Clarium Save Now Invest Later

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Save Now, Invest Later

“Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries.” —Ben Bernanke “I spent a lot of money on booze, birds, and fast cars. The rest I just squandered.” —George Best

August 2009

Not only did we spend beyond our means, but what we saved lost value, too. From vacation houses to Pets.com to the Nikkei, the bubbles of the last two decades have burst. As we nurse our hangover, we are hungry to save more, but we have lost our appetite for investment. Before we can make more intelligent choices for the future, we need a theory that accurately explains the past. A natural impulse is to preach the need to consume less and save more. Another approach is to analyze the basis of investment. A basic fact of economics is that the sum of all savings and investment around the world must be equal.1 If you want to increase your savings, you must find more investment opportunities (or a willing foreign dance partner). But how do you save when you don’t know where to invest? The traditional answer is not to worry about it and to let the bank managers sort it out, but when the global banking system has just been saved from its own excesses by taxpayer bailouts, one is inclined to question the judgment of most banks. Perhaps the ideas that motivate investment really do matter after all. The Industrial Revolution, for example, was good, but building surplus houses was not. As Mr. Bernanke says, people need to invest in things of real value.When Mr. Best spent his money, at least he knew what he was getting. Now that the party is over, everyone wants to invest wisely, but the scope and nature of this challenge are not broadly understood.The problems are too global to be cleaned up by micro-economic tweaks or better regulation. In fact, the developed world has nearly ceased to form new physical capital. Perhaps the West counts on the immense deepening of physical capital in China to power global growth; or perhaps the West believes its investment in intangible capital will have high economic returns.2 We argue that both ideas are mistaken. Indeed, the world is suffering from both the failure of old ideas and a dearth of new ones.

1. They must equilibrate in the sense of the GDP identity, Y=C+I+G. I is equal to S, savings, because all of the income (Y) in society must be either consumed (C), invested (I), or used by the government (G). Economists differ on what to count as investment (for example, whether education is investment or consumption). 2. Intangible capital stock is primarily a nation’s human and technological capital. We define tangible and intangible more fully below. This document is confidential, for qualified individuals only, and not for further circulation. This is not a solicitation or recommendation to buy, sell, or hold any securities or commodities. Certain statements contained herein may be forwardlooking. Information contained herein is believed to be accurate and/or derived from sources which Clarium Capital Management LLC believes to be reliable, but such information may not be independently confirmed. Graphics contained herein are purely representational and do not reflect any hypothetical return from an investment in the depicted instruments. 3lkka 


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TAXONOMY OF SAVINGS AND INVESTMENT

In order to think clearly about how people form expectations and how these expectations affect savings demand and investment demand, we need new terminology. Our terminology describes individuals’ and societies’ demand to save and demand to invest for given interest rates. We will use this terminology to categorize the beliefs that determine the amount of savings on one side of the scale, and both the amount and type of investment on the other. These terms will allow us to distinguish four archetypal societies that match the recent behavior of the largest economies in the world. In each archetype, a fundamental question has emerged. So far, none have been answered.

SAVINGS DEMAND

First, let us develop a stylized model of savings demand for a given interest rate. A cautious society will save more for a given interest rate because it does not value current consumption much more than future consumption and because it has doubts about its future income stream. A cautious society has a high demand for savings. Conversely, a consumerist society will save less for a given interest rate because it values current consumption much more than future consumption and is sanguine about its future income. Its demand for savings is low.3 These terms are meant to describe the demand to save for all parts of society; the intentional effects of governmental policies also affect the supply of savings in aggregate.

INVESTMENT DEMAND

Second, let us develop a stylized model of investment demand for a given interest rate. Society’s demand to invest is a function of confidence in the future income stream of investment (which affects the quantity of investment demanded) and personal preferences (which affect the type of investment demanded). A tangible society4 seeks to invest by adding to the physical capital stock. By physical capital stock we primarily mean things measured in the national accounts of given countries as fixed capital formation. Obviously, tangible investment requires intangible know-how. The construction of an oil refinery, for instance, demands a great deal of technological expertise.

3. While our model could have derived savings demand from consumption preferences and income certainty independently, we derive our model from a union of these two notions for ease of analysis. 4. We focus on the supply of savings and the type of investment demanded for pragmatism’s sake. While tangible societies generally have empirically higher rates of investment than intangible societies, this empirical reality does not describe a more fundamental truth. Much of this difference is simply definitional: for example, the treatment of education and health care spending. Other examples include the failure of the Bureau of Economic Analysis to include R&D as capital expenditure in the national accounts of the United States.

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An intangible society seeks to invest by adding to human capital or to technological capital.Whereas the tangible society is most concerned with solving today’s problems with today’s technologies, the intangible society aims to expand the technological frontier.

MACRO ARCHETYPES

If we map our concepts onto real societies, we can begin to predict whether a given society is likely to be a net demander or a net supplier of capital to the rest of the world. Tangible

Cautious

THE MIRACLE

CASTLES IN THE SKY

Chinese society in the era of capitalist growth.

Asset-based societies in the era of the housing and leverage bubble.

Can China’s investment machine power the developed world onward?

Can Americans find a home for the investment previously used in housing?

