drive risk taking beyond the
point of optimality by over-allocating investment to one sector
– subprime housing, for example — at the cost of
underinvestment in other sectors.
– Monetary policy: Printing money doesn’t magically
stimulate the economy. Instead, monetary policy allows risk
taking to grow when it is hampered by a lack of credit, and the
economy has excess capacity available to produce the increased
growth. An owner of future cash flows (assets) may seek to
increase the amount of risk he is taking by splitting his future
cash flows into tranches so that he can exchange the low-risk
first-to-be-repaid tranche (debt) for a risk-averse saver’s
income. Putting that hoarded capital to use expands the economy.
If credit is restricted, risk takers may be unable to tap
those savings. Constraints on credit may occur if banks have
already loaned all the available deposits, or if they have used
all their equity to meet capital-adequacy requirements for
existing loans. Lower short-term interest rates increase the
spread that banks earn by borrowing short-term savings and
making long-term loans. This increases bank profits and grows
their equity, which reduces constraints. Relieving credit
constraints will grow the economy, but only if the economy has
the capacity to produce the increase in demand and an appetite
for risk.
Increases or decreases in optimism tend to create self-
reinforcing feedback loops that monetary policy can either allow
or restrict. As risk takers grow increasingly optimistic, asset
values rise. This makes investors and consumers grow
increasingly willing to take risks. As risk taking grows, the
economy expands, increasing the amount of investment and the
value of assets relative to the economy.
– Investment is understated: Our antiquated 1940s
manufacturing-based accounting rules expense the salaries of
creative thinkers and leaders as intermediate costs of
production, rather than capitalizing them as investments. Only
recently have accounting rules allowed the capitalization of
software-development costs, for example. Accounting rules demand
highly restrictive measures of investment to ensure
comparability between results. A fast-growing company with
higher profit margins that is pouring more money into investment
than its competitors looks more attractive to investors and
garners a higher stock price. Accounting rules prevent this lack
of comparability by erring on the side of expensing rather than
capitalizing costs, especially employee-related costs.
Survivor bias exacerbates this masking effect and further
obscures the link between investment in risky innovation and its
return. One breakthrough may require hundreds of failures.
Failed investments in intellectual capital are expensed and
forgotten, decoupled from the cost of the resulting success.
Without clear linkages between the value of success and the
hidden cost of failure, investment appears dramatically
understated.
Conservative measurements such as those employed in a 2006
Federal Reserve study, “Intangible Capital and Economic Growth,”
show significant increases in intangible investments. According
to the Fed, intangible investments rose from about 7 percent of
non-farm business output in the late 1970s to 10 percent in the
early 1990s to about 14 percent today, see Figure 3, attached.
These investments rose dramatically in the 1990s when
productivity accelerated.
Over the same period, traditional business investments in
factories and machinery grew from about 5.5 percent of GDP after
World War II to about 8 percent today. Adding both tangible and
intangible investments shows that business investment grew from
15 percent of GDP after the war to a level approaching 25
percent today.
It is likely that these simple estimates understate
investment, and that the expenditures that increase the
productivity of the most talented employees are much broader.
Almost everyone engaged in finance, for example, thinks about
the value of future cash flows and how to maximize them. They
make decisions about the allocation of assets that set the
prices for various risks. These prices influence the allocation
of investment. Again, economic statistics expense all these
costs.
There are other forms of overlooked investment. The most
talented U.S. workers now spend more time working while the
hours of their European peers have declined.
The productivity of the most talented workers is also
growing faster than the U.S. economy as a whole. With 5 percent
of the workforce producing more than a third of the output,
increases in this group’s productivity have a big impact on the
economy overall.
Pundits often wonder why median wages have failed to rise
in proportion to increased levels of productivity, as they have
in the past. The answer is obvious: The median wage is the
highest wage of the lowest 50 percent of workers, and
productivity growth has occurred predominantly at the top of the
wage scale. Above the median, the wage premium for the most
talented workers grew, despite a surge in the productivity-
enhanced supply of knowledge workers, see Figure 4, attached. An
increase in supply should drive down wages, but pay rose because
the value from deploying this talent was greater than their pay.
We can also see the increase in intangible investment in
the changing composition of U.S. jobs since the mid-1980s.
Again, half of all the new jobs created over the last 25 years
have been in thought-oriented professions. Such jobs made up
only a quarter of total employment in the 1980s.
It’s also clear why the income of the top 1 percent is
growing faster in the U.S. than in Europe and Japan. U.S.
innovators produced Intel Corp. (INTC), Microsoft Corp. (MSFT), Google and
Facebook. The rest of the world contributed next to nothing.
(Edward Conard was a partner at Bain Capital LLC from 1993
to 2007. This is the second of two excerpts from his new book,
“Unintended Consequences: Why Everything You’ve Been Told About
the Economy Is Wrong,” available now as an e-book to be
published in hardcover on June 7 from Portfolio, a member of
Penguin Group (USA) Inc. The opinions expressed are his own.)
Read more opinion online from Bloomberg View.
Today’s highlights: the View editors on better cookstoves for
the developing world; Albert R. Hunt on the next Kennedy
superstar; David Aaker on marketing brands; Aaron David Miller
on safe zones in Syria; Simon Johnson and Peter Boone on the
euro and banks; Rachelle Bergstein on wedges and World War I.
To contact the writer of this article:
Edward Conard at edwardconard@gmail.com.
To contact the editor responsible for this article:
Max Berley at mberley@bloomberg.net
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