fault, and too much as another.
The reason is obvious. Jack’s ambitions for kin will eventually conflict with Zack’s,
just as with ambitions for food and nest sites and mating opportunities. Not
everyone’s firstborn can be king of the hill. Social creatures evolve agonistic rules to
settle such conflicts peacefully. Losers in mating tournaments, or in contests where
males display and females choose, usually survive to compete again next year. The
contest is in the group interest because the traits of strength and skill proved in the
winner will be those passed on. Our genes tell us to compete as best we can for the
sake of a fair test, and to stop when the verdict seems clear. And soon enough it does.
The quarterback tries his best for three downs to move the yardsticks, but trots to
the sidelines on fourth down for the sake of another chance later. If genes can
encode this farsighted strategy for those other kinds of competition, why not for
nepotistic competition too?
For decades, biologists wondered why genes need so much selecting in species long
established. Shouldn’t earlier contests have selected the fittest genes once and for all,
with no need for further ones but to screen out recent and harmful mutations?
Shouldn’t the best traits have become clear millennia ago? Why need males contest
in tournaments or beauty contests every breeding season, with mostly the same
contestants, when best genes ought to have proved themselves soon after the
species began? Then there would be no genetic diversity except for recent
mutations not yet screened out. Population genetists such as Fisher, J. B. S. Haldane
and Sewall Wright had written mathematical models showing that even the slightest
selection pressures should drive a gene to fixity, and its rivals to extinction, within a
few generations if selection favored it consistently. Their argument was Malthus’
insight: breeding success is geometric. Yet there is rich allelic diversity wherever we
look. There are some gene sites in some species where the most common allele
Chapter 7 Petty’s Idea 2/3/16 6
holds frequencies under ten percent, and those frequencies are constantly shifting.
The flux proves that losers are allowed mating opportunities too, though not as
much, and leave young to compete in the next generation.
Hamilton explained why that could make sense in a paper published with Marlene
Zuk in 1982. George Williams in 1976 and John Tooby in 1980 had argued that
fittest genes in one generation might not be fittest in the next if niche pressures
varied to counter current gene choices. Tooby had pointed to parasites and
pathogens, particularly single-cell ones whose life cycle runs less than an hour. They
could evolve new strains to outflank our old defenses and call for new ones.
Hamilton and Zuk continued this theme. They suggested that genes might have long
memories, put in human terms, and might have seen the same parasites and
pathogens pull such tricks before. If some individuals in the host population still
carried the antidote gene that worked the last time the same unexpected strain
arose, or something close enough to it, hosts collectively could weather the threat if
that antidote gene could be identified and spread fast enough. Then how? Hamilton
and Zuk proposed that what winning males display in contests of singing or
croaking or agility or symmetry, or bright colors in the right places, was possession
of the genes needed to counter the current strains of pathogens and parasites.
Losers in the same contests carried genes that had proved best against strains of the
past and might come back in the future. Nepotism practiced by winners would
speed up the spread of the current antidote. But losers carried genes that had
worked against other strains that might recur. A way had to be found to keep all
those potential antidotes somewhere in the medicine cabinet. Current losers had to
be saved for later. Gene diversity was the key to group survival in the long run. The
quarterback trots to the bench on fourth down because that is better for himself and
the team than being carried to the hospital. He realizes that other players are best
for punts or field goals or defense until he gets the ball again. Selection pressures do
not favor the same traits and genes every time.
Chapter 7 Petty’s Idea 2/3/16 7
Hamilton’s Parasite Theory
My take on Hamilton’s 1982 paper, which I consider his masterpiece, is a blend of
his thoughts, Bob Trivers’ from a decade before, Richard Alexander’s, and maybe
mine. Mine sees a population arranged in local “demes” which intrabreed in most
cases for best adaptation to local pressures including pathogens and parasites. A
local strain to which the local deme is adapted might spread to other demes which
are not. Hosts in the invaded demes become sick. Female ones there intuit the
degraded conditions, breed less often, and breed mostly females (mothers can
choose) because males with their now ill-adapted anti-parasite (histocampatability)
genes will find few willing mates. This begins the part from Trivers. I’ll come to
Alexander’s later.
Mothers in the source deme see an opposite picture. Conditions are not necessarily
better than before, but they are better than in the invaded demes. They intuit this,
breed more often, and breed mostly males. The males migrate to those invaded
demes, carrying histocompatibility genes pre-adapted to the invaders, and find
willing mates there if they can show the signs. The idea that mothers choose to
breed mostly males in prosperous conditions is the other half of Trivers’ idea. The
idea that the invading parasite and the males with antidote genes might tend to
originate from the same deme may be mine.
That presupposes that females can trust the signs. Nature makes sure they can. She
provides resistant males with hard-to-feign ones to prove it. This was one of
Hamilton’s key insights. His idea has been called the “truth in advertising” theory.
Symmetrical antlers, deep croaks, accurate songs and bright colors where they
should be tell the females whose genes can be trusted. Parasites and pathogens
would fake them in afflicted host males if they could. It seems they can’t.
Hamilton, I believe, had solved three nagging puzzles at once. Why does nature
waste resources on beauty displays that seem at first glance to hinder fitness? A
Chapter 7 Petty’s Idea 2/3/16 8
peacock’s tail feathers are an encumbrance in running from predators. And why give
the expensive displays mostly to males? Why do males exist at all in species where
they contribute genes but no care?
We just saw the answer to the first. Answers to the second two again build on an
insight of Trivers in 1973. Males produce cheap sperm carrying genes alone.
Females produce eggs packed with costly nutrients. A male can pass genes to many
descendants through many mates if they approve his signs. That speeds up the fight
against parasites. Nature evolved males and their self-promoting signs and their
contests for fastest spread of antidote genes to catch up to shifts in parasite load.
Where Do Losers Go?
A key point in the Hamilton-Zuk theory is that losers’ genes in the beauty contest are
typically not driven to extinction. They are driven to low frequencies until needed
again. Kin selection, up to a point, helps maintain genic diversity by preserving
current losers within the gene pool. Selection pressures punish and restrain kin
selection when it conflicts with preservation of other genes whose time will come
again. I met Hamilton at a conference in Squaw Valley, where Bob Trivers had
helped us attract him, and told him this reason why I thought his 1982 paper helped
complete and qualify his 1964 paper. He was the absent-minded professor to
perfection. Moody, distracted, profound. He smiled, a rare thing for him, and said
“It’s been a long search.”
This explains what I mean by lineage survival or fitness. Much of this book assumes
its maximization even among modern humans, who create our own urban
environments in place of the ancestral savanna for which we were adapted. And
much of economic history, although written in cities by city-dwellers, appears to
assume the same. Chapter 2 listed some examples. Let’s review them. There was
Petty’s of 1662. The similar equilibrium wage theories of Smith and Ricardo
expected pay to converge to the level maintaining and replacing the work force,
which is trusted to spend it on both. Malthus’ population principle in 1798 and 1801
Chapter 7 Petty’s Idea 2/3/16 9
added the mechanics. Nassau Senior made that principle his first axiom in his
Outline of 1836. The biological imperative lapsed from attention when the first
generation of marginalists, led by Jevons and Menger, with Walras soon to follow,
thought it unscientific to explain or justify tastes. It reemerged a century later in
bioeconomics, much of which looked for economic implications of Hamilton’s rule.
We will see how it might clarify pure consumption and the maximand.
Enlightened Kin Selection
Hamilton’s rule needs completion because the quarterback and his genes have
figured out that the bench is better than the hospital. What really happens, I think, is
a long-range example of Bob Trivers’ “reciprocal altruism” of 1971 as generalized by
Richard Alexander. Bob wrote that creatures might invest in non-kin if the
investment were expected to be repaid with interest. Alexander added that the
repayment could be to the investor’s kin with equal genetic benefit if Hamilton’s
hurdle rb > c were cleared from the investor’s perspective. The quarterback yields
to special teams on fourth down, and they to the defense until possession changes
again, for the best interests of each and all in the long run. The interest they receive
in turn for deferring to non-kin is the cost of maintaining themselves on the bench. It
does not accrue and compound because it is paid out continuously. It is an insurance
cost that each temporary winner dares not trim. Group selection is enlightened kin
selection.
Three or four decades ago, this much acknowledgement of group selection would
have met more resistance than I expect now. It shouldn’t have. Half the beauty of the
Hamilton-Zuc scenario is in explaining allelic diversity as a result of agonistic rather
than lethal competition. Zack and Jack and their genotypes are rivals now because
they are teammates in the big picture.
Kin selection is a help until it crosses the line and becomes a hindrance. Some
mothers in the source deme will carry higher frequencies of the antidote gene than
others. They will tend to be healthier, and so able to invest more energy in more
Chapter 7 Petty’s Idea 2/3/16 10
young. If all mothers invest preferentially in their own, or maximize Hamilton’s
standard rb > c , healthier mothers will produce more young with higher doses of
the antidote genes, while sicklier mothers will produce less with less. Here it is
females who compete to prove the same better genes that males just proved in the
tournaments or beauty contests.
The race against parasites speeds up again with Trivers’ fine insight about healthier
mothers choosing to dial up the ratio of sons to daughters (“primary sex ratio”), and
to expand the reproductive period at both ends with shorter birth spacing for more
male offspring still. (Some of this may be my idea rather than his.) Nature proves
best current genes twice. Fathers prove them by duking it out or strutting their stuff.
Mothers carrying the same best genes prove it by winning the breeding contest
against other mothers after.
The ex ante/ ex post distinction counts as much in biology as in economics. Here it
accelerates the selection process. Offspring carrying the antidote gene to meet
current parasites will generally not on that account cost more ex ante invested
consumption to raise. If they are males, who can turn that advantage into many
offspring, the ex post value of that same investment can be far higher. The converse
works for offspring lacking the gene. Their mothers can make the best of it by
producing females who will find breeding opportunities anyhow with mates
carrying the gene, since she knows which they are and males always have cheap
sperm to spare, and will so keep their own genes in the gene pool.
