Finance, Investment, Wealth 2014

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There are at least three areas where finance will determine whether 9-10 billion people can live well by 2050, addressed below.

  • First is the extent to which wealth investment strategies can pro-actively support or undermine sustainable trend bending requirements.
  • Second, covered in ‘Ecology for Bankers’, are the risks posed to the real economy from the lack of sustainability of the financial sector due to declining diversity and over-connection in the globally simplified financial ‘ecosystem’, where flows in wealth are increasingly concentrated between fewer larger institutions. Mathematically inclined ecologists have long studied network stability in living ecosystems, and recently bankers, including the Bank of England, have realised that this provides insights for sustainable banking systems.
  • Third are the unsustainable (in all senses of the word) consequences from the increasing concentration of wealth, both regarding falling growth rates, but also regarding solutions. These range from a trend-bending 21st century global Marshall Plan (major financial stimulation of the real economy through building sustainable infrastructure and businesses) to changing taxation to converge ‘True Value’ with financial value (the latter being another need identified by WBCSD, among others).

1. Investment Strategies to support trend bending requirements

In the 1950s it was considered sound investment advice to have a significant part of e.g. your pension portfolio (if you are fortunate enough to have one) in long term investment strategies, based on intrinsic value. Company dividends were a substantial part of income and were re-invested until the capital was finally required, perhaps in retirement. But in recent decades dividends have been de-emphasised in investment strategies in favour of short term speculation and other offerings less firmly based on ‘real’ historic returns (profits), such as IPOs (Initial Public Offerings) and buy backs, where company creators either sell the idea to investors, or buy back shares from the public to speculate on future value of the company.

long term investment in intrinsic value … locks in steadier, higher and more secure returns

But it now turns out that our grand-parents were right: long-term investment strategies directed at intrinsic value (see graph) is demonstrably an important part of a portfolio, locking in steadier, higher and more secure rates of return. That doesn’t necessarily mean buying shares and holding for twenty years, but it does mean being aware of long-term trends and implications, rather than trading for short term capital gains, regardless of the underlying nature of the businesses. According to Dimson, Marsh and Staunton’s Triumph of the Optimists, now regularly updated in a series of (free) Credit Suisse Global Investment Returns Yearbooks starting in 2009, reinvestment of dividends over the 108 years 1900-2008 would have seen 582-fold inflation adjusted growth (1,248 fold increase, 1900-2014). Relying on stock market gains only, without dividend reinvestment, would have resulted in only six fold inflation corrected growth.

Above: Cumulative return on US asset classes in real terms 1900–2008 There are two components to returns on equities (shares): actual return on investment from dividends payouts and, second, capital gains from stock market fluctuations. If dividends were reinvested, 1$ invested in 1900 would have increased in value 582-fold, allowing for inflation. If the investor relied instead only on capital gains in the value of the stock, the real increase would only be six-fold. Other countries show very similar patterns; the countries with the best returns on equities over the whole period, now extended to 1900–2013 being South Africa, Australia, the USA, New Zealand, Canada and Sweden. Last, note that returns on investment are poorly related to a country’s rate of growth of GDP; for an extended discussion of possible reasons see Credit Suisse (2014). Sources: Dimson et al. (2002), Credit Suisse (2009) to (2014).


The tortoise will likely prosper over the hare

Reid and Burns of Deutsche Bank in their post-crash report From the Golden to the Grey Age, came to a similar conclusion, that “We think the market will increasingly remember that returns in equities over the medium to long run are largely driven by dividend and dividend reinvestment. The tortoise will likely prosper over the hare, in our view.”

Reid and Burn’s Golden Age dates between the late 1970s to 2008 when historically remarkable rates of return could be achieved in the US from certain combinations of shares, Treasury and company bonds (see graph below).

