Capital in the Twenty-First Century (37 page)

How is the pure return on capital determined (that is, what is the annual return on
capital after deducting all management costs, including the value of the time spent
in portfolio management)? Why did it decrease over the long run from roughly 4–5 percent
in the age of Balzac and Austen to roughly 3–4 percent today?

Before attempting to answer these questions, another important issue needs to be clarified.
Some readers may find the assertion that the average return on capital today is 3–4
percent quite optimistic in view of the paltry return that they obtain on their meager
savings. A number of points need to be made.

First, the returns indicated in
Figures 6.3
and
6.4
are pretax returns. In other words, they are the returns that capital would earn
if there were no taxes on capital or income. In
Part Four
I will consider the role such taxes have played in the past and may play in the future
as fiscal competition between states increases. At this stage, let me say simply that
fiscal pressure was virtually nonexistent in the eighteenth and nineteenth centuries.
It was sharply higher in the twentieth century and remains higher today, so that the
average after-tax return on capital has decreased much more over the long run than
the average pretax return. Today, the level of taxation of capital and its income
may be fairly low if one adopts the correct strategy of fiscal optimization (and some
particularly persuasive investors even manage to obtain subsidies), but in most cases
the tax is substantial. In particular, it is important to remember that there are
many taxes other than income tax to consider: for instance, real estate taxes cut
into the return on investments in real estate, and corporate taxes do the same for
the income on financial capital invested in firms. Only if all these taxes were eliminated
(as may happen someday, but we are still a long way from that) that the returns on
capital actually accruing to its owners would reach the levels indicated in
Figures 6.3
and
6.4
. When all taxes are taken into account, the average tax rate on income from capital
is currently around 30 percent in most of the rich countries. This is the primary
reason for the large gap between the pure economic return on capital and the return
actually accruing to individual owners.

The second important point to keep in mind is that a pure return of around 3–4 percent
is an average that hides enormous disparities. For individuals whose only capital
is a small balance in a checking account, the return is negative, because such balances
yield no interest and are eaten away by inflation. Savings accounts often yield little
more than the inflation rate.
⁸
But the important point is that even if there are many such individuals, their total
wealth is relatively small. Recall that wealth in the rich countries is currently
divided into two approximately equal (or comparable) parts: real estate and financial
assets. Nearly all financial assets are accounted for by stocks, bonds, mutual funds,
and long-term financial contracts such as annuities or pension funds. Non-interest-bearing
checking accounts currently represent only about 10–20 percent of national income,
or at most 3–4 percent of total wealth (which, as readers will recall, is 500–600
percent of national income). If we add savings accounts, we increase the total to
just above 30 percent of national income, or barely more than 5 percent of total wealth.
⁹
The fact that checking and savings accounts yield only very meager interest is obviously
of some concern to depositors, but in terms of the average return on capital, this
fact is not very important.

In regard to average return, it is far more important to observe that the annual rental
value of housing, which accounts for half of total national wealth, is generally 3–4
percent of the value of the property. For example, an apartment worth 500,000 euros
will yield rent of 15,000–20,000 euros per year (or about 1,500 euros per month).
Those who prefer to own their property can save that amount in rent. This is also
true for more modest housing: an apartment worth 100,000 euros yields 3,000–4,000
euros of rent a year (or allows the owner to avoid paying that amount). And, as noted,
the rental yield on small apartments is as high as 5 percent. The returns on financial
investments, which are the predominant asset in larger fortunes, are higher still.
Taken together, it is these kinds of investments, in real estate and financial instruments,
that account for the bulk of private wealth, and this raises the average rate of return.

The third point that needs to be clarified is that the rates of return indicated in
Figures 6.3
and
6.4
are
real
rates of return. In other words, it would be a serious mistake to try to deduce the
rate of inflation (typically 1–2 percent in the rich countries today) from these yields.

The reason is simple and was touched on earlier: the lion’s share of household wealth
consists of “real assets” (that is, assets directly related to a real economic activity,
such as a house or shares in a corporation, the price of which therefore evolves as
the related activity evolves) rather than “nominal assets” (that is, assets whose
value is fixed at a nominal initial value, such as a sum of money deposited in a checking
or savings account or invested in a government bond that is not indexed to inflation).

Nominal assets are subject to a substantial inflation risk: if you invest 10,000 euros
in a checking or savings account or a nonindexed government or corporate bond, that
investment is still worth 10,000 euros ten years later, even if consumer prices have
doubled in the meantime. In that case, we say that the real value of the investment
has fallen by half: you can buy only half as much in goods and services as you could
have bought with the initial investment, so that your return after ten years is
−
50 percent, which may or may not have been compensated by the interest you earned
in the interim. In periods during which prices are rising sharply, the “nominal” rate
of interest, that is, the rate of interest prior to deduction of the inflation rate,
will rise to a high level, usually greater than the inflation rate. But the investor’s
results depend on when the investment was made, how the parties to the transaction
anticipated future inflation at that point in time, and so on: the “real” interest
rate, that is, the return actually obtained after inflation has been deducted, may
be significantly negative or significantly positive, depending on the case.
¹⁰
In any case, the inflation rate must be deducted from the interest rate if one wants
to know the real return on a nominal asset.