Parasites got the last laugh by killing Hamilton on research in Africa a few years
after I met him. I never knew well enough to call him Bill. Bob Trivers called him the
deepest thinker in the world. That couldn’t be wrong by much.
Parasites and Demes
Ernst Mayr, Bob Trivers’ doctoral advisor at Harvard, defined a deme as a race or
subpopulation that intrabreeds at least 95% of the time. I hypothesize that it does so,
Chapter 7 Petty’s Idea 2/3/16 11
in some cases, to maximize frequency of a histocompatibility gene which is an
antidote to the local strain of parasite or pathogen. This idea could complement the
Hamilton-Zuc parasite model nicely. It would give a safe home to which both gene
and parasite could retreat until their times come again.
Period of Production Theory
Back to economics. Chapter 4 mentioned John Rae as a contributor to what later
developed into Mill’s free growth theory. Rae’s book, published in 1834, also begins
what was called period of production theory. The idea was that production took
time, and that profit compensated the investor’s patience over the production
period. Senior, who had sent Rae’s book to Mill, adopted this idea in his own betterknown
Outline in 1836. Rae’s book itself found few readers, despite its warm
endorsement by Mill in his own magnus opus of 1848. Jevons adopted the idea from
Senior in 1871, and Boehm Bawerk from Senior and Jevons in his book of 1889.
Boehm Bawerk soon learned of Rae’s work, and dedicated later editions to him.
Period of production theory thrives today in the Austrian School, which had been
founded by Boehm Bawerk’s teacher Carl Menger in 1871. (Menger was the guy who
squabbled with Schmoller in Chapter 2.)
It has found little favor elsewhere. The period seemed impractical to define or
measure, and so gave little predictive value. Joseph Schumpeter, a student of Boehm
Bawerk who disagreed with him on this point, argued in 1911 that the period of
production is zero; capital is present continuously. Frank Knight, who had
anticipated Schultz in realizing that some consumption is investment in human
capital, argued as Schumpeter had.
But the theory is true by definition. Any rate is the inverse or reciprocal of a period.
The inverse of 4% per year is 25 years. Return is the ratio of net output to capital
producing it, meaning the rate of production, and its reciprocal is the period of
Chapter 7 Petty’s Idea 2/3/16 12
production. Where the critics were right was in finding a lack of clarity and
predictive value in the theory. Where does it lead? Rabbits and redwoods have
different periods of production, at first glance, but should nonetheless agree in
return if in risk. Jevons wrote that he meant production of the “wage fund” as a
whole, meaning the universe of consumer goods. But he pointed to wine and timber
as examples to help pin down the period. Boehm Bawerk picked nine years for no
reason I can see.
All went wrong by considering physical capital only. The factors blend into each
other; physical becomes human capital through invested consumption, and
conversely when human depreciation is recovered in products. The generation
length gives the replacement period for total capital if total capital is interpreted as
fitness and if all fitness of each generation is passed to the next.
Jevons and Boehm Bawerk assumed growthlessness for simplicity, and would have
realized that they were modeling only the replacement component in net output.
Boehm Bawerk’s contribution, anticipated by Petty, was his insight that time
preference rate explains rate of return by pricing the capital denominator, and not
the reverse. This had not been clear in Rae or Senior or Jevons. I give all four high
marks for a near miss. But they could have come closer. Remember that Senior’s
first axiom had been Malthus’ population principle. He and the others would also
have known of Petty’s human and total capital idea, which was occasionally revived
and critiqued. They didn’t quite connect the dots.
Next Generation Theory
Petty wrote A Treatise of Taxes in 1662. The whole title continues to about as many
words, counting ampersands, as pages in the book or pamphlet. His son tells us that
Petty dictated his books overnight to secretaries who slept by turns. It is easy to
believe that Petty didn’t need much sleep. He was a go-getter who had sailed to
Chapter 7 Petty’s Idea 2/3/16 13
Ireland as chief medical officer to Cromwell’s ironsides, stayed on to survey the Irish
land with which Cromwell would pay his troops, and then got Parliament’s approval
to invest in that high-risk land to make a fortune. It is rare for a man of practical gifts
to be a deep thinker too. Petty, like my father, was both. His Verbum Sapienti of 1664
was first to apply the ancient capitalization formula to both factors, meaning
workers as well as tradeable things, and so originated the concept of human capital
as present value. He applied this insight there and his Political Arithmetick in 1676,
and again in The Total Wealth of England in 1683, to measure the total wealth of
England including human capital. That makes him the father of national accounts.
But his greatest achievements, I think came in A Treatise of Taxes.
Chapter 4, paragraph 9 of that book begins with
19. Having found the Rent or value of the usus fructus per annum, the
question is, how many years purchase (as we usually say) is the Fee simple
naturally worth? If we say an infinite number, then an Acre of Land would be
equal in value to a thousand Acres of the same Land; which is absurd, an
infinity of unites being equal to an infinity of thousands.
Petty clearly recognizes that time preference, meaning our taste for impatience,
explains productivity, or ratio of output to capital, rather than the other way around.
This powerful and counterintuitive insight is usually credited to Boehm Bawerk in
1889, who showed that it is true for man-made things as well as land. The utility or
usus fructus being a given, we bid less for the land or other capital producing it if we
are less patient, and more if more. Bidding less for this denominator of rate of return
bids that rate itself up if the numerator is a given, and conversely. That’s why riskier
assets offer higher return. Petty’s reductio ad absurdam of a hypothesis of infinite
patience is obvious in hindsight, but may not have been written down before. Petty
continues:
Chapter 7 Petty’s Idea 2/3/16 14
Wherefore we must pitch upon some limited number, and that I apprehend
to be the number of years, which I conceive one man of fifty years old,
another of twenty eight, and another of seven years old, all being alive
together may be thought to live; that is to say, of a Grandfather, Father and
Childe; few men having reason to take care of more remote Posterity: for if a
man be a great Grandfather, he himself is so much nearer his end, so as there
are but three in a continual line of descent usually coexisting together; and as
some are Grandfathers at forty years, yet as many are not till above sixty, and
sic de eteteris.
20. Wherefore I pitch the number of years purchase, that any Land is
naturally worth, to be the ordinary extent of three such person their lives.
Now in England we esteem three lives equal to one and twenty years, and
consequently the value of Land, to be about the same number of years
purchase. Possibly if they thought themselves mistaken. . . .(as the observer
on the Bills of Mortality thinks they are. . .)
21. . . . But in other Countreys Lands are worth nearer thirty years purchase,
by reason of the better titles, more people, and perhaps truer opinion of the
value and duration of three lives.
23. One the other hand, Lands are worth fewer years purchase (as in
Ireland) . . . by reason of the frequent rebellions. . .”
The “other Countreys” could include France and especially Holland, then models of
prosperity. Petty had made his fortune in Irish mortgages, and knew the years
purchase there.
But the argument is a puzzle. There is a focus on longevity and mortality, as if the
generations are providing for old age. But Petty’s overlapping generations model
cannot be much like Paul Samuelson’s of three centuries later, where a generation of
productives leaves a nest egg for retirement. Samuelson’s productives are
replenished exogenously, with children left to the imagination. Why would Petty
have mentioned their ages? And retirement at age 50, as a norm, would have made
no sense to Petty or his readers. The grandfather will stay in harness.
Chapter 7 Petty’s Idea 2/3/16 15
The one and twenty years could mean remaining life expectancy at age 50. But Petty
could easily have spelled that out, or the implied 71 year terminus. He does spell out
the ages of the three generations. Their average difference in age rounds to 21
years.
Petty’s readers, like Smith’s and Ricardo’s after, would have taken it for granted that
each generation provides for the next. “Few men having reason to take care of more
remote posterity” would have registered in the context of that provision. “Posterity”
usually meant and means descendants.
His description, like mine, is incomplete. He may mean that life expectancy is also a
factor in calculating the years purchase. If so, he apparently leaves that thought to
be followed up later. There is also room to argue that the grandfather looks two
generations ahead, so that the years purchase becomes 42 years. But that would
give the usus fructus at 2.3%. All the rates Petty reports elsewhere in the tract are
much higher. One generation length is what he seems to apply. My reading is that
the grandfather provides for the grandson by passing all to the son.
Petty’s overlapping generation insight has been one of his least noticed, just as with
Mill’s on output growth preceding and explaining capital growth. I first read of
Petty’s idea in a collection of Lionel Robbins’ lectures at London School of
Economics delivered in 1979-1980, but published in 2000. I learned from these
lectures that Gustav Cassel had published the same idea in his The Nature and
Necessity of Interest in 1903. I hunted that down. Robbins misremembered in telling
his students that Cassel had arrived at the idea independently. In fact Cassel and
Robbins both quote the same excerpts from A Treatise of Taxes that I just did. Cassel
inferred that interest rates cannot stably be less than 2% per year.
Chapter 7 Petty’s Idea 2/3/16 16
I arrived at the same idea independently, anyhow, and published it in Social Science
Information in 1989. To date it is my only publication in a refereed journal, and
remains uncited as far as I know. Alan Rogers, a biologist at University of Utah,
published almost the same idea in 1994 1 and 1997 2 . Neither of us knew of Petty or
Cassel or each other. Both of Rogers’ two papers are included in my appendix.
Petty’s great idea has otherwise remained unnoticed as far as I know.
His idea in modern terms comes from the same ancient capitalization formula.
Sumerian temples knew how to evaluate land as well as mortgages and annuities by
discounting to present value. In the simplest case, where cash flow is expected to
hold constant forever, the logic begins with the definition
cash flow rate =
cash flow
capital
.
Algebra allows
capital =
cash flow
cash flow rate
. (7.1)
Years purchase, given those simplifying assumptions, meant
years purchase =
1
cash flow rate , (7.2)
1 The Evolution of Time Preference.
2 Evolution and Human Choice over Time.
Chapter 7 Petty’s Idea 2/3/16 17
Suppose for example that cash flow rate is known to be 4%. Using (7.2), we would
figure
years purchase =
1
4%/ year = year
4% = year
4 /100 = 100years = 25 years.