Above: From Golden to Grey Age US Dividend yields from equity (shares), from 10 year Treasury Yield (i.e. terminating at 10 years) and 30 year corporate bonds running back to 1802. Equities started to yield less than bonds from the late 1950s, and the period from the late 1970s to the late 00s mark ‘The Golden Age’. Source: Reid & Burns, Deutsche Bank (2010)

But what they also document is this was part of a unique period, going as far back as 1802, when returns on government (and later corporate) bonds, outstripped dividend yields on company shares (see graph). This started in the late 1950s, and the gap became huge from the early 1980s. It is extraordinary because investing in company shares is more risky that bonds, so should always attract higher rewards. Reid and Burn concluded that during this period investors came to believe that holding equities in companies would generate income by routes other than dividend payments including favourable tax status, from company share buybacks and a belief that companies could invest cash more profitably resulting in higher stock market valuations, leading to the expectation that capital gains (stock-market fluctuations) would more than make up for decreased dividend payments.

However, having comprehensively analysed the returns, they concluded “… the evidence … confirms that this was a failure at overall index levels. We think the market will increasingly remember that returns in equities over the medium to long run are largely driven by dividend and dividend reinvestment. The tortoise will likely prosper over the hare, in our view.”

The 2007/8 crash … has created a fantastic opportunity … to raise cheap finance for long-term investment in environmental and social infrastructure

The re-discovery of the importance of investing in intrinsic value, in dividend reinvestment, and in investing for the long term, is important. Much — if not all — of ‘trend bending’ investment demands long term infrastructure investment in intrinsic value, including energy generation and transmission, communications, water infrastructure, agriculture, and the development of substitutes and alternative to resources that may be in short supply, or which may be too damaging to extract and use.

It is sometimes said that every crisis is an opportunity. If so, it is an opportunity we have so far failed to grasp. The 2007/8 crash, and the need to stimulate the real economy has created a fantastic opportunity for governments to raise cheap finance for long-term investment in environmental and social infrastructure from micro- and SMEs (small and medium-sized enterprises) to transnational projects, as well as creating jobs and supporting the ‘real economy’. This would emulate the (good) stimulus to the 1930s New Deal US economy; the entirely bad but economically beneficial stimulus given to the US economy as a result of expenditure on the 1939-45 war; or the post-war rebuilding of the German and Japanese economies. Unfortunately the approach so far, in the US and UK at least, that of quantitative easing (essentially ‘printing money’ or deficit spending), has been done in a way that has meant that the stimulus has mainly inflated stock market prices to pre-2007 bubble bursting levels, with far less going directly to the real economy in general and specifically for trend-bending infrastructure.

One might speculate that this was partly because of ideological  beliefs, and partly through a practical lack of knowledge. The ideological belief is that the Keynesian approach of real economy stimulus by governments, during low points in economic cycles to prevent deflation and depression, by deficit spending, had gone out of fashion (due to serious problem encountered). Instead neoclassical economic approaches were favoured, that assume that markets are self correcting. That neoclassical presumption was evidently broken by the time of the 2007/08 crash, just as was classical economic theory that made the same assumptions in the early twentieth century, and which lead to Keynes. Nevertheless neoclassical beliefs are still strongly held, with the result the response to the 2007-08 crisis was primarily a Monetarist one, assuming that quantitative easing primarily directed at the financial system, along with monetary reforms, would be sufficient because of a trickle-down effect on the real economy, without Keynesian deficit spending directly targeted to the latter. The pendulum may be swinging back to a Goldilocks approach (not too much, not too little, of each paradigm), but it hasn’t got there yet. The practical reason, one may suspect, are the senior generations in governments, finance, investment and economics who know most about short term (speculative) trading environments, and have less knowledge of infrastructure planning or assessing intrinsic value.

For Germany … the better lessons to draw come from the economic miracle of the 1950s … not fear of the hyper-inflation of the 1920s

The EU Euro zone has so far conducted little quantitative easing; they may learn from the mistakes, although again there is an ideological objection — this time from Germany, deriving partly from history and partly from a suspicion that other countries will simply use the stimulus for short-term gains rather than investment, adding to future debt. For Germany (and indeed the rest of the world) the better lessons to draw come from the economic miracle of the 1950s, applied to global trend bending, not the fear of recreating the hyper-inflation of 1920s Germany. Despite the missed opportunities since 2007, global economic performance is still poor and in need of stimulus, and the opportunity for investment in real environmental and social infrastructure, at historically low real interest rates, remains.