THE POST - INDUSTRIALIST

THE AGE OF DREAMS

Japanese society in the Lost Decade and the current crisis.

American society during the Internet bubble and at the cusp of the future.

What will Japan do now that the world no longer demands its savings?

Will the intangible capital stock of the U.S. actually increase?

Consumerist

Intangible

THE POST-INDUSTRIALIST

That Japan should be the archetypal cautious-intangible economy seems counterintuitive.5 How could one of the world’s major manufacturing and exporting countries be considered intangible? The cautiousness of Japanese savers is not matched by an investment demand that allows this savings to be used domestically. The previous model has not failed; its very success has spawned tremendous competition from less developed economies. Some of Japan’s businesses have benefitted from this regional growth, while others have been harmed, but the winners have not offset the decrease in capital formation in the housing, commercial real estate, and lower-valueadded sectors. To increase its investment at home, Japan needs a new national business plan. At the same time, as certainty about the previous model has fallen away, figure 1 shows that Japan has begun to look more and more like the United States. A post-industrial society is, by definition, an intangible society.

5. The following analysis excludes Japan’s serious demographic challenge from a capital formation perspective. We ignore this to focus on the relative difference between savings demand and investment demand, which, while related to demography, is not driven by it.

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Fig. 1 Japan Becoming Like the U.S.

80%

Source: National Accounts

Japanese Consumption % of GDP

20%

Excess U.S. Consumption Compared with Japan, % of GDP

76%

16%

72%

12%

68%

8%

64%

4%

60%

0% 1989

1993

1997

2001

2005

2009

While Japan has become more like the United States in its domestic economy, the two countries differ in their external balances. Investment in the United States has been sustained by importing foreign savings (buying the present with the promise of the future); the Japanese demand to save has been sustained by exporting savings abroad (selling the present for claims upon the future). What economic flows have been sustained by this savings, and what ideas in the rest of the world have demanded this investment? A common answer is that the savings were consumed by profligate countries such as the United States, Britain, and those of Fig. 2 U.S. Change in Yearly Trade Deficit and Residential Construction Source: Bureau of Economic Analysis

$450

U.S. Residential Construction U.S. Trade Deficit

Billions USD

$350

$250

$150

$50 $0 -$50 2001

2003

2005

2007

2009

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southern Europe. A competing theory is that these savings were not consumed, but simply invested by those with a better bubble machine. Figure 2 shows a version of this correlation. Given energy constraints and the burst asset-bubbles in the rest of the developed world, perhaps Japan determined that funding such expansions on favorable terms was more compelling than pursuing the same strategy at home. Japan’s savings preferences, including a relative preference for government and government-guaranteed securities, reflect the level of safety demanded to fund investments of which they were likely skeptical. As these imbalances unwind, what will happen to the economic flows that were created out of Japanese savings? The fundamental question engendered by the post-industrial economy is, can Japan overcome the global decline in tangible capital formation? What will Japan do now that the world no longer demands its savings?

CASTLES IN THE SKY

The broad outlines of the global housing bubble and bust are well known. Observers correctly label the housing bubble the era of asset-price-based economies.6 While asset prices always influence economic decisions, this phrase highlights the precariousness of an economy that relies on the rising prices of long-lived assets for economic growth. While the first-order effect is to produce more of the assets as they increase in price, this approach is akin to making a desert bloom by drawing down the aquifers. If someone discovers a substitute for water, the gamble will have paid off. If not, the well will run dry, and the harvest will fail. The magnitude of the Fig. 3 Simple Economics

Sources: Case-Shiller; Census Bureau

200

Index Level

170

140

110

80 U.S. Home Price Level

50 2001

U.S. Residential Construction Completions

2003

2005

2007

2009

6. For example: “You’ve inherited an asset-based economy whose well has been pumped nearly dry with lower and lower interest rates and lender of last resort liquidity provisions that have managed to support Ponzi-style prosperity in recent years. Bill Gross, “Dear President Obama,” PIMCO (July 2008). http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/ IO+July+2008.htm.

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error is proportionate to the scarcity of the resources misused. Having learned a lesson, society can then move on to producing new assets of more enduring worth. Figure 3 simply shows the working of economics: price signals encourage the production of more of what is valued and less of what is not. While we do not minimize the value of these wasted resources, we also do not underestimate the problem faced by global society at the onset of this boom. The problem has become clearer. The actual amount of investment done by a society always occurs at the intersection of the savings demand curve and the investment demand curve. Because economists think investment is generally beneficial, it is unusual to worry about having too much actual savings. Therefore, when there are no good investment ideas, it is polite to speak of a savings glut. The fundamental question engendered by the Castles in the Sky analogy is, can Americans find a home for the investment previously used in housing? THE MIRACLE

The success of China’s economy since the late 1970s is well known. The formula is simple: take a billion people with no capital and grow by relentlessly building up the capital stock. This capital deepening creates a significant catch-up effect and very strong growth. Normally, this high growth should attract foreign investment to China and lead to significant capital inflow, as it does in India. But China has experienced net capital outflow even as its domestic investment7 has continued to increase as a share of total output. Fig. 4 Chinese Gross Capital Formation