4
That allows (7.1) to be reexpressed as
capital = (cash flow) x (years purchase). (7.3)
Where cash flow and cash flow rate are assumed constant over time, they become
identical to profit and rate of return. Sumerians realized that return is the universal
maximand, three millennia before Turgot wrote that down, and that competition
tended to equalize it to a current market norm. Then it would also equal years
purchase.
Petty was searching for the rationale of years purchase, and found it in the
generation length. Petty’s idea I think, and mine anyhow, could begin with
capital = means of accomplishing goals= means of lineage survival= fitness. (7.4)
Nature’s way is transmission of all fitness, meaning total capital for humans, to the
next generation. Nature cares just as much for later generations, but trusts each
generation of immediate descendants to know best what their own immediate
descendants will need for that long-range goal. Each passes the baton and retires.
We invest everything in the next generaton precisely because we care about the
ones after. Hamilton’s rule reflects this reality. Grandoffspring are only ¼ related to
Chapter 7 Petty’s Idea 2/3/16 18
donors, while offspring are ½ related. Hamilton thus predicts grandoffspring to
receive investment only when benefit/cost ratio is double. My own analysis allows
more role for group selection, without saying how much, and shifts attention from
who benefits to when.
Petty’s idea, if I understand him, is
years purchase = generation length = 21years, (7.5)
which would give
cash flow rate
1
generation length = 1
21 years
= 4.7%/year. (7.6)
This would tally well enough with rates of return and interest rates as Petty knew
them.
I would adjust Petty’s estimate of the generational length. Petty’s primogeniture
model may have been true to law and custom for land inheritance, but it is not true
to biology. I prefer R. A. Fisher’s 3 method equal-weighting all births from first to last,
and equal-weighing ages of both parents at each birth. We have some evidence that
the maternal generation length in recent decades, by that method, has run near 26
years over recent decades. If fathers are five years older on average, Fisher’s method
would arrive at 28.5 years. Rogers found 28.9 years from other sources. Then (7.6)
would give
cash flow rate =
1
= 3.5%/year. (7.7)
28.5 years
3 The Genetical Theory of Natural Selection (1930).
Chapter 7 Petty’s Idea 2/3/16 19
All this has assumed has assumed constant cash flow indefinitely. That would imply
zero growth. Only under zero growth do output and rate of return simplify to cash
flow and cash flow rate.
Now let’s model growth in. I divide the Y rule by total capital, as in Chapter 4, to get
output
total capital
=
total capital growth
total capital
+
cash flow
total capital ,
or more compactly
rate of return = growth rate + cash flow rate. (7.8)
At the collective scale, cash flow rate simplifies to pure consumption rate. That
would be written
rate of return = growth rate + pure consumption rate, (7.9)
as in Chapter 4. Then (7.6) through (7.9) allow
rate of return = growth rate + 3.5%/year (7.10)
at the collective scale.
(7.10) would be wrong if growth rate were a function of cash flow rate. I said that
politicians, and even economists to a degree, teach that faster growth needs
consumption restraint first. That corresponds to cash flow restraint in (7.10). Free
Chapter 7 Petty’s Idea 2/3/16 20
growth theory says such restraint doesn’t happen. Data say the same. I apply the
same idea in next generation theory.
My 3.5% is a rough estimate. What counts is the generation length. The length was
probably higher, and the rate lower, before medicine and sanitation lowered
mortality rates, and let two or three births per couple meet the need for population
replenishment.
The cash flow or pure consumption rate modeled at 3.5% might also vary for
reasons other than changes in the generation length. My charts show the pure
consumption/total capital rate as higher in the middle part of the twentieth century
as people drained capital reserves to keep up consumption in times of world-wide
depression. I’ll say more about these reserves.
First Interpretation
Next generation theory says in effect that R. A. Fisher’s version of the generation
length, not Petty’s primogeniture version, gives the period of production of total
capital. We would miss the point if we focused on the period production of human
capital separately. Total capital is our means of lineage survival. This reinforces my
theme that human capital does not mean humans. It means skill sets priced at
present value of foreseen cash flow. Skill sets are not enough for lineage survival.
We also need things. We should not fall into the trap of surplus value theory, which
had been taught by communists for decades before Karl Marx joined their ranks, in
supposing that skills make things. It is only half the truth. Skills plus things make
skills plus things as the generations repeat.
Nor should we make the mistake of supposing that the generation length begins and
ends uniquely from birth to birth, so that the remaining period of production grows
shorter over adult life and the time discount rate steeper. The period of a cycle is the
same at any point. The young, simply by maturing, are already investing in their
Chapter 7 Petty’s Idea 2/3/16 21
counterparts in the next generation. Each cohort (same-age group) invests
effectively in its immediate descendent. Eight-year-olds are investing in the next
generation of eight-year-olds, and so to the end. That’s why Fisher’s version of the
generation length is best. It prioritizes each cohort and gender without judgment as
to which matter more. The period of production gives our patience horizon. The
horizon and its reciprocal, the pure consumption rate, both hold the same at any age.
Cash Flow and Risk
The maximand rule notes that time preference and return vary with risk. Return is
growth rate plus cash flow rate. Is variance with risk captured more in one of these
two components than the other?
We might intuit that riskier and higher-return assets grow faster on average, over
enough time for the bumps of risk to even out. But if that tended to be true, the
universe of assets would grow progressively riskier over the decades and centuries.
That is not my reading of history. My impression is that smoother and rockier
periods come and go without overall trend. In the world we know, then, it is cash
flow rate rather than growth rate that varies from asset to asset with risk.
For illustration, consider factor risk. I argued that human capital figures to be the
riskier and higher return factor because assets tend to reflect the risk appetites of
their owners. The young are more risk-tolerant, and own human capital
disproportionately. If this higher return were reflected in higher growth, rather than
in higher cash flow, the ratio of human to physical capital would tend to rise steadily
over the millennia. Most readings have tended to see it the other way around. I
myself favor the neutral assumption that the factors keep pace. Then cash flow rate
becomes higher for human than physical capital, with 3.5% the cap-weighted
average.
Chapter 7 Petty’s Idea 2/3/16 22
Consider also the history of corporate leverage. Equities are riskier because bond
interest is paid first. If equities grew faster, however, leverage would constantly
decline. That is not what we see.
This inferred concentration of risk premium in cash flow rate is convenient for
testing. Growth and return are two of the most closely followed variables in
economics. We have no direct measure of the pure consumption rate, or cash flow
rate at the collective scale. Nor have we any direct measure of growth and return to
total capital at any scale. But we have a good idea of average return and growth and
cash flow to securities and business assets. By the maximand rule, return to human
capital should be the same but for differences in risk. I model human capital as
somewhat riskier, for reasons just given, and human capital is the larger factor.
Then if I am right in placing the risk premium within the cash flow component of
return, and in estimating average-risk cash flow rate at 3.5%, cash-flow rate to the
business sector as a whole should be somewhat less.
Next generation theory predicts at the collective scale. Collective return is implicitly
average return, and that means average-risk return. My reading of history, which
rules out progressive growth of higher-risk assets at the expense of lower-risk ones,
simplifies that to average-risk cash flow plus whatever collective or average growth
happens to be at the moment.
Don’t Grandparents Invest?
Next generation theory assumes that each generation invests all its capital of both
factors in the next within the generation length. We expect it to do the same in turn.
We care about grandoffspring too, but serve them best by trusting and enabling
their parents only.
A first reaction is that this denies the obvious. Humans today, in advanced countries,
normally live to nearly three times the generation length. (3 x 28.5 = 85.5). Even
retirement at age 65 comes eight years after twice that length. And job number one
Chapter 7 Petty’s Idea 2/3/16 23
for grandparents seems to be helping take care of grandchildren. Doesn’t that falsify
next generation theory?
Note quite. Retirement typically means dependence on savings or subsidy. The
parental generation subsidizes both the young and the old. Retirees can be
interpreted to some extent as hired though willing caregivers paid for by parents.
That explains part. The rest, I think, is best explained as replenishing a capital
reserve. Nature builds up reserves in good times and depletes them in bad times. A
rise in longevity from what is normally needed for lineage survival is a rise in
human capital reserves. Human capital is the most versatile kind. We geezers have
lost a step. But we remember how it’s done. We particularly remember how
parenting and homemaking are done, since those change least with technology.
Julius Caesar’s nanny, with a few pointers, could probably fill in as a nanny today. If
the parental generation were pulled away to fight a war, or rebuild after a
catastrophe, we oldsters could keep up the home front.
Free growth theory, abundantly proved in the data, is essential to next generation
theory. What each generation invests in the next is all its fitness (total capital). All ex
post growth, up or down, is added or subtracted for free. Catastrophes and windfalls
are the random kind of free growth. Tech gain is the accumulating “secular” (of
ages) kind. I wouldn’t put it past nature to have learned that sustained growth
means rising risk. She could adjust with reserves. We may be selected (a nicer word
than programmed) to build human capital reserves intentionally, whether or not
seeing nature’s motives for the buildup as distinct from our own, when real wealth
doubles with every generation.
That intentional or ex ante part would mean investment in the reserve. It isn’t
targeted to the grandoffspring generation, because they aren’t expected to draw it
down unless needed. All the rest of the buildup of human capital reserves in lifespan
prolongation is best explained as random free growth if my interpretation holds
Chapter 7 Petty’s Idea 2/3/16 24
water. Next generation theory is not contradicted because it describes cash flows
only. It treats all growth at the collective scale as free and exogenous.
Testing Next Generation Theory
The proxies for the pure consumption rate (Schultz’ pure consumption over total
capital) in security markets would be dividend yield for equities, and interest for
debt claims. Ibbotson Associates’ SBII (2012), Chapter 4, shows average real
interest on U.S. corporate bonds as 3.0% over the period 1926-2011. Real corporate
dividend yield rate over the period can be estimated from the same source at about
2.9%. Jeremy Siegel’s Stocks for the Long Run (2002), Table 1-2, reports data
extending back to 1802. Real return over the period 1802 – 2001 is shown as
averaging 3.5% for long-term governments, and 2.9% for short-term governments.
