What Is the Effect of Inflation on Inequality of Returns to Capital?
The results concerning the returns on university endowments suggest that it may also be useful to say a few words about the pure return on capital and the inegalitarian effects of inflation. As I showed in Chapter 1, the rate of inflation in the wealthy countries has been stable at around 2 percent since the 1980s: this new norm is both much lower than the peak inflation rates seen in the twentieth century and much higher than the zero or virtually zero inflation that prevailed in the nineteenth century and up to World War I. In the emerging countries, inflation is currently higher than in the rich countries (often above 5 percent). The question, then, is the following: What is the effect on returns to capital of inflation at 2 percent or even 5 percent rather than 0 percent?
Some people think, wrongly, that inflation reduces the average return on capital. This is false, because the average asset price (that is, the average price of real estate and financial securities) tends to rise at the same pace as consumer prices. Take a country with a capital stock equal to six years of national income (β = 6) and where capital’s share of national income equals 30 percent (α = 30%), so that the average return on capital is 5 percent (r = 5%). Imagine that inflation in this country increases from 0 to 2 percent a year. Is it really true that the average return on capital will then decrease from 5 percent to 3? Obviously not. To a first approximation, if consumer prices rise by 2 percent a year, then it is probable that asset prices will also increase by 2 percent a year on average. There will be no capital gains or losses, and the return on capital will still be 5 percent. By contrast, it is likely that inflation changes the distribution of this average return among individual citizens. The problem is that in practice the redistributions induced by inflation are always complex, multidimensional, and largely unpredictable and uncontrollable.
People sometimes believe that inflation is the enemy of the rentier and that this may in part explain why modern societies like inflation. This is partly true, in the sense that inflation forces people to pay some attention to their capital. When inflation exists, anyone who is content to perch on a pile of banknotes will see that pile melt away before his eyes, leaving him with nothing even if wealth is untaxed. In this respect, inflation is indeed a tax on the idle rich, or, more precisely, on wealth that is not invested. But as I have noted a number of times already, it is enough to invest one’s wealth in real assets, such as real estate or shares of stock, in order to escape the inflation tax entirely.36 Our results on university endowments confirm this in the clearest possible terms. There can be no doubt that inflation of 2 percent rather than 0 percent in no way prevents large fortunes from obtaining very high real returns.
One can even imagine that inflation tends to improve the relative position of the wealthiest individuals compared to the least wealthy, in that it enhances the importance of financial managers and intermediaries. A person with 10 or 50 million euros cannot afford the money managers that Harvard has but can nevertheless pay financial advisors and stockbrokers to mitigate the effects of inflation. By contrast, a person with only 10 or 50 thousand euros to invest will not be offered the same choices by her broker (if she has one): contacts with financial advisors are briefer, and many people in this category keep most of their savings in checking accounts that pay little or nothing and/or savings accounts that pay little more than the rate of inflation. Furthermore, some assets exhibit size effects of their own, but these are generally unavailable to small investors. It is important to realize that this inequality of access to the most remunerative investments as a reality for everyone (and thus much broader than the extreme case of “alternative investments” available only to the wealthiest individuals and largest endowments). For example, some financial products require very large minimum investments (on the order of hundreds of thousands of euros), so that small investors must make do with less profitable opportunities (allowing intermediaries to charge big investors more for their services).
These size effects are particularly important in regard to real estate. In practice, this is the most important type of capital asset for the vast majority of the population. For most people, the simplest way to invest is to buy a home. This provides protection against inflation (since the price of housing generally rises at least as fast as the price of consumption), and it also allows the owner to avoid paying rent, which is equivalent to a real return on investment of 3–4 percent a year. But for a person with 10 to 50 thousand euros, it is not enough to decide to buy a home: the possibility may not exist. And even for a person with 100 or 200 thousand euros but who works in a big city in a job whose pay is not in the top 2 or 3 centiles of the wage hierarchy, it may be difficult to purchase a home or apartment even if one is willing to go into debt for a long period of time and pay a high rate of interest. As a result, those who start out with a small initial fortune will often remain tenants, who must therefore pay a substantial rent (affording a high return on capital to the landlord) for a long period of time, possibly for life, while their bank savings are just barely protected from inflation.
Conversely, a person who starts out with more wealth thanks to an inheritance or gift, or who earns a sufficiently high salary, or both, will more quickly be in a position to buy a home or apartment and therefore earn a real return of 3–4 percent on their investment while being able to save more thanks to not having to pay rent. This unequal access to real estate as an effect of fortune size has of course always existed.37 One could conceivably circumvent the barrier by buying a smaller apartment than one needs (in order to rent it) or by investing in other types of assets. But the problem has to some extent been aggravated by modern inflation: in the nineteenth century, when inflation was zero, it was relatively easy for a small saver to obtain a real return of 3 or 4 percent, for example by buying government bonds. Today, many small savers cannot enjoy such returns.