2. Ecology for Bankers

2011 marked a remarkable event: an ecologist and a senior official at the Bank of England publishing a joint research paper in the leading scientific journal Nature

The year 2011 marked a remarkable event: an ecologist and a senior official at the Bank of England publishing a joint research paper in the leading scientific journal Nature. Andrew Haldane (now Chief Economist at the Bank of England) and Bob May (ex-Chief Scientist of the UK government and a mathematical ecologist) paper, Systemic Risk in Banking Ecosystems, following on from another Nature paper by May and colleagues called Ecology for Bankers. After the 2007/08 crash, banking regulators become very interested in what aspects of global banking networks — the number and strength of interconnections, direct and indirect, between banks — make global banking system more or less stable. It turns out that the problem parallels one that had been exercising mathematical ecologists, with some success, for the last few decades. Their question was what makes food-webs (the links and rate of flows of food between species) that we observe in the real world, with their rather stable combinations of species that are rare, moderately common, and abundant. It is interesting because it turns out that when you try and simulate natural ecosystems with mathematical models, it turned out to be very easy to make unstable food-webs, and was initially very hard to identify the positive and negative feedbacks that make natural ones stable (we now have a better, but not complete, understanding). One difference between financial institutions such as banks, and life, is perhaps that the flows are of money rather than food — although you could also say that society needs to satisfy multiple forms of value, that life has multiple nutrient requirements, making a single parameter a challenge for both. Another practical difference is that for natural ecosystems we observe the outcomes of natural experiments — the few successes — without at first realising how easy it is to create failure until the simulation studies were done. The equivalent stage we had got to with the creation of globalised banking, was in effect to be simplifying the global banking ecosystems, without realising how easy it was to create homogeneous systems that were intrinsically fragile.

Even if ecological cycles of ‘boom and bust’ are predictable, they would not be desirable, especially in an economy!

The mathematics can be fiendishly complex. There are many implications. May established his reputation in the early 1970s demonstrating that chaotic (unpredictable) fluctuations in species abundance could arise from simple systems defined by only a few parameters , but on the other hand, complex ecosystems with many species and many links were not necessarily stable either (or for that matter the number and sizes of banks – even then May and others were pointing out the general applicability of the mathematics “… in the everyday world of politics and economics we would all be better off if more people realised that simple non-linear systems do not necessarily possess simple dynamic properties”). One illustrative example is given here, first for ecology, and then the banking analogy. This is that simple ecosystems, with few species, as you might find in the high latitudes, can cycle dramatically compared to more diverse systems (more species, more ways of making a living) elsewhere in the world, for example where a predator and prey species cause each other’s population to cycle. The classic example that of Canadian snowshoe hare and lynx, was originally detected in economic data — the animal skins from trappers delivered to the Hudson Bay Company. Even thought these ecological cycles of ‘boom and bust’ may be predictable, they would not be desirable, especially in an economy! Factors that can reduce cycles, or even extinction, is that each species has some refuge, something they do where their competitors cannot beat them and predators cannot affect them. Another factor is impediments that slow down the transmission of effects through the system, allowing species to persist in the long term. The analogy for calm stable banking conditions is lots of smaller banks, all doing slightly different things, with some USP (unique selling point) giving them an advantage in some aspects of their business, and some resistance to rapid transmission through the global banking system.

The risks indicated by ecological theory, arising from simplification of global banking systems … is of concern

The risks indicated by ecological theory, arising from simplification of global banking systems, in the name of driving out inefficiency, is of concern. The graph below gives one example from Haldane and May, the increasing domination of the US banking system by a few banks. The warning is not to allow banking to become dominated by a few global players, and that system resilience may be increased if banking is not totally integrated and uniform in its approach within markets and across the world. That happens to coincide with some none-ecological arguments for keeping banking diverse, not being dominated by a few players, and also having banks mutually insure one another, and to produce their own rescue packages, which requires banks to be diverse and not to be ‘too big to fail’.