Corporate bond returns would have run somewhat higher.
Global Financial Data shows stock market information for 95 countries. Data for U.K.,
U.S., Germany, Australia and France begin from 1701, 1801, 1870, 1883 and 1896
respectively. My charts and tables, and my website Free Growth and Other Surprises,
show this information along with evidence for free growth.
The eighteenth century is represented by U.K. alone. U.K. then showed real price
return, dividend yield and total return at 21.4%, 7.9% and 29.3%. Volatility of
dividend yield was exceptional. From 1801 forward, U.K. averages for these flows
were 2.2%, 4.2% and 6.4%. U.S. figures from 1801 forward were 2.9%, 5.3% and
8.3%. Global Financial Data also shows collective flows for Europe and the world
since 1926. Here the figures were 3.3%, 3.9% and 7.3% for Europe, and 3.5%, 3.8%
and 7.3% for the world.
Modeling of the pure consumption rate before the emergence of security markets
could refer to the history of interest rates alone. Interest is rate of return to senior
claims. Rate of return to any claim is realization by investors net of all expense.
Chapter 7 Petty’s Idea 2/3/16 25
Investors as to interest means lenders, not borrowers. Interest rates published
historically are rates borrowers are contracted to pay. Interest rates realized by
lenders are less for two reasons. There are friction costs of due diligence,
contracting and collection. Default costs, slight when times are good, can be
catastrophic when times are bad.
Homer and Sylla describe normal contracted rates, not realized rates net of those
costs, as 10% − 40% in Sumer and Babylonia, 6% − 18% in ancient Greece, 5% −
24% in Egypt, and 4% − 12+% in Rome and the Byzantine Empire. 4 After higher
rates in the dark ages, European mortgages and commercial loans found the range
7% − 25% in the thirteenth and fourteenth centuries. 5 The range settled down to
4% − 14% in the sixteenth century, 6 and to 3% − 10% by the seventeenth and
eighteenth 7 . The authors comment: 8 “…interest rates declined during much of the
later Middle Ages and Renaissance. The earliest short-term rates quoted were
somewhat higher than the last and highest of the western Roman Legal limits. They
were not too different from early Greek rates and were within the range of
Babylonian rates… The later Renaissance rates were well within the range of
modern rates and the lowest were far below modern rates in periods of credit
stringency.” Merchants of Venice in Shakespeare’s time and long before borrowed
from banks, not from Shylocks, and at rather lower cost than merchants of the
twentieth century.
Economics and Biology
Bioeconomics has meant economics informed by biology. I argued that this
describes much or all of classical economics from Petty through Mill, then lapsed
when the marginalists preferred to do without any explanations or justifications of
tastes, and revived a century later to explore Hamilton’s rule.
4 A History of Interest Rates, Rutgers, 1996, Table 4.
5 Ibid. Tables 6 and 7.
6 Ibid. Table 9.
7 Ibid. Tables 10 and 14.
8 Ibid. Chapter 10.
Chapter 7 Petty’s Idea 2/3/16 26
I too reason from biological axioms, and from much the same ones implicit or
explicit in the classical period. But I end up framing ideas of biology in the language
of economics rather than the opposite. I begin with
total capital = means of ends = means of replication = fitness,
where fitness is understood as a stock. The concomitant flow and rate would be
output (creation of fitness/total capital) and return (ratio of the two).
Free growth theory gave the inference
optimum ex ante output = optimum controllable output
= exact offset of pure consumption, at the collective scale.
Next generation theory specified the period of this exhaust and recovery as the
generation length.
Consider Hamilton’s rule in this context. All ex ante output, continuing steadily at
the generation rate, must be invested concurrently in the next generation or stored
for later investment within the deadline. It is the problem of Brewster’s millions.
Adults must invest or store as efficiently as practical (the maximand rule) before the
output means has slipped by. And the more stored instead, the more pressure to
invest later within the deadline. Time left for investment is another of the practical
constraints on maximization of rb/c.
What I sense is a watering down of Hamilton’s rule from what seemed logical
compulsion a few decades ago to something more like a target of opportunity. A
prediction maximizing rb/c has proved its value as a useful rule of thumb. I
suggested why some nepotism might be more adaptive than none in my review of
the Hamilton-Zuk parasite theory. It’s about giving all genes a fair but speedy trial.
Chapter 7 Petty’s Idea 2/3/16 27
The quarterback gets three downs, and the batter three strikes, before they go back
to the bench. Some nepotism directs healthier mothers to invest in more and
healthier offspring, and sicker ones conversely, long enough to demonstrate which
is really which. Males passing the test carry the signs to prove it. Females choose
them to spread the antidote gene to the whole population. Losing genes and losing
parasites retreat until their time comes again.
Summary
This chapter trades my wannabe economist hat for my wannabe biologist one.
Herbert Spencer called those fields the same at bottom. I never read Spencer, and
know him mostly from Bertrand Russell’s books on the history of philosophy.
Spencer rates a subchapter there. Yet he was an autodidact with less training in
either field than mine. He even had less training in philosophy than mine. He was a
philosopher all the same, by Russell’s tough standards, and knew that logic comes
first. Data eventually prove their worth when it’s time to test. The data I’ve found
fits net generation theory more or less. What I really have on, all the while, is my
wannabe philosopher hat.
Popperians make no sense. Are we supposed to find that a rose is not a rose? Or that
all reasoning from definition is as transparent as that example? Wiles’ proof of
Fermat’s last theorem ended a search that took some pretty bright minds three
centuries. My best guess would be that Popperians confuse the concepts of logic and
question-begging. They are opposite. Logic (reasoning from definition) means
taking out no more than you put in. Truism or tautology usually means obvious
examples of the same, but sometimes includes subtle ones too. Question-begging
means taking out what you never put in 9 .
9 Circularity is question-begging which claims to take out as inference what it put in as assumption.
Assumption that Socrates is a man and that all men are mortal does not confirm that Socrates is a
man. It confirms that Socrates is mortal if assumptions are sound.
Chapter 7 Petty’s Idea 2/3/16 28
Spencer’s “survival of the fittest’ doctrine would be a truism if we could prove the
theory of natural causality. We can’t by any means known to me. Science takes it as a
working assumption. So did Hume, and so do I. If God intervenes only a little, so that
laws of nature comes close to reality most of the time, we’re still in business.
My critique of Hamilton’s rule proposed that nepotism meets resistance when it
conflicts with nepotistic goals of others. I proposed a modus vivendi through
agonistic rules. Hamilton’s parasite theory with Zuk, written 18 years later, gives the
game plan.
Nepotism, meaning kin selection through Hamilton’s rule, is in the common interest
to a point. It speeds up proof of best genes to beat the current parasites by testing
female genes as well as male ones. Healthier mothers and sisters and aunts carry
more fitness to invest in more young. And females in most K-selected species,
including humans, perform most care of the offspring and siblings and nepotes
(nephews and nieces) that receive it 10 . Male competition alone does not determine
best current genes to nature’s satisfaction. Female breeding competition and
nepotistic investment help prove them farther.
All agonistic rules are about keeping the contest fair and deciding when proof is
enough. Long-term success against future as well as current parasites needs most
losers, not all, to go to the bench (low frequencies; source demes in my version)
rather than to extinction. Most losers survived to enter the contest because they
10 The burden is about 50-50 in pair-bonding birds. Fathers look to be the only caregivers in
territorial fish such as sticklebacks.
Chapter 7 Petty’s Idea 2/3/16 29
were winners once before. Their cost on the bench, or on the taxi squad, is good
insurance.
My version of Hamilton’s parasite theory patched in some of Trivers’ ideas. One was
that mothers intuiting self-health and good prospects should tend to breed higher
primary sex ratios and conversely. Their male offspring can then find willing mates
if health carries reliable signs as Hamilton proposed. Also the investment of
insurance cost by winners in maintaining losers on the bench can be interpreted as
Trivers’ reciprocal altruism to be recovered when winners now become losers later.
My discussion of grandparental investment let still more worms out of the can. It is
clear that humans in advanced economies today normally live to nearly three
generation lengths. I proposed that we are replenishing a total capital reserve,
meaning mainly a human capital one, when recovering from hard times in the world
wars and world depression. No one really knows.
Chapter 7 Petty’s Idea 2/3/16 30
CHAPTER 8: BANKS, MONEY AND MACROECONOMICS
Splitting up Banks
I started to write a book on banks and money a year ago. I stopped when I realized
that I don’t know enough about the subject. I have some experience and have done
some reading in those fields, but not enough to justify a whole book. A chapter, or
part of a chapter, is more like it.
Sumerian temples doubled as banks, mostly for agricultural loans to finance the next
crop. It is from their records, in clay tablets, that we know they understood
compound interest and the capitalization formula.
Deposit-and-lend banks as we know them today emerged in Venice and other
European cities in the twelfth and thirteenth centuries. Chapter 1 said that equity
investors cannot be attracted at leverage (deposit/equity) of less than 10:1, that
even one tenth so much leverage is unstable in high winds, and that we rebuild the
banking system after every systemic failure because we blamed the high winds
rather than the rickety structure.
I said that the solution is to split up banks as we know them into deposit banks
which invest in ETFs on the one side, and lending banks which raise funds from
investors rather than depositors on the other. These entities would have separate
stockholders, and would not interact unless incidentally.
A different kind of bank split-up has been urged since the 2008 crash. Repeal of the
Glass-Steagle act had allowed commercial (deposit-and-lend) banks to operate as
investment banks (brokerage firms). Many blamed the crash on that repeal, and on
investment bank innovations such as mortgage-backed securities. I think those
critics are looking in the wrong direction. The problem, as with most bank crashes
over the centuries, was overleverage encouraged by nearly costless deposits. The
solution is not to peel off brokerage operations from the mix, but to peel off deposits.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 1
I see no reason why lending banks should be separate from investment banks.
Rather the depositors’ money should not be risked in either.
