The Capital/Labor Ratio
March 30, 2008
Whew! We can finally talk about something besides banks — though I’m sure we’ll go back there pretty soon. This is quite the historic moment in the financial sector.
Instead, we’ll talk about something else: the idea of the Capital/Labor Ratio. I call it an “idea” because there’s no real ratio, as in a number with several decimal places. If there was, or someone made one, you should probably ignore it anyway.
Ever since the beginning of the industrial revolution, in the late 18th century, people have wondered: it’s great that one person, with a steam-powered spinning machine, can do what took a dozen people with spinning wheels used to do, but what happens then to the other eleven people? Do they become unemployed?
Possibly. But, on the other hand, if they all had steam-powered spinning machines, then they would all be employed, and the total output of cotton cloth would be twelve times more than it was before. And, there being twelve times as much cotton cloth produced, people could thus use 12x more cotton cloth, or sell it for something else they wanted, or what have you. Thus, we see greater productivity leading to greater wealth. There is also the question of who gets what. Do the workers get salaries equivalent to 12x as much cotton cloth, or do they get no more than what they got when they used spinning wheels, and the factory owner gets the benefit of all the surplus production?
Let’s say that, in one case, one person operates the steam-powered spinning machine, and 11 people are unemployed. They are no longer able to compete against the machine-made cotton with their spinning wheels. If they don’t have spinning machines of their own, maybe they end up as floor-sweepers, ditch-diggers and prostitutes. Low-value, low-paid, non-capital-intensive activities. How much does a broom cost? In short, they are underemployed.
What’s the difference between the somewhat sunny scenario where there are lots of spinning machines (12 people with 12 machines), and lots of productivity, leading to higher wages and wealth, and the more dismal scenario where there is one person with a spinning machine, who is underpaid because of the great surplus of labor, and 11 underemployed people?
The difference, it seems, is the other 11 spinning machines. Spinning machines are “capital,” specifically capital expenditure. When there is lots of capital, then labor is in demand and is well-used. When there is not enough capital, labor is in surplus and is underused. Also, let’s say that the cotton cloth business is very profitable. There is a high return on capital. Thus, more capital pours into the sector. This capital is useless unless combined with labor to operate the machines. The value of labor thus goes up. Wages rise — to the point at which they reduce the profits of capital, and investment becomes less attractive. Thus, when there is plenty of capital, two things happen: 1) labor is well utilized (lots of good jobs) and 2) labor is well paid, which is to say, a greater degree of the additional productivity resulting from the capital investment is paid to labor.
What if you had capital to produce 20 machines, but there were only 11 people available in the labor pool to operate them?
One of the problems in the US right now, for example, is that there is an effective surplus of labor as immigration rules are rather lax, and there has been a huge amount of effective labor introduced via India and China for example. (You don’t hear much talk about how the high tide for the middle class in the US, which was really the 1950s and 1960s, were a time of restricted immigration.) At the same time, capital investment and capital creation is rather low.
“Capital investment”can take many forms. There is the traditional “big company buys a big machine” sort of capital investment. However, any investment that results in “greater productivity” can be considered a capital investment. If a cook sets aside time and effort (capital) to become a better cook, then his product (food) may be tastier. This is greater productivity. Both Wolfgang Puck (celebrity chef of yore) and the burger-flipper at McDonald’s spend about eight hours a day cooking. However, Puck is vastly more productive (considered simply as a chef rather than a media figure and restaurant entrepreneur), which can be considered a result of his capital investment in building cooking skills. This greater “productivity” may result in a higher income as well. Many “capital investments” today are in the form of education and training, formal or informal, which doesn’t really show up on any statistics as “capex.”
From this, it can be readily seen that high levels of capital investment are beneficial, and indeed even necessary because the effect of increasing productivity is that it typically takes fewer and fewer people to do something. This means more and more “surplus labor” that needs new capital. The increasing productivity of agriculture, to take one of the longest-running examples, has resulted in fewer and fewer people needed in the industry. In some sense, capital investment (in agriculture for example) creates the need for more capital investment (what to do with the people no longer needed in agriculture).