Source: National Bureau of Statistics

Fig. 5 Chinese Trade Surplus

Source: National Bureau of Statistics

25%

10%

42%

20%

8%

120%

39%

15%

6%

80%

36%

10%

4%

40%

33%

5%

2%

0%

30%

0%

0%

-40%

45%

% of GDP

1996

Real Growth Rate YoY

1998

2000

2002

2004

2006

2008

% of GDP

1996

Real Growth Rate YoY

1998

2000

2002

2004

2006

2008

While this is unusual, China’s export dependency has varied considerably over time. Capital formation, on the other hand, has secularly increased as a share of total output. China’s level of tangible capital formation is astounding. No other country in modern history has allocated such

7. Gross investment and gross capital formation are used interchangeably throughout this paper. They are equal to each other when gross investment includes gross investment of the government. This paper adds U.S. government investment to private investment for comparison with other countries unless explicitly noted.

160%

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Fig. 6 Chinese Gross Capital Formation Driving Growth

9%

Source: National Bureau of Statistics

Contribution from Capital Formation

Real GDP Growth YoY

14% 12% 10%

6%

8% 6% 3%

4% 2% 0%

0% 1996

1998

2000

2002

2004

2006

2008

a significant portion of its total income to future production. Japan was able to achieve capital formation averaging 35% of GDP per year for roughly one economic cycle ending in the 1974 recession, during nearly a decade of double-digit increases in real output. But Chinese capital formation has averaged 38% for the last twenty-five years—and is accelerating, as figure 6 shows. The growth in the output from that investment has been remarkable, but the ability to direct an increasing share of that output to create more capacity is unprecedented. Such an effort demands tremendous certainty of vision. Chinese society can be confident about capital deepening of technologies and advancements the West made long ago. While investment in innovation is risky, one may copy with confidence, and this confidence is driving explosive investment.Yet with equal confidence in higher incomes tomorrow, Chinese people should want to consume more today. We know, however, that Chinese savings rates are increasing. How can certainty drive such high demand to invest on the one hand but such low demand to consume on the other? Observers often attribute China’s high savings to its lack of a social safety net,8 but the analysis can be extended one step further. Because savings is defined simply as all of society’s income that is invested, a social safety net leads to higher total consumption only if the government takes wealth from people who do not want to consume and gives to others who do. This is a political rather than an economic choice. With the same money available for transfer payments, the government could instead build highways with the promise that all will benefit. This building of national highways would rightly be considered investment, and therefore savings. China’s consumption and investment behavior can thus be seen as a decision rather than a deficiency. In this interpretation, China’s government coordinates society such that short-term needs are largely abandoned in favor of long-term goals. What makes the model work is growth. The belief in future growth coordinates a high level of investment in the present, and past investment has 8. See for example: Paul Krugman, “Revenge of the Glut,” New York Times (March 1, 2009).

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so far fulfilled its promise to raise incomes. If we grant that China can continue to achieve high growth rates, at least over any foreseeable horizon, then what does this portend for the West? Can the developed world expect China’s success to drive strong global growth? The fundamental question engendered by the Miracle is, can China’s investment machine power the developed world onwards?

THE AGE OF DREAMS

Under what societal model does it make sense to lend money indefinitely to one country for nearly thirty years running?9 A variety of explanations have been proffered over the years, but the one that interests us is the idea of an intangible society. Investment in America usually begins with someone saying, “I’d love to drop by and run an investment concept past you.” Venture capital spending suggests Americans care intensely about what the future will look like. This is the great strength of the intangible. The weakness is that focusing on the far future easily blurs the problems of the

Fig. 7 2008 Global Venture Capital Spending 10

Source: VentureSource

US 69%

UK

4%

11%

10% 2% 4%

Europe ex UK

China India Israel

9. The United States has run a deficit in foreign trade from the bottom of the 1982 recession until the present. There was a quarter in the early 1990s recession where this measure shifted into surplus, but this was due to unusual transfer payments and quickly reversed. The deficit tends to expand at the peak of an economic cycle and contract as activity retrenches. 10. Perhaps the U.S. has a comparative advantage in venture capital and thus a more accurate measure would be total R&D spending by U.S. corporations in comparison to R&D spending of the world. In 2008, the U.S. represented over 38% of total R&D spending despite representing just 30% of world market capitalization. Japan was the other disproportionate spender with 18% of total R&D spending despite being only 10% of world market capitalization. Héctor Hernández Guevara, Alexander Tübke, and Andries Brandsma, “The 2008 EU Industrial R&D Investment Scoreboard,” Joint Research Centre and Research Directorates-General of the European Commission (2008).