It is also a mistake to blame Wall Street chicanery. Chicanery is a fact of life, and
Wall Street has more than its share. But I can testify, from a ringside seat, that many
sound financiers and first-rate economists genuinely believed in the sub-prime
derivatives they were selling. They were proposed to the trusts I run. I turned them
down as a business proposition because I saw too much complexity and no upside.
But my read was that the presenters were sold themselves.
The problem is not in the people. It is in the inherent fragility of deposit-and-lend
banks. Then what would the world be like without them? The answer first needs a
closer look at the problem.
Credit Risk is More than Leverage
Some leverage is a good thing. Firms issue bonds as well as stocks in order to attract
a wider range of investors. Risk-averse investors may choose the safety of bonds,
whose interest claims are paid first, while risk tolerant ones may be happy with the
iffier but more promising equity remainder. Leverage in general is a way to satisfy
both these constituencies.
Credit risk rises with term (duration) as well as amount of debt. One of the most
telling points in Siegel’s Stocks for the Long Run is that corporate bonds of 15 years
or more have proved more volatile in real total return than equities have. No
wonder. A corporate bond will have ample debt coverage (gross profit/debt service)
at date of issuance, and an appropriate credit rating. What will both be fifteen years
from now?
Homeowners also typically borrow long-term. They expect to have children in local
schools, husbands and/or wives in local jobs, and other roots in the community. But
Chapter 8 Banks, Money and Macroeconomics 2/8/16 2
who knows that husbands and wives will still be married in fifteen years? Who
knows that if they are, their careers will not have taken them to another city?
It seems to me that reducing the dangers of debt means reducing both term and
amount, and that the solution had better find ways that still accommodate the shortterm
and long-term needs of firms and people.
Now let’s look at how deposit banks might invest.
The Omnibus Fund Idea
If I were a couple of decades younger, I would try to create something I call an
omnibus fund. It starts by seeming to contradict what I just said. I said that firms
issue both stocks and bonds to reach different constituencies. The omnibus fund
would first erase that separation. In principle it would reconstruct the firm as a
whole, or put the pieces back together again, by assembling proportionate shares of
the debt and equity claims on it in a single portfolio.
Suppose for example that the market cap (number of shares times current market
quotation) for a firm’s equity shares is one billion dollars, while the market cap of all
debt claims together in half that. Then the omnibus fund, in principle, would buy
each firm’s equities and debt instruments in that proportion at current market
valuation. In practice it could realize the same effect in a simpler way.
The omnibus fund would be a balanced index fund. Index funds are representative
of all the funds in an index, such as the S&P 500, weighted again to market cap. The
omnibus fund would pick a still more inclusive index, say the Russell 3000 or even
the Wilshire 5000. It would add in a corporate bond index, since balanced means
mixing stocks and bonds, and cap weight the two. The object would be to model the
publicly-traded corporate sector as a whole. The simplest way to get there would be
to buy index ETFs (exchange traded funds) directly, rather than duplicating their
work of assembling portfolios of the underlying individual issues.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 3
If it stopped at that point, the omnibus fund would probably attract few investors. It
would offer the aggregate return and risk of the publicity-traded corporate sector as
if it had never borrowed or issued debt. Aggregate means average. No one is exactly
average. Some like me and my father happen to be more risk-tolerant, and opt for
the higher returns that tend to come from higher risk. Some prefer the opposite.
How can the omnibus fund attract both?
The answer is derivatives. Derivatives are obligations whose benefits depend on
outcomes imperfectly foreseen. I said in the forward that I’m all in favor of them so
long as we respect and manage the risks. Equities themselves are the classical
example. Mortgage-backed securities give another. Common forms include futures
and swaps. The idea is about the same. Each typically picks an index, often the S&P
500. One party, the “short leg”, bets so much money, the “notional amount”, that the
S&P 500 index will go down tomorrow. Another party, the “long leg”, bets it will go
up. The short leg gets so much, say Libor plus 20 basis points (hundredths of a
percent) of the notional amount, in any outcome. The long leg gets the index change,
whether up or down, times the same notional amount.
No one actually invests the notional amount. It is called “notional” for good reason.
Rather each side (leg) commits a cash reserve, held by the firm managing the swap
or future, in this case the omnibus fund itself, of 20% of the notional amount. The
reserve is drawn down to meet payments required when market swings are averse,
and replenished when favorable. When it falls to 10% of the notional amount, it is
considered unsafe and the swap or future ends prematurely. Parties are warned,
and new reserves can be committed in time.
Monitoring of the reserve is continuous during market hours. Whenever the reserve
falls to 10%, even in the middle of the day, the account is closed immediately. This
discipline keeps the other party safe.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 4
Risk-averse clients in the omnibus fund can take short legs, and risk-tolerant ones
long legs. Management of the omnibus fund can handle the mechanics of the swaps
or futures.
The effect would be not less leverage per se, since leverage at the individual account
level is substituted for leverage at the corporate level. The difference is duration.
Swaps and futures are short-term commitments. Three months is typical. Futures
trade in active markets, for good measure, and can usually be liquidated in seconds
at current market during trading hours. So can ETFs themselves.
What do these derivatives cost? Essentially nothing. Those who prefer safety and
the short leg are matched with those who prefer return and the long leg, while the
manager charges only for its time in working the mechanics.
What About Asset Allocation?
Where the omnibus fund seems to violate common sense is in merging out what had
seemed to be valuable distinctions. So it would seem with the blending of equity and
debt claims, but for an optional overlay of derivatives such as futures to restore
whatever risk and expected return we want. Many distinctions blended out,
including that one, have been important to principles of asset allocation and modern
portfolio theory. They are important because some investment sectors are less
correlated than others, meaning less likely to risk and fall in lockstep. Lowcorrelation
portfolios are better because less volatile as a whole without sacrifice of
return. That’s why hedge funds typically assemble portfolios judged low or negative
in correlation, and then try to reduce correlation still further with an overlay of
derivatives. The omnibus fund seems to throw away all these options.
Not really. One of the lessons of the 2008 crash is that everything but Treasuries
tends to go down in high winds. Anti-correlation strategies failed when we most
needed them. The omnibus fund isn’t really giving up so much. Its exceptional
diversity makes it begin with less correlation than specializing portfolios. And
Chapter 8 Banks, Money and Macroeconomics 2/8/16 5
nothing would prevent a sophisticated investor in the omnibus fund from
manipulating correlation further down with derivatives as hedge funds do.
Liquidity, Risk and Return
Demand deposits in banks today can be withdrawn at any time. Time deposits
cannot be attracted without either competitive interest or quick liquidity. This
liquidity requirement has been awkward in that bank deposits are usually reloaned
for years. A run on the bank soon finds no cash left to meet withdrawals. The runs
come when the high winds blow, and provide a coup de grace on top of high default
rates.
The omnibus fund meets withdrawals easily because it is invested only in the most
liquid securities. ETFs trade in seconds at current market quotations. Any mutual
fund shares that might belong to the portfolio trade at current close.
Like most funds, the omnibus fund would also maintain cash. Like some others, it
would “equitize” its cash by exposing it to swaps or futures. Equitized cash leaves a
fund fully invested in effect, while adding instant liquidity around the clock. ETFs
give instant liquidity, but only during trading hours. Mutual funds typically trade at
market close only.
A risk-averse investor in the omnibus fund who opts for Libor plus so many basis
points is more or less in the same position as a bank depositor today. She knows
that her account will grow only by deposits and by interest (Libor plus basis points)
left in to compound. She knows that it will decline only by withdrawals. The investor
who prefers the long leg in swaps or futures, or stays unhedged, will also see her
account rise and fall with the market. There are infinite graduations around these
three simple choices. An account might be partly hedged and partly exposed, or
even over-exposed to a notional amount larger than the account size where law and
markets permit. (They usually do.)
Chapter 8 Banks, Money and Macroeconomics 2/8/16 6
Payment Mediation
Banks effect payments from depositors’ accounts. An omnibus fund can do the same.
Payments out are directed “redemptions” in the language of brokerage accounts, or
withdrawals in the language of bank accounts. Payments in are “subscriptions” to
brokers and their clients, or deposits to bankers.
All these payments can be electronic. A payer, typically a customer, might swipe a
card or click a screen. A payee, typically a vendor, typically must verify first that the
account is authentic and covers the payment offered. An omnibus fund could be well
suited to give this quick transparency.
First, it is essentially an index fund. It is composed of a published ratio of index ETFs
and index mutual funds and index-equitized cash. Individual accounts are then
hedged or exposed to index swaps or future overlays administered by the omnibus
fund itself. The fund can track all these indexes online, and knows from tick to tick
what each account is worth. This holds true even for volatile accounts where risktolerant
clients have opted for long legs in swaps and futures. So long as
management effects all payments in an out, and constructs each account of index
exposures itself, and tracks those exposures and payments in real time, it knows
account values exactly.
Risk-tolerant clients will expect daily ups and downs in account size. That means
that they will have to carry larger accounts in order to be sure of covering payments
in the downswings. That would be a problem if accounts yielded zero return, as
checkable bank deposits do. The gist of my answer to Milton Friedman was that no
amount of money is too much if it yields as much return as other assets of equal risk.
Accounts are hedged or leveraged to do so. Omnibus fund accounts burn no holes in
pockets. We do not own one to spend, like a checking account, and treat it as a drag
on earnings until spent. We own it as a fully competitive investment, and spend it
reluctantly when bills are presented.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 7
Why Invest in Indexes?
The last section showed that index funds offer easy trackability over market hours.
What are the other pros and cons?
On sound microeconomic principle, professional asset management will add value
over index results before deduction of fees. Otherwise they couldn’t stay in business.
The same principle says that the fees will converge to that pre-fee value added. Price
converges to marginal utility (value). Investors bid fees up when fees are less, and
down when they are more. As a rule of thumb, investors should expect to do equally
well in managed or index accounts when fee costs are considered too.
The mechanics of convergence is worth a look. Managed and index funds compete in
a kind of density-dependent flux like hawks and doves in game theory. It pays to be
a hawk when the hawk/dove ratio is too low, and a dove when too high. When
hawks have only hawks to fight, they will win only half the time. Fighting becomes a
losing strategy when it risks more than winning stands to gain. More doves will
mean easier contests.