Ideally, you want this process to be “proactive,” such that people that are no longer needed in one industry are enticed to higher-productivity activities by higher wages (“I’m dumping this bogus nonsense to get a good, high-paying job in the city”) rather than via depressed wages and unemployment. (“Factory closed, now what am I going to do?”).
Where does this “capital investment” come from? Mostly it comes from current income, or “savings.” We are familiar with household savings, but corporations “save” as well. In short, they have surplus cashflow, which is channeled into investment. On a physical level, it means that people spend time and effort (capital) on investment-type activities, whether education and training or building the machines and other physical capital that people will use in the future to be more productive.
The capex of the developing Asian economies is phenomenal. For China today, and places like Japan or Malaysia in the past, you could often see capex on the order of 50% of GDP, and super-high savings rates to match. When there is this much investment in higher productivity, is there any surprise that higher productivity results — accompanied by higher wages and high demand for labor?
Thus, it would make sense for a government to promote capital accumulation. This was a very basic idea a hundred years ago, but it seems rather foreign to governments today. How do you promote capital accumulation? Mostly, the government should avoid discouraging and preventing capital formation. Investors are naturally anxious to accumulate capital anyway, if they are not prevented from doing so.
One of the biggest impairments in capital accumulation, it seems to me, is the corporate income tax. On the corporate level, capital investment (in excess of capital consumption, ie depreciation) is financed primarily via profits. Higher taxes = less profits = less capex. It’s not too much more complicated than that. Plus, taxes introduce a distortion, namely that returns on capital are impaired, so that not only is there less capital to work with, but it tends to be channeled into less-productive uses (muni bonds?) due to tax considerations. Thus, a double impairment to productivity.
Even if a corporation uses outside capital, in the form of debt or equity, that capital also has to come from somewhere — typically excess cashflow of some other corporate entity. Likewise, capital (profits) that are not invested at one corporation are most likely invested at another.
If a corporation isn’t paying out 40% in taxes, that money goes somewhere else. In practice, it is either reinvested, in a new factory for example, or paid out to shareholders as a dividend, where it is typically then reinvested in another company that wants to build a factory but is short of cash. (We have to talk in these 50-year old “build a factory” terms, even though maybe factories aren’t what is needed today, and instead someone will rent an office and spend $100m on software R&D.) When you have a new factory , then of course you have new demand for labor to work at the factory, which means more jobs and higher demand for labor.
Capital gains and dividend taxes have much the same effects, impairing the process of capital accumulation. Of course, personal income taxes create similar effects. Also, when taxes are low or nonexistent, the incentive to invest, i.e. “save” or accumulate capital, is greater. Otherwise, the income is “consumed,” creating no future productive advantage.
In effect, these taxes channel cashflow to the government, instead of into more capital accumulation. The government also makes capital investments of its own. Typically the “public works” type projects are the most economically useful. Indeed, the government can often get things done here that would be difficult in the private realm, particularly as regards rights-of-way for highways, building ports, etc. However, rather little government spending today is directed into productive capital investments. Mostly it is waste, via corporate subsidy, military spending, etc. Transfer payments, namely Social Security and Medicare, don’t do much for capital accumulation either, although they may be important for other reasons.
Thus, with these principles, if you wanted, for example, to improve the situation for America’s middle class, you would encourage the formation of capital. This means lower taxes on capital, particularly corporate taxes, capital gains taxes, taxes on dividends, interest income etc. The US today has some of the highest taxes on corporations and capital in the developed world. Is it any surprise that the US also has one of the sickliest middle classes in the developed world? Hardly. You might also limit the supply of labor, at least within the US, perhaps by enforcing existing immigration laws. It is typical of the capitalist class to prefer low taxes on capital and capital accumulation, but also policies that create a surplus and excess of labor, as this tends to maximize the share of production that is enjoyed by capital. (In short, low wages.)