To sum up: the main effect of inflation is not to reduce the average return on capital but to redistribute it. And even though the effects of inflation are complex and multidimensional, the preponderance of the evidence suggests that the redistribution induced by inflation is mainly to the detriment of the least wealthy and to the benefit of the wealthiest, hence in the opposite direction from what is generally desired. To be sure, inflation may slightly reduce the pure return on capital, in that it forces everyone to spend more time doing asset management. One might compare this historic change to the very long-run increase in the rate of depreciation of capital, which requires more frequent investment decisions and replacement of old assets with new ones.38 In both cases, one has to work a little harder today to obtain a given return: capital has become more “dynamic.” But these are relatively indirect and ineffective ways of combating rent: the evidence suggests that the slight decrease in the pure return on capital due to these causes is much smaller than the increase of inequality of returns on capital; in particular, it poses little threat to the largest fortunes.
Inflation does not do away with rent: on the contrary, it probably helps to make the distribution of capital more unequal.
To avoid any misunderstanding, let me say at once that I am not proposing a return to the gold standard or zero inflation. Under some conditions, inflation may have virtues, though smaller virtues than is sometimes imagined. I will come back to this when I discuss the role of central banks in monetary creation, especially in times of financial crisis and large sovereign debt. There are ways for people of modest means to have access to remunerative saving without zero inflation and government bonds as in the nineteenth century. But it is important to realize that inflation is today an extremely blunt instrument, and often a counterproductive one, if the goal is to avoid a return to a society of rentiers and, more generally, to reduce inequalities of wealth. A progressive tax on capital is a much more appropriate policy in terms of both democratic transparency and real efficacy.
The Return on Sovereign Wealth Funds: Capital and Politics
; Consider now the case of sovereign wealth funds, which have grown substantially in recent years, particularly in the petroleum exporting countries. Unfortunately, there is much less publicly available data concerning the investment strategies and returns obtained by sovereign wealth funds than there is for university endowments, and this is all the more unfortunate in that the financial stakes are much, much larger. The Norwegian sovereign wealth fund, which alone was worth more than 700 billion euros in 2013 (twice as much as all US university endowments combined), publishes the most detailed financial reports. Its investment strategy, at least at the beginning, seems to have been more standard than that of the university endowments, in part, no doubt, because it was subject to public scrutiny (and the people of Norway may have been less willing than the Harvard Corporation to accept massive investments in hedge funds and unlisted stocks), and the returns obtained were apparently not as good.39 The fund’s officials recently received authorization to place larger amounts in alternative investments (especially international real estate), and returns may be higher in the future. Note, too, that the fund’s management costs are less than 0.1 percent of its assets (compared with 0.3 percent for Harvard), but since the Norwegian fund is 20 times larger than Harvard’s endowment, this is enough to pay for thorough investment advice. We also learn that during the period 1970–2010, about 60 percent of the money Norway earned from petroleum was invested in the fund, while 40 percent a year went to government expenses. The Norwegian authorities do not tell us what their long-term objective for the fund is or when the country can begin to consume all or part of the returns on its investment. They probably do not know themselves: everything depends on how Norway’s petroleum reserves evolve as well as on the price of a barrel of oil and the fund’s returns in the decades ahead.
If we look at other sovereign wealth funds, particularly n the Middle East, we unfortunately find that they are much more opaque than the Norwegian fund. Their financial reports are frequently rather scanty. It is generally impossible to know precisely what the investment strategy is, and returns are discussed obliquely at best, with little consistency from year to year. The most recent reports published by the Abu Dhabi Investment Authority, which manages the world’s largest sovereign wealth fund (about the same size as Norway’s), speak of a real return greater than 7 percent a year for 1990–2010 and more than 8 percent for 1980–2010. In view of the returns obtained by university endowments, these figures seem entirely plausible, but in the absence of detailed annual information, it is difficult to say more.
It is interesting to note that different funds apparently follow very different investment strategies, which are related, moreover, to very different ways of communicating with the public and very different approaches to global politics. Abu Dhabi is outspoken about its fund’s high returns, but Saudi Arabia’s sovereign wealth fund, which ranks third after Abu Dhabi and Norway among sovereign wealth funds of petroleum exporting states and ahead of Kuwait, Qatar, and Russia, has chosen to keep a very low profile. The small petroleum states of the Persian Gulf, which have only tiny populations to worry about, are clearly addressing the international financial community as the primary audience for their reports. The Saudi reports are more sober and provide information not only about oil reserves but also about national accounts and the government budget. These are clearly addressed to the people of the Kingdom of Saudi Arabia, whose population was close to 20 million in 2010—still small compared to the large countries in the region (Iran, 80 million; Egypt, 85 million; Iraq, 35 million) but far larger than the microstates of the Gulf.40 And that is not the only difference: Saudi funds seem to be invested much less aggressively. According to official documents, the average return on the Saudi sovereign wealth fund was no more than 2–3 percent, mainly because much of the money was invested in US Treasury bonds. Saudi financial reports do not come close to providing enough information to know how the portfolio has evolved, but the information they do provide is much more detailed than that provided by the Emirates, and on this specific point they seem to be accurate.