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Fig. 8 U.S. Goes from Exporter to Importer of Computer Goods

20

Source: Bureau of Economic Analysis

Net Export of Computer Goods

Real Quantity Index

15

10

5

0

-5

-10 1995

1996

1997

1998

1999

present. Figure 8 shows that even as the Internet boom was hitting its stride, America was relying ever more on foreigners for the goods the boom demanded. The convergence between Japan and the United States that was illustrated earlier in figure 1 has another aspect. Companies cannot maintain high capital expenditures when forward growth expectations decline significantly. Japan’s corporations demanded capital through the bubble, but supplied capital thereafter. In the United States, corporations have likewise become net suppliers of cash to the rest of the economy since the 2000 market collapse.11 The magnitude of this change is striking. Corporations went from demanding an average of $275 billion a quarter in 2000 to supplying $175 billion a quarter in 2005. Even with the private equity boom and the largest commodity price increase since the 1970s having led to a vigorous capital expenditure cycle in 2007 and early 2008, the corporate sector was only a net demander of capital on the order of $75 billion a quarter over this time period. The corporate sector has since switched back to being a net supplier of capital, even while profits have fallen. Without the household sector to pick up the slack (for it also is now a net supplier of capital), there are only two candidates left: foreign business and the government. Japan’s government originally borrowed money to fund exactly the same type of capital formation (buildings and infrastructure) that the private sector was abandoning. Eventually it gave up on this approach and simply recycled the money through the economy as consumption.

11. By net, we mean the difference between the cash flow generated by corporations and the sum of their expenditures on their own internal investment needs. This measure is not biased by what is counted as investment and what is counted as expenses as both these measures subtract from free cash flow. The way this difference is equilibrated is either through the direct return of cash to shareholders in the form of dividends or through the indirect transfer of funds to the rest of the economy through the net acquisition of financial assets.

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As noted above, American corporations have been a net supplier of capital throughout the decade, so their sensitivity to a collapse in forward expectations is smaller than was the case in Japan. The downside is simply the reverse: the United States has already put more of its hope in the promise of growth through intangible capital formation. We will later examine the two largest candidates for this intangible capital formation: education and health care. The fundamental question engendered by the Age of Dreams analogy is, will the intangible capital stock of the United States actually increase?

ARCHETYPAL FAILURES

Two things drive long-term per capita economic growth: capital formation and increases in productivity. Each of the questions engendered by the macro archetypes concerns the formation of either tangible or intangible capital. Capital formation often fails because people mistake it for innovation. Producing more houses and more quants to finance them is not innovation; it is simply building up the residential capital stock. Creating physical capital (say, an office building) is correct to the degree that innovative ideas can produce new companies to occupy the space. Without a true story, the capital formation becomes a bubble. Without true capital formation, the innovation proves a mirage. Tangible A LOCAL TRIUMPH , A GLOBAL FAILURE

FALSE OPTIMISM

Even if China’s growth is not a bubble, its model will not help the developed world address its deeper problems.

Americans need to increase savings in light of lost wealth. W ithout a credible plan for how to likewise raise investment, the demanded savings will not materialize.

A FAILURE OF IMAGINATION

FAILED OPTIMISM

Japan lacks an obvious way to invest its savings domestically.

Because U.S. resources are increasingly being directed towards consumable goods, the intangible capital stock is not increasing.

Cautious

Consumerist

Intangible

Note that the question about China is not its ability to form capital, but rather what the future consequences of doing so will be. China has 1.3 billion people and a society that up until the modern age was among the richest on earth. Even if nothing is invented in China this century, China can increase its wealth simply by catching up with the West. But optimism about China as a local triumph exposes a complementary pessimism about innovation in the world. If China is the

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new frontier, then the frontier is not innovation but new demand for tangible capital. China has been a rising economic force for a generation now and still the benefits to the developed world have been modest. The relative gains accruing to the West from increased trade may have been overstated because the losses from slowing tangible capital formation have been understated. Moving away from forming tangible capital is a problem unless the developed world has been forming intangible capital instead.12 Under this scenario, the capital stock has grown more than people think. But if the capital stock is greater than currently measured, this means that the corporate return on capital is lower than currently measured. This could explain why business has been a net supplier of cash even as conventionally-measured profitability has increased over the long term. A competing explanation is that a large part of the West’s capital stock, tangible and intangible, is not reproducible: the prohibitive cost of reproducing a global brand or the inability to build a new oil rig offshore California. The economic rents earned by the controllers of the existing capital stock are thus being returned to their ultimate claimants. As we will see, this cash is increasingly spent on health care and education. If these are investments, then the human capital stock is being built up and society will reap future dividends. If not, the money is being consumed. In that case, it will be difficult to increase actual investment rates, and therefore savings rates.

A FAILURE OF IMAGINATION

Japan has punched well above its weight-class during the last twenty years in two important ways. It has become a remarkably efficient producer of what the world wants, and it has taken the ensuing export surpluses and plowed them back into the world’s economy by funding its trading partners. Japan’s defining event in the last generation was the asset bubble and subsequent Lost Decade. An asset bubble collapse, by dramatically changing the price level of long-lived assets, and therefore people’s expectations, decreases the demand for capital formation. Japan’s gross capital formation is now lower than at any time since 1987,13 which is more historically unusual than even the woeful performance of the Nikkei over that time. Capitalist societies continue to build more and more stuff over long periods, whether they need it or not; there is no precedent for their stopping. Why can Japan find no domestic object for the savings its cautiousness demands? Because one does not build more of what one does not need. Without new ideas, Japan does not need more of its old capital stock. Further, Japan’s accumulated foreign assets have led to appreciations of the yen at exactly the wrong times. The export sector is the most profitable part of Japan’s economy. This profitability is affected by the level of the yen, and at times of global and Japanese weakness, the yen has strengthened materially. This strengthening leads to decreased profitability expectations, and, therefore, decreased demand for capital expenditure. These come when Japan’s ability to save abroad is declining.This stranded demand for savings ultimately works through the system, usually through government borrowing, as consumption.