At this point, the more environmentalist type cringes in horror at the thought of ever-greater empowerment of the concrete-pouring, suburb-building, Big Box-shopping, fossil fuel-burning element of the economy. Indeed, I suspect that, at some collective level, certain populations have determined that “enough is enough,” and have accepted a certain amount of economic stagnation (France for example) in return for a slowdown of environmental destruction and general cultural demolition. However, this is in large part a measure of choice. There is nothing that requires “capex” to take the form of a superhighway or a strip mall. If the highest return on capital was to opera singers, instead of Big Box stores — which is another way of saying, people are paying for opera singers rather than Big Box retail, such that one is more profitable than the other — then we would have an economy rich with opera singers and few Big Box stores. Or, to put it another way, we would spend lots of our money at the opera and little at the Big Box Mart. What if 20% of people’s total income was spent on art and artists — jazz clubs, paintings, dance and so forth. Then 20% of the economy would be artists. (GDP is basically a measure of spending.) So, for those with such environmental or societal concerns, I say: put your money where your mouth is. Don’t shop at the Big Box. Don’t buy a McMansion in the ‘burbs. “But it’s cheaper there!!!!” comes the whine. Of course it is. So what. Just don’t participate in the collective delusion. Pay up for the small, independent store, if it is the sort of thing you would like to see multiply and prosper. Pay up for the organic food, the custom tailored (or otherwise well-made) clothes, the artisan-made housewares, the independently-owned restaurant. Vote with your wallet, instead of complaining why other people don’t vote with theirs. You see, people have to be shown how to do things that are different than what they are being told to do by their television sets.
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Bailout Watch: The Fed has hired Blackrock to manage its portfolio of mortgage-related securities. Manage? That’s a funny thing to do on collateral on 28-day loans.
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T2 Partners has put out a big Powerpoint with interesting info on how the mortgage situation is developing. It is available at http://www.valueinvestingcongress.com/. Basically, it’s worse than you think. I suspect that this spring/early summer selling season will see some “give up” among sellers, and further reluctance among buyers (as the last round of “dip-buying” buyers gets whacked), producing a significant drop lower in prices. Just think of how things have changed since the last spring/summer selling season, April-July of 2007. More bubbly areas, like California and Florida, could see another 20%-30% downmove, while more marginal areas could see weakness due more to a weak economy. Prices are still too high. Prices have to get down to the point where the monthly cashflow costs of buying and owning a house — on a 30yr fully-amortized mortgage — are less than the cashflow costs of renting. Because: nobody has more cashflow than that — most renters spend as much on rent as they are capable — so where would the extra money to pay the mortgage and expenses come from? Besides, banks aren’t going to loan you the money anymore unless you can document the ability to pay it back, so how are people going to document that they can pay more than their rent? That’s a maximum price, it seems to me, and realistically the number of people who want to buy a house, and are able to put up the 20% downpayment, are rather scarce. Probably, prices would fall well below that. I still see 50x a month’s rent as the probable floor of our crash crater. We can imagine the effects on the mortgage-finance sphere. I’ve thought for a while that inflation (declining dollar value) would help prop up housing values, but none of that inflation has been making it into people’s incomes yet. I think incomes (ability to pay) will be the primary determinant of nominal prices for now. Prices in terms of gold oz. may collapse to astounding levels.
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Silver Shortage: Retail bullion dealers reported “the busiest day in forty years” when silver fell recently below $18/oz. on the Comex. It appears that dealers are sold out across Canada, and available silver in the U.S. is very spotty. I’ve heard that dealers are even bidding $0.50 over Comex for 1000oz. good-delivery bars. The markets for metal and paper (the heavily-manipulated Comex) are beginning to diverge. Indeed, a couple large funds could take delivery on the entire Comex inventory, which would probably put an end to that charade. If you have any form of “paper silver” — pooled accounts, certificates, ETFs etc. — I’d consider going to bullion except perhaps for a trading position. For accounts of less than $2m or so, Goldmoney.com provides a good alternative. While holdings via Goldmoney are “direct held” in a legal sense, in a practical sense one is still somewhat reliant on the custody and trading framework Goldmoney provides. Still, it looks better than the many alternatives, if you don’t want to take personal delivery.