This is another trend to be bent. The good news is that if banking wishes to learn, there is a lot to be learnt.

The recent rise in the concentration of banking in the US The red line indicates the repeal in 1999 of the Glass–Steagal restrictions in banking concentration. This is one example that Haldane and May used how an increasingly elaborate set of financial instruments intended to optimise returns to individual institutions with minimal risk are having possible effects on the stability of the system as a whole. Source: Haldane & May 2011

3. The Optimal Distribution of Wealth for Growth, Prosperity and Sustainability

There is a pregnant pause. Now is the time to take stock, not just of the 2007/08 crash, but of the lessons of the past century and more

The optimal distribution of wealth for growth and prosperity — and now sustainability — defines politics. People have long wondered where this will all end (see Keynes’ 15 hour working week). The world may not have worked out quite as Keynes and others suggested — although some were remarkably prescient regarding issues that are now coming to a head. Most recently, recovering global growth and prosperity has been a major concern since the 2007/08 crash — an event as epoch-defining as the Great Depression, yet to play itself out, or perhaps even be widely appreciated as such. So far the response has been uncertain (of the establishment and protesters alike) and the recovery stalled, perhaps because the fundamental principles underlying the crisis have yet to be widely perceived. There is a pregnant pause. Now is the time to take stock, not just of the 2007/08 crash, but of the lessons of the past century and more.

Much of this is about the best vehicles for finance and investment, of the lessons of mutuals and cooperative financial sector, and the implications of a broadening interpretation of fiduciary responsibility to society of investing.

But that doesn’t address the optimal distribution of wealth within societies to brings the greatest overall sustainable growth of wealth to the benefit of all, rich and poor alike. For millennia the highly unequal distribution of wealth brought little change in life style even for the very richest. As John Kay recently pointed out, according to inflation-adjusted figures, Nathan Rothschild was the richest person of recent times, yet had a rubbish life compared to many today, and died from an infection that now costs a few pence to treat. The unusually fast changes since then come from a period where wealth and reward were unusually and demonstrably more evenly spread. Social innovations as the limited-liability company, and technological innovations, such as the steam engine, were part of this mix. Nonetheless, the impact of the distribution of wealth towards the goal of 9–10 billion living well by 2050 is not something to be ignored, especially now that society is once again demonstrably becoming more unequal. The optimal distribution of wealth, with an eye to creating the world where the greatest number can live well, at the fastest rate of change, is the subject of this section.

The challenges to nine billion people living well are significant. The number of jobs associated with manufacturing in developed and developing countries is generally falling with automation and/or shifting to lower wage economies — but how many substantial countries with low wage economies are left? Moreover the number of jobs associated with the digital economy, that were supposed to replace manufacturing in developed countries appear, for now at least, insufficient to make up for those lost from traditional employment. So working people are facing a squeeze in earnings worldwide, in both developed and developing economies. Indeed, technology can displace systematic jobs requiring considerable training previously thought to be too skilled for automation, for example not only in the transport sector (driver-less delivery vehicles, taxis) but also many well-paid jobs in higher and technical education and (less appreciated) accountancy and legal professions. Indeed, their high incomes, and the high costs for their clients, makes them particularly vulnerable to displacement, and the trend is already clear in education.

Some assumed that new jobs will appear as old ones go, but others are not so sure. Forster in The Machine Stops (1909) drew an astonishingly prescient picture of today’s social media internet peer-to-peer connected world. Some think that the modern equivalent, along with, for example 3-D printing, can create a direct globalised peer-to-peer economy, cutting out traditional and new distribution chains. Where machines take care of the mundane, such an economy might support some elements of a craftsman and bespoke economy envisaged by Morris’ 1893 News From Nowhere, although very different in its fundamentals. Lanier, in Who Owns the Future?, thinks peer-to-peer economies could happen, but believes the default outcome is for accumulating power for a few global companies (and accumulating wealth for their owners, at least at first) who hold masses of personal data.