12. We examine whether health care and education are investment below under Failed Optimism. 13. This is in nominal terms. Because of deflation over that period, gross capital formation in real terms is only the lowest for the last twenty years.

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Fig. 9 Depression vs. Lost Decade

300

Sources: Bureau of Economic Analysis; National Accounts

U.S. Real Gross Private Investment, Indexed to 1929 Japanese Real Gross Capital Formation, Indexed to 1989

250

Index Level

200

150

100

50

0 1

7

14

21

Years

As a significant energy importer, Japan does not want to add capacity that will obsolesce at higher energy prices. While this long-term vision has sustained funding for long-term energy efficiency, this has not been sufficient to offset the decline in capital formation that is energy-intensive. Japan serves as a warning that, even from the perspective of capital formation, it is unclear whether a global recognition of the energy problem would, on balance, create more new investment opportunities or destroy more old ones. What will Japan do now that the world no longer demands its savings? An excess of savings in Japan funded an excess of investment in its debtor countries. As that investment falls, this demanded savings must be invested at home. A failure of imagination means this transition will not occur, and investment rates will not move higher in Japan. While some of this previous income will be consumed, some will simply vanish.14

FALSE OPTIMISM

Asset bubbles can produce significant economic flows because the level of production is not fixed. These flows are not mirages. Real houses are built and the income attributable to this construction is truly earned.

14. It is not the stock of its previously accumulated savings that will vanish. In fact, the value of the previous stock of savings probably increased due to Japanese preferences for relatively risk-free foreign assets. What will vanish is the percentage of the increase in global income, created by the use of slack resources in housing, which had consumed Japanese goods. This is equivalent to saying that Japan’s falling trade surplus will not be met with increased investment or consumption at home. Because of the link between capital formation and exports, capital formation will fall the most significantly. The severity of the crisis means that consumption will rise materially as a percentage of total output, even though it too will decline in absolute terms.

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Another effect is exhaustion. The income growth needed to meet expectations derives from the economic flows to which the expectations themselves give rise. While the first-order effect is still extant, society is directing more of its resources (borrowed or self-funded) than it otherwise would toward an investment good. In so doing, it is saving more than it otherwise would. As this bubble unwinds, we can observe one of two outcomes. Investment can fall more quickly than income, in which case the actual savings rate goes down, or investment can fall more slowly than income, in which case the actual savings rate goes up. To understand why, we have to understand the supply of savings that funds investment.

Fig. 10 U.S. Supply of Savings, % of GDP

25%

Source: Bureau of Economic Analysis

Total Gross Savings

Household Gross Savings

Business Gross Savings

Foreign Supply of Savings

Gov’t Gross Savings

20%

15%

10%

5%

0%

-5% 1981

1988

1995

2002

2009

Figure 10 shows one phenomenon very clearly: as foreign savings in the United States declines, American households are materially increasing their own contribution to overall savings. This corresponds to the widespread notion that the savings rate is going up. The sum of investment by households and from abroad remains about level. The other two suppliers of investment in the economy are significantly reducing this supply.15 Government dis-saving (when government borrows more than it invests) and corporate retrenchment are driving overall investment down materially. In terms of the GDP identity, I is going down more rapidly than NX (total net exports), which by definition means that either C or G as a percentage of Y must go up.16 Because the formula deems housing to be an investment good, one might expect a decline in housing to drive a decline in investment. Total investment outside of housing is also declining, however.

15. The other components are reducing their gross supply of savings. The business sector is actually increasing its net supply of savings, which is remarkable given that corporate profits have fallen so significantly. 16. This is our previous GDP identity, Y=C+I+G, with NX added. For individual open economies, savings can be lent abroad or borrowed from abroad. Total consumption is simply C+G with the parts of G that qualify as capital formation stripped out, to reflect the notion that government spending on infrastructure is investment.

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The above pattern is consistent across the asset-based economies. As the supply of savings from countries like Japan returns home but fails to find profitable investment there, so too is government dis-saving and corporate pessimism leading to a decline in domestic savings in countries like the United States. In this context, we do not see higher actual savings rates as an impediment to future growth, whether consumption-based or income-based. Instead, we see higher actual savings as the most important sign that the world economy is sustainably healing. Creative destruction requires creation to offset the destruction. If economics is working and the decline of housing construction is a sign of health, then why has total investment continued to decline so precipitously? The housing bubble had to burst; a misuse of scarce resources cannot continue indefinitely. The fact that investment demand is falling everywhere simply highlights the challenge of re-expanding the investment demand curve.

Fig. 11 U.S. GDP Composition

90%

Source: Bureau of Economic Analysis

Total Consumption: Government and Households

Non-Residential Private Investment

15%

88% 13% 86% 11%

84% 82%

9%

80% 7% 78% 76%

5% 1993

1997

2001

2005

2009

Can Americans find a home for the investment previously used in housing? We remain convinced that the world must think up better ideas than the construction bubble. But to say that society needs increased savings without proposing how to increase investment is not a complete answer.