So it is with asset managers. Index funds (doves) avoid commitment (fights) as to
which firms and sectors will outperform. This neutrality saves the costs of research
needed for commitment (fights). Asset managers (hawks) pay those costs, and
recover them when outperformance results. That means outperforming the index.
But if asset managers collectively managed the whole market, they would become
the index. Some would outperform others, but the whole group cannot outperform
itself. Then it could not recover its research costs. Many would have to close their
doors, leaving the field to index funds which don’t pay those costs, until market
equilibrium was restored.
Then what determines equilibrium? Is the critical variable percent of trades by
managed funds? I thought so for a while. Now I think it’s percent of AUM (market
value of assets under management). My reasoning now is that holds by portfolio
Chapter 8 Banks, Money and Macroeconomics 2/8/16 8
managers reveal informed opinion on security values as clearly as trades do.
Research cost is the same for both. If a manger neither buys nor sells, she tells us
that she thinks the price is right. The critical variable is not trade volume, but
percent of aggregate market cap controlled by asset managers collectively.
The number of asset managers is much less critical. There must be enough for
competition within each specialty or sector of investment. Too many is not a
concern. Abler ones, on microeconomic principle, will displace the less able. That’s
why Herbert Spencer taught that natural selection works the same in economics as
in biology.
A particular reason for preferring index ETFs as omnibus fund investments is for
cheaper liquidity. The omnibus fund must compete with banks in accommodating
payments and other withdrawals (redemptions). Popular index ETFs such as
spiders (SPDRs, for Standard and Poor’s Depository Receipts) are bought and sold in
seconds for a fee of a couple of basis points. So are Treasury ETFs. Thus the omnibus
fund might do best not to include actual corporate bond ETFs in reintegrating the
corporate sector. Treasuries of equal value should do about as well at much lower
trading cost. Easy liquidity is essential.
Why Omnibus?
Omnibus means for everyone as well as of everything. It is all-inclusive either way.
Individuals differ in risk tolerance. An omnibus fund provides for all. The portfolio
of index exposures to riskier equity claims and safer debt claims is meant to satisfy
average risk tolerance as a whole. Individual accounts then choose short-leg hedges
or long-leg exposure or anything between. An omnibus portfolio best matches
aggregate risk and return to individual claims on it.
Other approaches would work too. A broad-based equity index fund, targeting say
the S&P 500 or Russell 3000, could give the same tick-to-tick transparency in
individual accounts. Hedging would still be available to cater to individual risk
Chapter 8 Banks, Money and Macroeconomics 2/8/16 9
appetites within the risk-tolerant groups. A broad-based bond index fund would do
the same for the risk-averse.
It seems to me that the omnibus fund would do both jobs at once, and would attract
more clients collectively. Bigger is better for payment processing. The more clients,
the more “two-sided” payments from one client to another. These payments are
always cheapest.
If accounts cost little or nothing to open, vendors would logically need no urging to
open them. That again favors the simplicity and economy and immediacy of twosided
payments by including both buyers and sellers within the fund.
The omnibus fund is also for everyone as a investor as well as a payer. Very few
people have the time or training to beat the market. I myself have not. What we have
is a sense of our degree of risk-aversion. The omnibus fund gives the broadest and
most flexible coverage of risk appetites. It can poll and advise clients on risk
preferences, and mediate hedges and exposures to suit.
How the Omnibus Fund Might Evolve
I said that if I were a couple of decades younger, I would start an omnibus fund. Not
to worry. If the idea holds water, as I think, someone else will.
It seems to me that banks could not offer much competition. Demand deposits
typically pay no interest, and process payments no better. Omnibus clients offer an
infinite range of returns according to client tolerance for risk.
Banks offer the advantage of federal deposit insurance (FDIC). It will not be enough.
The omnibus fund carries no leverage, and needs no insurance. As it grows, banks
will take notice. They can keep up the uneven fight, or they can join the parade. My
working assumption is that many will prefer the latter. Banks are well positioned to
make the most of the idea. They have the needed expertise and systems and
Chapter 8 Banks, Money and Macroeconomics 2/8/16 10
clientele in place. They can spin off their lending operations as separate ventures to
find funds from investors rather than depositors.
If there were no FDIC, there would be no deposits and no commercial banks. People
can read the newspapers. Anyone old enough has lived through periodic bailouts.
I’m a free market fan who dislikes FDIC. But we would be rash to yank the rug from
under banks by repealing it. We shouldn’t even hint that we might. The world we
know is build around banks, and banks are built on FDIC. Let it stand. How can
anyone know for sure that omnibus funds and independent lending banks will do
better? I think omnibus funds figure to win despite that advantage for banks.
Lending Banks
This is the area least clear to me. Banks as we know them begin with expertise,
systems and clientele in the loans business as well as the deposit and payment
processing business. That could position them to take the lead in both if spun off
separately. Lending can stand alone. There are many lending firms other than banks.
They raise funds from investors seeking returns, rather than depositors seeking
liquidity, and somehow mange to compete with banks today. Lending banks
divorced from depositors could do whatever they do.
If interest rates must rise because investors demand competitive returns, some
traditional borrowers will be motivated to attract equity investment instead.
Corporations and other firms could phase out structural (long-term) debt, and float
new stock issues in its place. The effect would be to lower leverage, risk and return
together. Investors could then tailor risk and return more flexibly by hedging or
leveraging their individual holdings through professional services.
If the same rise in interest rates makes it impractical for newlyweds to buy homes,
they can rent until their means improve. In ten or fifteen years their incomes will
double. They will know if they are still married, how much house they need if so,
and where their careers have taken them. Meanwhile they might rent the same
Chapter 8 Banks, Money and Macroeconomics 2/8/16 11
house they would have bought. They will not have missed a sure-fire investment.
The crash of 2008 showed that houses are risky too. The time to commit to huge and
illiquid investments, as houses are, is after ten or fifteen years of business
experience.
I see no reason why lending banks should not make equity investments too. Loans,
convertible loans and equity investments need the same “due diligence”, or research
into prospects of success and return. All might serve the same clients. “Lending
banks” might simply be investment banks. That’s why splitting of investment banks
and commercial (deposit-and-lend) banks may be a step in the wrong direction. The
key is splitting off deposits.
Macroeconomics in General
Splitting up commercial banks into omnibus funds and depositless lending banks
could change the nature of macroeconomics. Macro has meant the art of maintaining
growth and money value stability at the same time. This has proved mostly a
tightrope walk between inflation and recession. Easy money risks the first, and tight
money the second. My idea is to disconnect the problems of underemployment and
money value instability. If medicine for one has no side effect on the other, each can
be treated more freely.
I would first dissociate money value from money supply. No supply is too large if
money earns competitive returns while we hold it. That was one of the main ideas of
the omnibus fund. Milton Friedman thought my early version of this idea was
anathema. Franco Modigliani liked it fine, but asked tough questions. I’ll try to
answer some of them below.
My approach to the problems of underemployment and the business cycle begins
with phasing out deposit-and-lend banks as I described. I more or less agree with
Chapter 8 Banks, Money and Macroeconomics 2/8/16 12
Ludwig von Mises and the Austrian school that slumps come from overinvestment
enabled by overlending. In 1928 1 , a year before the crash, Mises wrote:
Sooner or later, the crisis must inevitably break out as the result of change in the
conduct of the banks. The later the crack-up comes, the longer the period in which
the calculation of the entrepreneurs is misguided by the issue of additional fiduciary
media 2 . The greater this additional quantity of fiduciary money, the more factors of
production have been firmly committed in the form of investments which appeared
profitable only because of the artificially reduced interest rate and which prove to
be unprofitable… Great losses are sustained as a result of misdirected capital
investments. Many new structures remain unfinished. Others, already completed,
close down operations. Still others are carried on because, after writing off losses
which represent a waste of capital, operation of the existing structure pays at least
something.
Here Mises, writing in 1928, describes the crash of 2008 even more vividly than the
one in 1929. “Many new structures remain unfinished. Others, already completed,
close down operations.” These were mostly plant and office buildings in 1929, and
mostly houses in 2008.
Mises argued that money should be backed by precious metals. He was right in
thinking that it should be backed. But precious metals pay no return. The omnibus
fund earns competitive return at the risk level chosen in each account. Accounts are
owned for performance, and only incidentally for liquidity. No amount is so large as
to tempt overspending.
It did not occur to Mises that divorcement of deposits from lending might prevent
the cycle in the first place. Nor did he mention the danger of 10:1 bank leverage, and
often more, in amplifying consequences of bad guesses. His idea was better
governance of commercial banks. Mine is ending them.
Free growth theory also belongs to macroeconomics in that it predicts only at the
collective scale. It predicts that ex ante net investment, or attempted investment
1 Monetary Stabilization and Cyclical Policy.
2 Unbacked paper money. Also called government fiat money.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 13
beyond depreciation recovery, is simply less consumption with no growth to show
for it. My charts and tables show that this has been true wherever and whenever
tested, in eight economies over 40 to 140 years. We crowd our niches like other
creatures, I think, and have no room for growth except as innovation widens the
niche. The charts and tables seem to tell us that innovation costs no more in failure
rates and learning curves that daily coping does.
Macroeconomics and Keynes
Macro emerged in the 1930s under the influence of Keynes. Simon Kuznets, the chief
architect of the U.S. national accounts, was one of the five economists Keynes invited
to proof the chapters of his General Theory as he wrote them 3 . National accounts
were soon reorganized along Keynesian lines.
To read the General Theory, a beautiful work, one would think that counter opinions
were led by his close friend Arthur Pigou. But Pigou was already in print with
recommendations much like Keynes’ when it was published in 1936. Opposition
came rather from Mises, the other Austrians, Lionel Robbins and the Chicago school.
They argued that intervention tends to make things worse. So do many economists
today. Keynes believed in fiscal and monetary policy as I describe in Chapter 1. He
favored fiscal policy.