With real assets, everything is different. The price of real estate, like the price
of shares of stock or parts of a company or investments in a mutual fund, generally
rises at least as rapidly as the consumer price index. In other words, not only must
we not subtract inflation from the annual rents or dividends received on such assets,
but we often need to add to the annual return the capital gains earned when the asset
is sold (or subtract the capital loss, as the case may be). The crucial point is that
real assets are far more representative than nominal assets: they generally account
for more than three-quarters of total household assets and in some cases as much as
nine-tenths.
¹¹

When I examined the accumulation of capital in
Chapter 5
, I concluded that these various effects tend to balance out over the long run. Concretely,
if we look at all assets over the period 1910–2010, we find that their average price
seems to have increased at about the same rate as the consumer price index, at least
to a first approximation. To be sure, there may have been large capital gains or losses
for a given category of assets (and nominal assets, in particular, generate capital
losses, which are compensated by capital gains on real assets), which vary greatly
from period to period: the relative price of capital decreased sharply in the period
1910–1950 before trending upward between 1950 and 2010. Under these conditions, the
most reasonable approach is to take the view that the average returns on capital indicated
in
Figures 6.3
and
6.4
, which I obtained by dividing the annual flow of income on capital (from rents, dividends,
interest, profits, etc.) by the stock of capital, thus neglecting both capital gains
and capital losses, is a good estimate of the average return on capital over the long
run.
¹²
Of course, this does not mean that when we study the yield of a particular asset
we need not add any capital gain or subtract any capital loss (and, in particular,
deduct inflation in the case of a nominal asset). But it would not make much sense
to deduct inflation from the return on all forms of capital without adding capital
gains, which on average amply make up for the effects of inflation.

Make no mistake: I am obviously not denying that inflation can in some cases have
real effects on wealth, the return on wealth, and the distribution of wealth. The
effect, however, is largely one of redistributing wealth among asset categories rather
than a long-term structural effect. For example, I showed earlier that inflation played
a central role in virtually wiping out the value of public debt in the rich countries
in the wake of the two world wars. But when inflation remains high for a considerable
period of time, investors will try to protect themselves by investing in real assets.
There is every reason to believe that the largest fortunes are often those that are
best indexed and most diversified over the long run, while smaller fortunes—typically
checking or savings accounts—are the most seriously affected by inflation.

To be sure, one could argue that the transition from virtually zero inflation in the
nineteenth century to 2 percent inflation in the late twentieth and early twenty-first
centuries led to a slight decrease in the pure return on capital, in the sense that
it is easier to be a rentier in a regime of zero inflation (where wealth accumulated
in the past runs no risk of being whittled away by rising prices), whereas today’s
investor must spend more time reallocating her wealth among different asset categories
in order to achieve the best investment strategy. Again, however, there is no certainty
that the largest fortunes are the ones most affected by inflation or that relying
on inflation to reduce the influence of wealth accumulated in the past is the best
way of attaining that goal. I will come back to this key question in the next
Part Three
, when I turn to the way the effective returns obtained by different investors vary
with size of fortune, and in
Part Four
, when I compare the various institutions and policies that may influence the distribution
of wealth, including primarily taxes and inflation. At this stage, let me note simply
that inflation primarily plays a role—sometimes desirable, sometimes not—in redistributing
wealth among those who have it. In any case, the potential impact of inflation on
the average return on capital is fairly limited and much smaller than the apparent
nominal effect.
¹³

Using the best available historical data, I have shown how the return on capital evolved
over time. I will now try to explain the changes observed. How is the rate of return
on capital determined in a particular society at a particular point in time? What
are the main social and economic forces at work, why do these forces change over time,
and what can we predict about how the rate of return on capital will evolve in the
twenty-first century?

According to the simplest economic models, assuming “pure and perfect” competition
in both capital and labor markets, the rate of return on capital should be exactly
equal to the “marginal productivity” of capital (that is, the additional output due
to one additional unit of capital). In more complex models, which are also more realistic,
the rate of return on capital also depends on the relative bargaining power of the
various parties involved. Depending on the situation, it may be higher or lower than
the marginal productivity of capital (especially since this quantity is not always
precisely measurable).

In any case, the rate of return on capital is determined by the following two forces:
first, technology (what is capital used for?), and second, the abundance of the capital
stock (too much capital kills the return on capital).

Technology naturally plays a key role. If capital is of no use as a factor of production,
then by definition its marginal productivity is zero. In the abstract, one can easily
imagine a society in which capital is of no use in the production process: no investment
can increase the productivity of farmland, no tool or machine can increase output,
and having a roof over one’s head adds nothing to well-being compared with sleeping
outdoors. Yet capital might still play an important role in such a society as a pure
store of value: for example, people might choose to accumulate piles of food (assuming
that conditions allow for such storage) in anticipation of a possible future famine
or perhaps for purely aesthetic reasons (adding piles of jewels and other ornaments
to the food piles, perhaps). In the abstract, nothing prevents us from imagining a
society in which the capital/income ratio
β
is quite high but the return on capital
r
is strictly zero. In that case, the share of capital in national income,
α
=
r
×
β
, would also be zero. In such a society, all of national income and output would go
to labor.