A LOCAL TRIUMPH, A GLOBAL CHALLENGE

While China has relentlessly increased its capital deepening, the developed world has nearly stopped building new physical capital. There are only two ways of considering this contrasting image. Either trade really matters or it does not. If trade matters, then China and the West are anti-coupled. If trade does not matter, then China and the West are decoupled.

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Start with the first case. In a world where trade is important, China’s comparative advantage has the effect of hollowing out the West’s physical capital stock. As Chinese exporters become more competitive, China adds both the logistical infrastructure necessary to manage complex supply chains and the machinery necessary to produce the output the rest of the world demands. At the same time, the West stops allocating capital towards industries such as manufacturing, where its comparative advantage is decreasing, and instead focuses resources on industries such as services.

Fig. 12 China Increasing Capital Formation Source: National Bureau of Statistics

Fig. 13 While the U.S., Japan, and Germany Move the Other Way 17 Sources: Bureau of Economic Analysis; National Accounts; Eurostat

40.0%

9%

Net Investment as % of GDP

Net Investment as % of GDP

Industrial Output Relative to Trend

36.0%

110

100 6%

32.0% 90 28.0% 3% 80

24.0%

20.0%

0% 1992

1996

2000

2004

2008

70 1991

1994

1997

2000

2003

2006

2009

Housing is a capital good that is non-tradable. Why can’t the West deepen its capital by building more houses? The problem is that building up the physical stock of houses does not increase society’s long-term income. When you build a factory, you can produce more cars. When you build more houses than you need, you just get vacant housing—and over the past decade the West built many more houses than it needs. In contrast, if trade does not matter, then factors other than comparative advantage are at work. By this account the West needs more physical capital, but it is either difficult to profit from or politically constrained. For example, the United States might need infrastructure investment in airports and mass transit, but be unable to form this capital in the private markets because the investment horizon is too long. Likewise, energy investment that would greatly benefit society might be significantly curtailed by political constraints. We are agnostic on whether China and the West are anti-coupled or decoupled. The West can argue that because intangible capital is its competitive advantage, it must build more.The West can also argue that it must form new physical capital to promote economic growth, precisely because the success of China will not be the boon previously envisioned. Both arguments contradict the conventional wisdom that the developed world will benefit materially from the increased prosperity of China. In the next section, we analyze the position of the United States largely from the anti-coupled perspective only because that seems to be the position from which policy makers are beginning.

17. Index of U.S., Japan, and German capital formation with the following weightings: 60% U.S., 20% Germany, 20% Japan.

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The West would face serious challenges in either an anti-coupled or a decoupled world. China, on the other hand, will have dramatically different outcomes depending upon which model proves true. China analysts tend to be bearish if they hold an anti-coupled view, and bullish if they hold a decoupled view. The bearish outlook on China is simple: Chinese exports were 32% of GDP in 2008, and are down 22% year-on-year in 2009. How can China recover in the face of such a collapse in external demand? The empirical answer so far is that China will compensate for the drop in exports by ramping up its capital investment, as shown in figure 14. But if recent experience has taught us anything, it is that a boom can be a bubble. If the anti-coupled account is correct, then China’s growth is not sustainable because the export markets will not support it. Only if the decoupled model is correct might China prove not to be a bubble.

Fig. 14 China Revving Up the Investment Machine

40.0%

Source: Bloomberg

Urban Fixed-Asset Investment, YoY

36.0%

32.0%

28.0%

24.0%

20.0% Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

Jun-09

The best argument for the decoupled account is the sheer volume of catching-up available to China.The United States has twenty times more physical capital per person than China, and Japan has nineteen. To approach the United States or the Japanese capital stock in aggregate, let alone per capita, the Chinese must invest far more than they already have.18 Two conditions are necessary for China to achieve this continued capital deepening: one, copying, and two, ensuring that economic activity in the short run is largely consistent with Chinese society’s long-term vision.

18. The current U.S. capital stock is approximately $45 trillion. At market exchange rates, the current Chinese capital stock is approximately $11 trillion. If Chinese capital formation grows at 10% YoY in real terms and the capital stock depreciates by 5% per year, then the Chinese could have a capital stock of $45 trillion in 2021. In 2021, gross capital formation would be $6 trillion in 2008 dollars. This would approximately triple current Chinese gross capital formation. For reference, peak U.S. gross capital formation was $2.6 trillion in Q2 2007. Source: Goldman Sachs estimate and BEA.

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We share Beijing’s belief that China can profitably use substantially more physical capital than it currently possesses.19 Therefore, China’s ability to make the decoupling account true will depend upon its ability to invest wisely in whatever will make it more productive. This is a political question. Can China’s investment machine power the developed world onwards? The task for the rest of the world is to re-expand the production frontier. Because any sustainable China investment boom would require China to be decoupled from the rest of the world, its story will not help in this task.