Chapter 2 said that he made a basic distinction between investment producing new
things and repurchase of things already produced. Only the first counted as real
investment. The difference matters because only the first puts plant and people to
work. Transfers neither add nor subtract value. Even so, my own language counts all
as investment, and ranks investment only by return. I make no distinction among
investment adding new plant and equipment, or investment in stocks and bonds
already issued, or in existing structures, or even under the mattress.
3 The others were Harrod, Sraffa, Joan Robinson and Ralph Hawtree.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 14
What matters is return. I don’t have to specify “risk-adjusted” return so long as I
describe the collective scale alone. Collective return is implicitly average-risk return.
I prioritize it on the reasoning that optimizing employment of people and plant is
implicit, and that optimizing means putting them to work most productively rather
than over the most hours.
If policy maximizes rate of return, at the collective scale, it will maximize true output
perforce. Return is output divided by total capital producing it. More return is more
output per unit capital. Putting idle plant and people to work, in a slump, is a step in
the right direction. But it doesn’t get the job done unless they work productively.
Even putting money under the mattress is better than investing at a loss. Zero
return is better than negative return. I accept Keynes’ distinction between new
investment and transfer payments. But I see the latter as part of the mechanics that
ends up in the former. Maximize return, and full employment will happen.
Keynes’ opposition is now mostly the Chicago school and other “freshwater” schools
bordering the Great Lakes and along inland rivers. Somehow the taste for Keynesian
intervention resonated best in “saltwater” seaboard school such as Harvard, MIT,
Stanford, and University of California. It is probably no coincidence that the
saltwater states are the “blue” ones tending to vote Democrat, while the freshwater
ones are the “red” ones favoring Republicans. (I call myself a free market Democrat,
whether or not that’s a contradiction in terms.) Freshwater views tend to oppose
intervention, but accept Keynesian basic definitions and equations such as the
Y = I + C doctrine and the distinction between “attempted saving” and investment.
It is these I question.
I don’t think much of his view that intended saving (consumption foregone)
becomes actual saving only if invested, and becomes an equal amount of physical
capital growth if it is. Then (actual) net saving, net investment and physical capital
growth would become synonymous. I said why I prefer a language where saving
and investment are synonymous in the first place. What matters is rate of return.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 15
Investment (saving) under the mattress yields only the psychic value of liquidity.
Actual capital growth depends on rate of return as much as amount invested. If
return holds the same as it was before, growth and net ex ante investment will be
equal. Growth will be less than consumption foregone (remembering the asterisks)
if return drops, and more if return rises.
Keynes saw slumps as investment deficits. I see them as return deficits. Keynes
assumed uncritically, I think, that new investment is the path out of slumps.
Investment will come when prospects of return do.
Although the General Theory was published three years before Myrdal’s ex ante – ex
post distinction, Keynes would have realized the same thing. I think he made the
understandable mistake of supposing that the difference would balance out as
random noise. The charts and tables show otherwise. The optimum ex ante
investment target is enough to offset realistic depreciation exactly.
Keynes was a great thinker, a lively writer and a decent man. I happen to endorse
some of his policy ideas. So did my father. When I asked him what he thought of
fiscal policy, I expected something like Hawtree’s “crowding out” argument:
government investment preempts and prevents private investment. I got a surprise.
My father said “When people are out of work, that’s the time to build a new post
office.” It is, if you need a new post office, because returns can be higher when
contractors strapped for options bid construction cost down.
But it is no disrespect to point that the General Theory was published 80 years ago. I
tend to support Keynes on some points, for example the usefulness of fiscal policy in
relieving slumps, but to agree mostly with Mises on their causes in the first place.
Where I differ from both is in the fundamental anatomy.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 16
Stabilizing Money Value
Modigliani’s main critique was that money earning full competitive return, so that
no amount was too much, would make monetary policy impossible in its usual
forms. My best answer at the time was that full-return money ought to remove
inflationary or deflationary pressures. But I agreed with him that money value
might drift, even so, and that some control would be a safeguard if someone could
think of a way.
The best that occurs to me is continuous revaluation of the dollar. Legal tender laws
specify dollars, or other currency in other countries, as the default means of
payment recognized in satisfying money obligations. Laws could be changed to
specify real dollars instead. Real means corrected for inflation or deflation.
This would have been impractical before the information age. The problem now
seems less. Spendable money, called M1, now means currency plus checking
accounts. Government publishes current inflation figures online. Omnibus accounts
could adjust automatically. They might show values in nominal and real dollars both.
Account value would not change. Correction for inflation would show fewer dollars
worth more each. Correction for deflation would show the opposite.
Currency itself cannot adjust so elegantly. It would remain legal tender, but not
necessarily at face value. Currency would impose a translation cost on its spenders
and receivers. Say for example that the change in legal tender laws was effective as
of January 1, 2020. The real value of the dollar, whether accounts or currency, would
mean its value of that baseline. Nominal value would be that plus inflation since.
Calculators or iPads could keep track of the conversion rate. The cost and nuisance
of this conversion should be manageable. But it would probably reduce demand for
currency where cards or the equivalent do as well. The benefit is in encouraging
long-term contracts and saving “menu change costs.” That means costs of changing
prices. There is no need to change them on account of inflation if prices are specified
in real rather than nominal dollars.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 17
Price stability can matter. The United States has managed to avoid double-digit
inflation since the Volker reforms of the 1980s. But the danger remains. Modigliani
was right to worry.
A law making real dollars legal tender might prompt better measurements of
inflation. Many economists agree that our official ones overstate inflation by
allowing two little for quality improvements. A Lexus or Tesla is not a Model A. That
was the theme of the Boskin Commission report to President Clinton in 1995. The
Boskin panel argued that quality-corrected inflation has run about 1.1% less than
the numbers posted in the consumer price index (CPI). I think so too. But making
real dollars legal tender, even by these imperfect measures, could still give more
confidence in long-term commitments than the status quo.
Speeding Up Fiscal Policy
Designating real rather than nominal dollars as legal tender would amount to an
unfamiliar and more direct form of monetary policy. Meanwhile devolution of banks
into their separate deposit and lending functions, along with emergence of omnibus
funds, need put no constraints on fiscal policy.
Fiscal policy has prescribed tax cuts and government spending in slumps. It
prescribes the opposite, at least in principle, in booms. A problem is that it has
proved slow to implement. There is an “inside lag” while government diagnoses the
problem and calls for a vote in the legislature. An “outside lag” follows until taxes
come due and spending programs are put together and gradually put plant and
people to work.
The inside lag is unavoidable in a democracy unless the executive branch, or an
independent agency like the Fed, is given standing limited authority to diagnose
early signs of unemployment, and to address them with tax cuts or spending. And
there must be enough outside lag to make sure that the medicine has good
prospects in rate of return. Return comes first.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 18
Tax cuts can be faster-acting than spending programs because they obviate the
construction period. Freshwater economists argue plausibly that they are likely to
prove ineffective. They foresee “rational expectations” of taxpayers as predicting
eventual restoration of the taxes when full employment resumes. This gives a
motive to save the tax cut rather than spend it as intended. I see it a little differently.
Most consumption is maintenance or investment to keep up human capital. We will
need that earning power when taxes are restored.
Say’s Law
Jean Baptiste Say, in writings I haven’t read, argued two centuries ago that supply
creates its own demand. The logic is sound to a point. The claims on output simplify
to pay plus profit. The asterisks don’t matter here. Thus pay plus profit is always
enough to clear that market. There could be “partial gluts” when we produced too
much of one thing and not enough of another, but never a “general glut” where
production got ahead of our means to pay for it.
All too true. Consumption plus investment equals pay plus profit. But the sad fact is
that profit can be negative. Deadweight loss happens. When it happens, at the
collective scale, even pay claims may be left unsatisfied. Say’s law gives no comfort
except where outcomes are as expected.
Tax Considerations
Schultz in 1962 argued that educational (human) capital is overtaxed. What he
wrote was: “The established tax treatment takes account of both depreciation and
obsolescence in the case of physical capital, but this accounting is not extended to
human capital”. He was right. Income tax is charged on net profit of firms and pay of
workers. Pay measures gross realized work including human depreciation.
Tax laws now counter that imbalance by applying lower rates to pay as “earned
income”. If we could measure human depreciation, or model it with enough
Chapter 8 Banks, Money and Macroeconomics 2/8/16 19
confidence, we would know how much correction was enough. That’s a reason to
take depreciation theory seriously.
Market-Valued Capital in Macroeconomics
Another reason why macro should be reconceived from scratch is that its defining
equations, written mostly over half a century ago, leave out capital. Change in capital
shows as net investment, but capital itself stays outside. Flows are considered
sufficient for description.
Piketty, a good economic historian, tells us that this did not have to be. It seems that
the largest economies had good records of market-valued capital since the latemiddle
nineteenth century. Piketty does not speculate why macro and national
accounts ignored them when both took form in the 1920s and 1930s.
Physical capital and its changes can be measured at market or calculated by the
perpetual inventory method used in balance sheets. I showed in Chapter 2 why that
method is not the best. Depreciation accounting assumes norms in the loss of capital
value with time, and gets the news of actual outcomes long after. National accounts
reported positive real net investment, meaning growth in capital value, in 1929,
1930, 1937 and 2008. They give little clue to reality in years of surprise.
The neglect of market-valued capital in macro and the national accounts until 1990
or so may have to do with the influence of Keynes. The General Theory includes
some hilarious broadsides on the fickleness of market speculators. He put more
trust in the sober disciplines of accounting. Piketty trusts the market more, and so
do I.
Then why does Piketty track new investment, or change in capital, by the accounting
methods used in national accounts? That seems inconsistent. My charts and tables
track it at market. It seems to me that national accounts should track it both ways,
Chapter 8 Banks, Money and Macroeconomics 2/8/16 20
and let each economist decide which version is more useful. Mine, at least, correctly
describes those same four years as losing ones.