Why would Saudi Arabia choose to invest in US Treasury bonds when it is possible to get far better returns elsewhere? The question is worth asking, especially since US university endowments stopped investing in their own government’s debt decades ago and roam the world in search of the best return, investing in hedge funds, unlisted shares, and commodities-based derivatives. To be sure, US Treasuries offer an enviable guarantee of stability in an unstable world, and it is possible that the Saudi public has little taste for alternative investments. But the political and military aspects of the choice must also be taken into account: even though it is never stated explicitly, it is not illogical for Saudia Arabia to lend at low interest to the country that protects it militarily. To my knowledge, no one has ever attempted to calculate precisely the return on such an investment, but it seems clear that it is rather high. If the United States, backed by other Western powers, had not driven the Iraqi army out of Kuwait in 1991, Iraq would probably have threatened Saudi Arabia’s oil fields next, and it is possible that other countries in the region, such as Iran, would have joined the fray to redistribute the region’s petroleum rents. The dynamics of the global distribution of capital are at once economic, political, and military. This was already the case in the colonial era, when the great powers of the day, Britain and France foremost among them, were quick to roll out the cannon to protect their investments. Clearly, the same will be true in the twenty-first century, in a tense new global political configuration whose contours are difficult to predict in advance.
Will Sovereign Wealth Funds Own the World?
How much richer can the sovereign wealth funds become in the decades ahead? According to available (and notoriously imperfect) estimates, sovereign wealth funds in 2013 had total investments worth a little over $5.3 trillion, of which about $3.2 trillion belongs to the funds of petroleum exporting states (including, in addition to those mentioned above, the smaller funds of Dubai, Libya, Kazakhstan, Algeria, Iran, Azerbaijan, Brunei, Oman, and many others), and approximately $2.1 trillion to funds of nonpetroleum states (primarily China, Hong Kong, Singapore, and many smaller funds).41 For reference, note that this is almost exactly the same total wealth as that represented by the Forbes billionaires (around $5.4 trillion in 2013). In other words, billionaires today own roughly 1.5 percent of the world’s total private wealth, and sovereign wealth funds own another 1.5 percent. It is perhaps reassuring to note that this leaves 97 percent of global capital for the rest.42 One can also do projections for the sovereign wealth funds just as I did for billionaires, from which it follows that they will not achieve decisive importance—10–20 percent of global capital—before the second half of the twenty-first century, and we are still a long way from having to pay our monthly rent to the emir of Qatar (or the taxpayers of Norway). Nevertheless, it would still be a mistake to ignore the issue. In the first place, there is no reason why we should not worry about the rents our children and grandchildren may have to pay, and we need not wait until things come to a head to think about what to do. Second, a substantial part of global capital is in relatively illiquid form (including real estate and business capital that cannot be traded on financial markets), so that the share of truly liquid capital owned by sovereign wealth funds (and to a lesser extent billionaires)—capital that can be used, say, to take over a bankrupt company, buy a football team, or invest in a decaying neighborhood when strapped governments lack the means to do so—is actually much higher.43 In fact, the issue of investments originating in the petroleum exporting countries has become increasingly salient in the wealthy countries, especially France, and as noted, these are perhaps the countries least psychologically prepared for the comeback of capital.
Last but not least, the key difference between the sovereign wealth funds and the billionaires is that the funds, or at any rate those of the petroleum exporting countries, grow not only by reinvesting their returns but also by investing part of
the proceeds of oil sales. Although the future amounts of such proceeds are highly uncertain, owing to uncertainties about the amount of oil still in the ground, the demand for oil, and the price per barrel, it is quite plausible to assume that this income from petroleum sales will largely outweigh the returns on existing investments. The annual rent derived from the exploitation of natural resources, defined as the difference between receipts from sales and the cost of production, has been about 5 percent of global GDP since the mid-2000s (half of which is petroleum rent and the rest rent on other natural resources, mainly gas, coal, minerals, and wood), compared with about 2 percent in the 1990s and less than 1 percent in the early 1970s.44 According to some forecasting models, the price of petroleum, currently around $100 a barrel (compared with $25 in the early 2000s) could rise as high as $200 a barrel by 2020–2030. If a sufficiently large fraction of the corresponding rent is invested in sovereign wealth funds every year (a fraction that should be considerably larger than it is today), one can imagine a scenario in which the sovereign wealth funds would own 10–20 percent or more of global capital by 2030–2040. No law of economics rules this out. Everything depends on supply and demand, on whether or not new oil deposits and/or sources of energy are discovered, and on how rapidly people learn to live without petroleum. In any event, it is almost inevitable that the sovereign wealth funds of the petroleum exporting countries will continue to grow and that their share of global assets in 2030–2040 will be at least two to three times greater than it is today—a significant increase.
Capital in the Twenty-First Century Page 53