FAILED OPTIMISM

The bursting of the 1990s bubble was not the last disappointment from the tech industry. Many second-generation technology companies do not even try to produce technological innovation. Web 2.0 must be considered a productivity failure even if it is a business success.The United States cannot count on greater prosperity if it is to get there on the back of Twitter. Web 2.0 is an easy target. Tech companies may behave as if they are still levered to innovation, but the facts suggest otherwise. The technology sector in the United States, despite acquisition of new companies and new IPOs, supplies capital to the rest of the economy. If households are the ultimate claimants upon these cash flows, then ultimately capital is moving from the tech sector to consumers. This might make sense if households are using the money to build up their human Fig. 15 Differential Inflation

600

Source: Bureau of Labor Statistics

Education Health Care

CPI Index Level

500

CPI ex Health and Education

400

300

200

100

0 1979

1989

1999

2009

19. Many other questions remain, however. It will be difficult for China to prevent damaging bubbles from forming as hot money chases the investment boom. Natural resources such as oil and water are potential bottlenecks. Externalities such as pollution may impose intolerable costs. Such issues are critical but lie outside this analysis.

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capital.Thus, to take seriously the promise embedded in an intangible model, we must analyze the two serious candidates for intangible capital formation: education and health care. The costs of education and health care are going up more rapidly than costs in the overall economy. This change in relative prices makes sense if people are getting more for the increased costs, or if their preferences for these two services increase as they get wealthier or older. If the former is true, then this increased expenditure counts as investment because the human capital stock is being built up. If the latter is true, then this increased spending will not produce future dividends and should rightly be considered consumption. Conceptual thinking has its own dogmata, just as concrete thinking does. None of these dogmata are more strongly or more universally held than the claim that investing in human capital creates both innovation and the jobs of tomorrow. The dogmatists rarely ask whether the students thus empowered want these jobs. Figure 16 demonstrates that the real cost of primary and secondary education has risen considerably.20 Real wages of employees with at least a high school degree have stagnated. Either the education is not producing the skill set demanded by the market, or people have failed to create new demands and uses for the human capital they are developing. Both mean the return on education as “investment” is in crisis.

Fig. 16 U.S. Return to High School Spending

350

Real Cost of Primary and Secondary Schooling Real Wages of Workers with at Least a High School Degree

300 Index Level, 1978=100

Source: Bureau of Labor Statistics

250 200 150 100 50 0 1978

1988

1998

2008

20. This is defined as the difference between the general inflation rate and the inflation rate for primary and secondary education. The difference between these two series over time is the extra cost of education not attributable to real quantities such as the number of children educated. As previously mentioned, extra inflation makes sense if the quality of education is better in a way that statistics cannot capture or if people value education much more highly than they did before. Increased quality would argue for the increase in education spending being a true investment. Changing preferences would argue that it is correct to consider this to be an increase in consumption.

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The conceptual mind argues against this crisis in two ways: first, that increasing returns to college education point a way forward, and, second, that a period of adjustment is to be expected as the economy begins creating the jobs of tomorrow. We consider each of these responses in turn. The return on college tuition did increase from the 1970s until about 2000. Figure 17 demonstrates this by computing the number of years required to pay back the cost of a college education out of the earnings differential attributable to that education. Relative to the past, students who go to college do better than their peers who do not, but this is simply a mathematical result of their peers doing worse than in the 1970s. The return on some levels of education, like college, is high only because the return on other levels, like high school, is so low. This increase in relative returns has reversed. What used to be an easy decision between a bad option and a good option is becoming a more difficult choice between a bad option and a less bad one. Fig. 17 U.S. Return to College Spending

12

Sources: Bureau of Economic Analysis; Bureau of Labor Statistics

Years of Payback at Wage Differential

Years

11

10

9

8 1978

1988

1998

2008

The past two decades cannot be defended as a transitional period. In a state like California, where the 1990s witnessed the largest boom in technology investment of at least a generation, it is easy to see why. From the bottom of the 1993 California recession until the current recession, however, the greatest areas for job growth in percentage terms have been construction and health care; technology has been one of the worst. If the supposed land of innovation has an economy whose job growth is driven more by housing than technology, then defenders of the educational system ought to show what tangible benefits it is producing. Health care seems to suffer the opposite problem: too many jobs and not enough growth. This can be expressed in much the same way as the housing bubble. Increased spending on health care adds to GDP by consuming more of GDP, a trend that cannot continue indefinitely. One rough measure of the success of health care is the relationship between increases in life expectancy and spending on health care.

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Fig. 18 U.S. Paying More Every Year to Live Longer 21 Sources: Bureau of Economic Analysis; Center for Disease Control and Prevention

