The Bear’s Lair: The need for rentier capitalism

Janet Yellen’s testimony to Congress this week, in which she indicated that inflation needed to be heading above 2% before the Fed made even the smallest shift in its zero interest rate policy, indicated that Maynard Keynes’ favored policy of the euthanasia of the rentier has been all too enthusiastically carried out. The rentier is for the moment dead and buried; nobody could make a living as a rentier with today’s interest rate structure. Yet it is worth examining what we have lost, and why a policy of rentier resurrection will be needed in coming years.

By definition, rentiers, living off rents (which as traditionally defined by economists includes the income from all investments) requires the income from investments to be positive, after taking account of inflation and the risks involved. Since 2008, this has not been the case. Risk free interest rates (those available on short-term investments) have consistently been well below the rate of inflation. In order to obtain a positive real return, investors have been forced to take risk.

The risks taken can come in several forms. If investors buy long-term government bonds, they take the risk of a rise in interest rates to more normal levels and a corresponding decline in their investments’ value. If they buy corporate bonds, let alone junk bonds, they also take a credit risk. If they buy equities, their risk is so far hidden, because of the inexorable rise in the U.S. stock market to levels 40%-50% above the 2000 peak. However, at some point both corporate earnings and stock valuations will revert to more normal historical levels, at which point equity investors will suffer severe losses.

Many investors have attempted to protect themselves from the effects of mad money by buying gold, gold mine shares or other commodities. Needless to say (and I can confirm this from painful personal experience) this has not been a successful strategy for the past 4 years, as gold has been almost the only investment asset declining steadily, trading as much as 40% below its 2011 peak.

Rentiers have thus been thoroughly harassed for the last two decades, since Alan Greenspan first took the brakes off monetary policy in February 1995. Little wonder therefore that savings rates in the United States and in most of the rich world have reached extraordinarily low and in some cases negative levels. Needless to say, the lack of savings has had a terrible effect on new business formation, and appears to be having a highly damaging effect on productivity growth.

The converse of the hard road trodden by savers over the last two decades has been the rose-strewn path enjoyed by those with access to low-cost borrowing in large quantities. Hedge funds, private equity funds and all kinds of real estate speculators have enjoyed double benefits from the rise in asset valuations together with their access to unlimited quantities of financing at close to the rate of inflation. Needless to say, each increase in asset values increases the amount they can borrow.

This game has been going on for a very long time; we must remember that Enron Corporation, the first big beneficiary of cheap money and readily available borrowing, went spectacularly bust almost 14 years ago. Contrary to popular belief, there was only modest fraud in Enron, confined to peripheral areas such as its special purpose vehicle companies. It simply entered into a series of massive and highly speculative leveraged trading businesses, based on a second-tier credit rating that rested on a base of assets, mostly highly questionable indeed foolish international acquisitions. The company’s failures were two-fold: excessive leverage, driven by the new prevalence of cheap money, and a singularly poor ability to select emerging market investments. The drivers of its bankruptcy were not criminal and the criminal convictions of Jeff Skilling and others (and the non-conviction of other equally culpable executives) were driven by post-bankruptcy political posturing.

Does anybody, anyone at all, doubt that there is Enron after Enron in our current corporate universe, only waiting for a downturn to collapse in ruin? No doubt as with Enron and the banking crisis, the politicians and corrupt prosecutors, seeking scapegoats and deep pockets to loot will spend a decade sentencing the wrong people to gigantic terms of imprisonment and levying multi-billion dollar fines on any entities lucky enough to have any money left.

To rebuild a sound economy, we will need at least a decade of a rentier-oriented society, in which high interest rates and low prices make capital accumulation through saving exceptionally attractive and leverage both perilous and very difficult to obtain.

There have been two such periods in U.S. economic history, the deflationary period from 1873 to 1896, when prices fell 20% making real interest rates exceptionally high, and the shorter inflationary period from 1980 to 1993, when Paul Volcker’s monetarism pushed interest rates far above the level of inflation, causing two painful recessions, but wringing out the inflationary excesses of the 1970s.