This an age old issue going back to Aristotle’s leading observation, in Politics (Book IV), also noted by Lanier, that when “the shuttle would weave and the plectrum touch the lyre without a hand to guide them, chief workmen would not want servants, nor masters slaves”. H.G. Wells explored outcomes, good and bad (in novels and in Anticipations and A Modern Utopia). Wells had a greater faith in science and scientists as arbiters of progress than others: some, at least, were appalled by underlying (if perhaps unintended) social and value judgements. C.S. Lewis (best known now for his Narnia books) set out what he believed to be the resulting dystopia, notably in That Hideous Strength.

Meanwhile the economist Keynes in 1930 forecast virtuous ‘technological under-employment’ when, if trends continued, by 2030 an average 15 hour working week would suffice for a high quality of life with pay relatively flat and abundant free time. The benefits that wealth previously brought would become cheap. For Keynes, those who pursued further wealth by working longer would in future be pitied for their pathology rather than envied. Moreover, this change wasn’t even necessarily actively driven, although it might be accelerated or retarded by policy. However, the world does not currently appear to be working out as Keynes suggested. Since then, notably Beck in Risk Society, which has been particularly influential in German speaking society, has emphasised the importance of distributional issues, not just of narrow wealth, but also, for example in the distribution of risks and rewards, and of opportunity, and of the need for societal engagement of how these are distributed across society.

Clearly there are a wide range of views, but it is also well trodden ground. Perhaps what is unusual, for now at least, is the lack of public engagement in the discussion of events, and alternative futures, that will materialise in next few decades that will have profound effects on everyone’s general quality of life.

there has been a growing concentration of wealth in the top few percent of the population since the 1980s

Two global trends in monetary wealth were evident before 2007/08, one good, one bad. First, the good: the globalisation of innovation has benefited a substantial number of people in developing countries over the last couple of decades, this in turn being a ripple effect from the so-called economic miracle in North America and western Europe of earlier decades. A significant number of urban and industrial workers did better than their parents in financial terms and quality of life, as they developed skills and created a growing middle class, a trend expected to continue in the NIC Report described early. But superimposed upon this there has been a growing concentration of wealth in the top few percent of the population since the 1980s first noted in the US, creating a ‘Second Guilded Age’, (see graph below, based on the work of Piketty and Saez and others contributing to the World Top Incomes Database). When companies such as Shell start citing such work in their scenario analyses, it is time to take note.

Above: The Second Guilded Age The levels of inequality in the United States have grown to those last seen in the first half of the twentieth century. The blue line shows the percentage of US annual income going to the highest 10% of income receivers, excluding capital gains. The green line shows the rate of growth of the overall economy: the same slope means there was no change (technically, this is the log per capita GDP, expressed in 2009 prices). There are significant technical and philosophical problems with the concept of GDP, growing or otherwise. Nevertheless it would be difficult to argue from this data that increasing the income of the top 10% results in an overall increase in economic growth. As explored in the drop-down, if capital gains are included the annual income of the top 10% rises to around 50% of total, and Western Europe and other parts of the world are not far behind. Source: US Income distribution from Piketty & Saez 2012, and Royal Dutch Shell 2012, data on US Real GDP from Measuring Wealth.

In 2014 Piketty followed this up with a detailed analysis (see additional graphs and text in Capital in the 21st Century, reviewed in a article). The same change in wealth distribution is occurring in many developed and developing countries, although not necessarily as extreme as in the US, and sometimes starting at a later date. In the past similar levels of inequality led to stalled growth, depression, civil disruption and war which — amongst much of wider concern — destroyed the wealth of the wealthy. So this is a trend that should concern everyone, rich and poor.


There is no need to be discouraged. Nations did emerge from inequality and strife, and prospered in the mid-20th century

But there is no need to be discouraged. Nations did emerge from inequality and strife, and prospered in the mid-twentieth century. So we can look to the past for at least part of the solution. In a separate article we review Progressive Tax of the past and learning from this for the future.

Source: Bending the Trends, modus vivendi, 2014, MMG