$100

Annual Spending per Person per Year of Life Expectancy, Real Dollars

$80

$60

$40

$20

$0 1960

1969

1978

1987

1996

2005

In 1960, the average American spent 1,000 real dollars a year on health care and died at 70. Today he spends more than 7,000 real dollars per year and lives until 79. Given the choice, many people would eagerly pay an extra 6,000 dollars per year to live for an extra nine years. The problem is that this increased spending is both a real source of ever-increasing costs to the average American (lower real wages plus higher spending) and a use of income that otherwise could have been saved for retirement. In a real sense, higher spending on health care contributes to the savings crisis. This spending can only be macro-economically sustainable to the extent the return to this health care spending is actually investment. At no compounding, the person who lives until 79 instead of 70 must replace $420,000 of foregone savings. This task is incredibly difficult for the average American because the entire fall-off in the savings rate is simply a result of increased expenditure on health care. Even working full-time for those extra nine years would not offset the increased health care spending at the current median real wage. (The preceding math assumes no increase in lifetime consumption due to living longer.) At low rates of compounding and with provision for consumption in the additional years of life, the increase in the average American’s expenditure on health care cannot be justified by our model, even if he never retired. The United States is also experiencing fairly significant declines in drug productivity, defined as new drugs per unit of spending on research and development.22 The causes are unclear, but rising drug development costs likely play a role. Industry sources estimate that getting a new drug from 21. Figure 18 shows much spending has increased for every year of life expectancy. This helps us understand the decreasing efficiency of buying more years of life. (Life expectancy does not measure other significant benefits of health care such as relief from pain, mitigation of disability, and other quality of life improvements. We use life expectancy as a rough proxy for health outcomes because it is easy to measure objectively.) It is important to note that this is not the marginal cost of an additional year of care, but rather the total cost of health care per year for every individual divided by the number of years of average life expectancy. In 1960, Americans spent much less and lived fewer years. The numerator (health care cost per year) has grown six times faster than the denominator (average life expectancy). 22. Defined as new drug applications and new biologic license applications approved by the Food and Drug Administration.

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discovery to approval takes about a billion dollars.23 The solution is not as simple as admitting failure and moving on to a different model. American drug companies spend about 70 percent of the world’s drug R&D.24 Europe spends most of the rest. As the following chart shows, this spending is higher than ever. Yet drug stocks have stagnated since the mid-1990s. Therefore, not only is current R&D less innovative than it was, but the returns on R&D have declined. This increases the implied opportunity cost of the capital invested in drug origination, and has given rise to mergers as an alternative to in-house development.

Fig. 19 U.S. R&D Spending and Innovative Output

Total Number of Approved Drugs

Pharmaceutical Industry R&D Expenditures

$60

50

$50

40

$40

30

$30

20

$20

10

$10

0

Real 2008 Billion USD

NME Approvals

60

Source: Congressional Budget Office

$0 1970

1977

1984

1991

1998

2005

There are no easy global solutions to the stagnation of health care innovation. If Americans spend less on health research to account for declining innovation and embedded inefficiencies, then the rest of the world will have to cope with the slowing down of its great innovator. Sub-Saharan Africa benefits from antiretroviral drugs developed in the intense American research effort against AIDS. But neglected tropical diseases rarely strike the West, stimulate less demand for new drugs, and therefore receive much less investment. Given the drug pipeline and the current lack of fundamental innovation in the United States, one could argue that health care would be more efficient if government stopped enforcing patents. Existing drugs would immediately become affordable, though new drug development would slow down. Perhaps innovation is overvalued and affordability is undervalued.

23 . Health Affairs estimates that, depending on the type of drug being researched, the total costs of a new drug are between $500 million and $2 billion. Christopher P. Adams and Van V. Brantner, “Estimating The Cost Of New Drug Development: Is It Really $802 Million?” Health Affairs 25, no. 2 (2006): 420-428. 24. Héctor Hernández Guevara, Alexander Tübke, and Andries Brandsma, “The 2008 EU Industrial R&D Investment Scoreboard,” Joint Research Centre and Research Directorates-General of the European Commission (2008).

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Health care and education are key aspirations of many societies. Deepening a nation’s human capital allows for continued increases in productivity and innovation. There is a fundamental flaw, however, in how Americans want to increase human capital. When Americans justify spending more on education and health care, they pretend that higher spending is correlated with better outcomes. Will the intangible capital stock in the United States actually increase? The world continues to count on the United States to generate innovation, and it is not clear who could fill this void if American ingenuity falters. If it doesn’t innovate, the United States cannot continue to absorb the world’s savings. The technology bubble was at least an attempt at innovation; the housing and finance bubbles were not even that. To continue as it has, the United States will have to prove that the money it spent on intangible capital has been well-invested. The states of education and health care are not encouraging in this regard.

A NEW STASIS

A world that is out of ideas must become a world of competing futures. China must create a global narrative out of a local triumph and make itself and the world a more productive place, if only for its own long-term growth. Japan can no longer claim that, by sending its savings abroad, it will always be able to save more than it invests. The Japanese must consume the money, or find ways to invest it profitably at home. The United States can no longer claim that the world’s savings are being well-used in housing, health care, and education that look more like inefficient consumption than intelligent investment. Who will arbitrate these competing futures until sustainable new ideas emerge? Likely, government will be the judge. And here lies the fundamental question that will be at the heart of valuation. To the extent governments can weigh these competing claims effectively, the intangible stock of society’s political capital will go up and we can be optimistic about medium-term growth. But if governments fail in this task, political capital in the West will decline, and we ought to be pessimistic about medium-term growth. Success or failure will be determined by whether the political class clings to failed illusions. We have gone from a bull market in politics to wondering whether politics can allow for a bull market.

TYLER McCLELLAN Vice President Clarium