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Too Much Capital
In a list of ills deviling the nation, "too much capital" should come in dead last.
Most countries -- to say nothing of individuals -- are constantly scheming to acquire capital. Yet, today, an excess of capital has created a situation which is awkward at best, is driving the Federal Reserve to distraction, and at worst... we don't want to talk about that.
The criticism that Americans do not save enough money -- unlike those super-successful Japanese -- has been drummed into our heads for years. However, flows of savings have little to do with capital accumulation in the sense of wealth.
"Savings" is defined in the national accounts as disposable income minus spending. In recent years, the outcome of this tidy equation has been "negative savings," as vastly increased national wealth has propelled spending beyond income.
Wealth is different from theoretical rates of household savings. The stock market has more than tripled in value in the 1990's with no corresponding liability -- pure wealth. The value of the average American home has nearly doubled, but home equity has grown many times more because of the leveraging effect of mortgages (if I put $10,000 down on a $100,000 house in 1990, now worth $200,000, my equity has grown 1,000%, in addition to principal reduction on the loan).
But, how can we have too much capital? That's like having too many Porsches, too many emeralds, or too much income.
It's also like too much chocolate cake. It can make you sick.
From what miraculous source commeth an excess of capital?
The prudent sources include the entire Baby Boom generation now straddling its most productive years, and the years during which it must save like mad. Another flow, coming from all working-age groups: the mechanical, tax-sheltered payroll deductions going into retirement savings like the ubiquitous 401k and 403b; plus other retirement saving, IRA-style.
Capital sources bordering on funny-money: the positive feedback spiral in stocks and homes in which higher prices beget wealth, and wealth begets investment and purchase, which beget higher prices. Venture capital funding of new companies leads to initial public offerings of stock which are gobbled up at high prices, which creates more venture capital.
Capital, like any other commodity, is subject to the laws of supply and demand. In the early stages of a capital excess, the excess is beneficial. Cheap capital in the form of low interest rates and easily sold new issues stimulates the economy through capital spending by businesses. If the capital is spent wisely, the investments not only cause the economy to run faster, but safer, inflation-free, as productivity rises.
As a period of capital excess matures, cheap capital, earning increasingly inferior returns, begins to chase weaker and weaker deals in search of higher return. As an excess capital epoch approaches its end stage, capital begins to chase its tail.
Tail-chasing by definition includes the "momentum investing" distinguishing the Nasdaq in the last year, and the inability of markets to distinguish between dot-com vision and dot-com value. Housing markets depart from appreciation at a high, but steady one or two or three percent per month to end-stage "ramping", where each new sale exceeds the prior one by arbitrary tens of thousands of dollars.
One typical remedy for an overheated economy has been a tax increase. However, this time, huge budget surpluses at the federal and state level are contributing to a shortage of investments for capital to chase. More tax revenue wouldn't necessarily help the situation: the Treasury is already so awash in cash that it is buying back the highest quality assets available for investment (U.S. Treasury notes and bonds), thereby driving capital into competition for fewer and lesser-quality investments.
The Fed knows how to intervene in an ordinary overheating episode, but these rare periods of excess capital tend to defy Fed action. Rate rises -- at 6.50%, the Fed funds rate is now the highest since the 1990 recession
-- usually slow the economy down by slowing credit-sensitive industries, like housing. Also, modest rate rises should hurt corporate earnings and make stocks unattractive.
It's hunch-work right now, but I have the impression from clients that the stock market and economic strength have poured money and confidence into housing faster than the Fed's rate rises are removing them. Stocks have suffered some in 2000, but a retreat to late 1999 values and immense embedded gains doesn't amount to much suffering. High rates on cash investments don't mean much to most Americans; why, many people younger than 40 may not have a single acquaintance who ever bought a certificate of deposit.
Alan Greenspan's favorite quotation is a line belonging to his friend and economist Herb Stein: "Unsustainable trends tend not to be sustained."
The Fed's predicament is the need to strike hard enough to interrupt this dangerous capital tail-chasing without extinguishing too much capital by accident -- and before the markets take the extinguisher into their own hands.
The long term prospects for the information-age New Economy are very bright, but in the near term, many an investor is going to get a lesson on the benefits of returns from the certificate of deposit and plain, old cash.
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