Both were periods of low asset prices. In the first stocks suffered two major bear markets, in 1873-79 and 1893-96. Prices of farmland also declined, as did commodity prices, causing much distress among indebted farmers. However U.S. GDP quadrupled during the period, which saw the most dynamic age of “robber baron” capitalism and unprecedented increases in productivity. Notably, industrial giants such as John D. Rockefeller, Andrew Carnegie and the banker J.P. Morgan achieved success with long-term oriented consolidation strategies, as did less-remembered figures such as the meat packer Philip Armour, the railroad tycoon E. H. Harriman, the telecom tycoon Theodore Vail and the power pioneer George Westinghouse.

In the early 1980s, stock prices had declined by three quarters from their 1966 peak, and although the market boomed, real stock prices remained low, still being below their 1966 level in 1993. Real yields were high throughout the period, and bonds were an exceptional investment in spite of inflation, because of their capital gains as yields declined. While housing was a decent asset in inflation-adjusted terms, high real interest rates caused periodic housing depressions in regions such as Texas and New England where prices became over-extended.

Through examination of the two past rentier-oriented societies, we can thus discern the characteristics of the society we will need from say 2017 to 2030. Stock prices will be low and real interest rates high, thus providing rentiers with a wide choice of genuinely attractive non-speculative investment opportunities. That will make rentier returns very attractive, maximizing saving and recapitalizing the U.S. economy.

Borrowing will be difficult to get, very expensive and dangerous to the fortunes of the borrower. Thus speculative vehicles such as hedge funds will disappear, and businesses with negative cash flows will quickly fail.

A new class of small businesses will appear, which have been suppressed in the past two decades. They will initially be financed by the plentiful savings of the entrepreneur and his friends and acquaintances, but will survive only by becoming cash-flow positive quickly. They will achieve this by undertaking modest ventures that build cash flow, then creating larger businesses that genuinely provide new and better products and services, like the revolutionary advances of the 1870s and 1880s. That in turn will ensure that productivity grows rapidly. In particular capital productivity, spurred by the new costliness of capital, will reverse the long decline it has suffered, which left it in 2012 at only 72% of 1966’s level.

Since new me-too companies will be unable to get financing, established companies, if they avoid leverage, will find life very much easier, and will be able to bolt on new businesses by acquisition and achieve economies of scale, as was possible in the 1880s and 1980s. The hollowing out of careers, that has made it unthinkable to pursue a career over the whole of a working 40-year lifespan, will also reverse, strengthening the upper middle classes and reversing the trend towards leveraged funny-money that has characterized the last two decades. Above all, successful business strategies will be oriented towards the long term.

The increase in inequality of the last decade, identified by Thomas Piketty, will be partially reversed. Fly-by-night leveraged billionaires will be unable to survive the credit crunch, and a majority of the Forbes 400 will once again come from inherited money, as it did in the 1980s. With asset values lower, the very rich will be somewhat less so, but on the other hand large investment incomes will be commonplace, and old money will achieve a substantial comeback (some of it, of course representing the likes of Bill Gates’ fortune, new money that has grown old.)

With jobs having more long-term stability, high quality workers at all levels will once again become valuable, so incomes for the bottom 99% will tend to increase in real terms, as they did in the 1880s for most people who weren’t over-leveraged subsistence farmers. As the Millennials grow older, they will discover their experience is valued more in the stabler corporate structure of the rentier society, so the relative poverty of their youth will be forgotten.

To make the rentier society a utopia not a dystopia, the right policies will have to be adopted. First, a new Paul Volcker must be found to run the Fed and allow interest rates to rise to the rentier-friendly level that is necessary. Second, tighter immigration controls must be put in place; in a more stable economy there will be little place for additional workers with neither skills nor experience. The United States provides exceptional living standards largely because of the capital available to support the efforts of each worker; as the rentier economy rebuilds capital levels, the progress must not be frittered away by allowing floods of additional low-wage job-seekers to overwhelm the pool of domestic labor.

Finally, government spending and the tax system must be restrained, and a bonfire of regulations must be carried out, to allow the additional productivity opportunities to be generated. No longer must the economy’s natural growth be stunted by such evil fatuities as the leftist yuppies of New York City preventing Binghamton from achieving its natural destiny as a generator of cheap fracked energy and provider of well-paid blue-collar jobs.

For the long-term health of the U.S. economy, the rentier society will be a great improvement on today’s speculator nirvana. It can’t come too quickly, though its arrival will be painful.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)