National Accounts Overall
It seems to me that national accounts are doing nothing wrong except in modeling
the depreciation curve from misleading sales evidence. Evidence seems to show
depreciation as fast at first, and slower later. That tends to be true when depreciable
assets are actually sold. Structures tend to be customized for their original owners
and occupants. They tend to be resold when results are disappointing. This
disappointment often comes when expectations are first tested. When distressed
sellers market illiquid structures customized for themselves, prices too will be
disappointing.
Better to trust evidence of structures intended in the first place to pass from owner
to owner, as with many standardized rather than customized apartment and office
and warehouse buildings. Better still, from an economist’s viewpoint if not an
accountant’s, is to trust logic. Capital is present value of expected cash flow. Its loss
of value with time, under simplifying assumptions, is the present value of the most
distant and most discounted cash flow. Depreciation of structures we keep, rather
than sell, is least at first and greatest at the end. It is the same as with a levelpayment
mortgage.
National accounts are nonetheless a magnificent achievement. They need
interpretation just as corporate accounts do. That’s where economics comes in. And
national accounts are not resting on past practices. They can be congratulated on
including market valued capital, even if sixty years too late, and on extrapolating it
backward where practical. This book could scarcely have been written if they hadn’t.
I would recommend the obvious next step. Net investment should be shown
alternatively as change in market-valued, and output as that plus consumption. Let
economists decide which version is good for what.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 21
National Wealth Including Human Capital
By definition, pure consumption rate is pure consumption divided by total capital.
This can be arranged as
total capital =
pure consumption
pure consumptionrate . (8.1)
Next generation theory modeled the pure consumption rate as 3.5% per year.
Historical data showed dividend and interest rates as more or less in this region
since Sumerian times. I model pure consumption as about three fourths of all
consumption. I take consumption as personal consumption expenditure (PCE) plus
government consumption expenditure (GCE) per the national accounts.
GCE includes government outlays, at all levels of government, on education and
welfare. These are easily recognized as consumption. It also includes costs of law
enforcement, national defense, fire control, and maintenance of infrastructure such
as highways and water systems and government buildings. These too count as
consumption, even if we mightn’t have thought so. They are part of the cost of our
survival. That’s why I agree with Kuznets and tradition, although I didn’t always,
that consumption includes all of GCE.
PCE in 2015 shows as $12.429 trillion. GCE is reported at $2.5855 trillion. Both are
in 2015 dollars. their sum is $15.0145 trillion. Three fourths of that is $11.2609
trillion. Then (8.1) gives
total capital =
pure consumption
pure consumptionrate = $11.2609
.035/ year
= $321.74 trillion,
in 2015 dollars. This rough estimate can be borne in mind when we evaluate the tax
base and the risk of national debt. U.S. public and private debt together has been
Chapter 8 Banks, Money and Macroeconomics 2/8/16 22
estimated at a little less than a fourth of this sum. My impression is that this
exposure is not yet dangerous. But it needs watching.
The best method to estimate aggregate adult human capital separately is Petty’s. It
is present value of future human cash flow. That means pay less invested
consumption. If I am right, meaning that Farr, Marshall and Kiker are wrong,
invested consumption is negligible among adults. Then Petty was right to capitalize
pay with no deduction. And he was right to capitalize aggregate current pay, with no
need to model the future. Growth of pay will tend to match growth of human capital.
The discount rate to find its present value is expected rated of return. Rate of return
is growth rate plus cash flow rate. Evaluating human capital as constant current pay
discounted by cash flow rate alone will give the same answer as if we modeled in
expected pay growth, but then discounted at cash flow rate plus the same projected
growth rate.
Total human capital is adult capital plus that of the young. That part might be
measured at current cost. I won’t attempt either of those calculations here, since
they seem to call for economists expert in interpreting national accounts.
To Do List
Books and papers on economics tend to lead to “policy prescriptions”. That means
recommendations on what governments and markets and educators should do. My
list begins with getting rid of the double tax on dividends. To get democrats on
board, make the effect revenue neutral by raising the corporate tax rate. Dividend
rates have been far too low for about 50 years now. They should average 5% to 6%
real, as they did in the nineteenth century. The result of low dividends has been
dangerous overinvestment in the private sector, with growth hampered rather than
enhanced. Charts and tables make it clear that ex ante investment beyond
depreciation recovery is deadweight loss.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 23
I would tax capital gains as much as ordinary income for the same reason. Level the
playing field. Solow saw most of the truth, but didn’t go far enough. Mill saw more.
And even Mill stopped short. All we have to do is look at the charts and tables.
Capital accumulation does not exist. Any attempt lowers consumption with no
growth to show for it.
Keep track of national wealth including human capital by my method here, and also
by Petty’s of 1664, 1676 and 1685. What would we think of corporate management
that added up only the smaller part of corporate assets? We now consider physical
capital only. Political parties debate what taxes and the national debt should be
without the key facts.
Policy prescriptions can also aim at schools and what they teach. Macroeconomics
should start over. It reached most of its present form in the “years of high theory”, in
the 1920s through 1950s, without the concepts of human capital or market-valued
capital. It is founded on the inaccurate Y = C + I equation and the concomitant belief
that output equals pay plus profit. It recognizes ex ante – ex post distinctions only
crudely as to saving, by taking it as either invested or uninvested, and not at all as to
investment itself. By missing the lag between market effects and book reaction, it
misreads some of our worst years as our best and conversely.
The path forward is omnibus funds and devolution of commercial banks. Bank
reform along the lines I suggested should need no help from lawmakers. But for
gosh sakes, let’s not set up barriers against it. Commercial banks and 10:1 leverage
make slumps inevitable. Crashes are as sure as death and taxes until we phase them
out.
Summary
Macro has meant a tightrope walk between the risks of inflation and recession. That
doesn’t have to be. The problems are detachable. Even today, It should be practical
to redefine legal tender as real or inflation-corrected dollars. But the deeper
Chapter 8 Banks, Money and Macroeconomics 2/8/16 24
solution is to devolve commercial banks into their separate deposit and lending
functions, with separate stockholders and only incidental interaction.
It is best for the free market to do this alone. The omnibus fund could be the decisive
innovation. It too is possible today. It would offer clients full competitive return, so
that no supply would be too large. It would match bank deposits in liquidity and
payment services with the low service charges typical of other index funds, while
tailoring risk and return to client needs with essentially costless derivatives. The
intention would be obsolescence of bank accounts, and devolution of banks in result.
Deposit-and-lend banks, inevitably leveraged at 10:1 or more, are the weak link
explaining economic collapses about once a generation since the system was
founded in the Renaissance. Misdeeds and misguesses and world events were only
the proximate cause. Chicanery will be with us forever. Honest bad judgment will be
with us forever. Supply shocks, as when OPEC raised oil prices in 1973, will be with
us forever. Wars will be with us forever. Setbacks for our trading partners will be
with us forever. These bring the high winds. I don’t foresee much payout in trying to
dial down the winds by upgrading human nature. The payout is in stabler structures.
The big bad wolf huffed and puffed, and the brick house stood. Omnibus funds will
carry no leverage. Accounts themselves will be levered to taste, but for short periods
only. Futures trade in seconds. The fund as a whole cannot become worthless until
each and every security in its portfolio does. High winds and leverage can wipe out
the accounts of risk-takers who chose the long leg, but not of those who opted for
contractual interest and safety. That’s as it should be. Risk-takers may name their
poison. Omnibus means for all, and all-inclusive.
Derivatives are central to the omnibus fund idea. Some see them as dangerous. They
can be. They are powerful. But they have a good track record of performing as
contracted. Cash reserves, called margins, have proved enough to escape default
Chapter 8 Banks, Money and Macroeconomics 2/8/16 25
even in 2008 and the flash crash of 2013. Short legs have been protected without fail,
and long legs have got what they bargained for. The reason is that margin
sufficiency is monitored from tick to tick. Checking every few seconds doesn’t rule
out every doomsday scenario, but gives about as much confidence as we’re going to
find in this uncertain world.
Saltwater and freshwater schools debate the wisdom of fiscal and monetary policy.
But both sides frame their arguments in Keynesian language. I find it wanting. The
idea that intended consumption is either invested or not, and realized in equal
capital growth if it is, misses the essential mechanics. It measures employment of
plant and people in hours rather than in production. This is a good reason why
macro should start again from scratch. Another is to recast its basis equations in
terms of market-valued capital as well as flows. Another is to accommodate human
capital, for example by substituting the pay and Y rules for the doctrines that pay
measures work and that output is investment plus consumption.
None of those good reasons refers to the possibility of omnibus funds. They are only
a gleam in my eye. If they come to pass, and succeed as I imagine, macro will have
still more novelty to digest. If they lead to devolution into separate deposit and
lending banks, with the deposit banks operating as omnibus funds, good riddance to
the 10:1 leverage that has brought down economies every generation or so since
Marco Polo’s time.
The lagged flow method of assessing efficacy of ex ante investment is outdated by
the simultaneous rates one outlined in Chapter 4. It should go to honorable
retirement whenever market-valued capital is available. It superimposes the
inevitable unintended lag of accounts themselves, even under best practices, onto
the intended one needed for the new tree planted to bear fruit. Both lags blur
causality.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 26
Some famous economists are tougher on the current state of macro than I am.
Recent books argue that it should no longer be taught, and should receive no Nobel
prizes. My diagnosis is about the same. But my prescription is opposite. Reconceive
it from scratch, and teach it right. Award Nobel prizes to those who help. My first
nominees would be Piketty and Zucman. Not that I think much of Piketty’s
arguments. But his website with Zucman is as powerful a new resource for
scholarship and the database as national accounts were eight decades ago.
Chapter 8 Banks, Money and Macroeconomics 2/8/16 27
CHAPTER 9: SO WHAT’S NEW?
To claim originality in any field is rash. It is safer to say that some things in this book
are new as far as I know. I know at least what I can’t remember reading elsewhere. I
am more confident in judging what will surprise in the sense of conflict with what is
taught today. There we need only keep up with the current conversation. Judging
originality with confidence means having read everything before.
My surprises were not all new, and my novelties (if such) where not all surprises. A
few ideas met both descriptions. They pay rule, and the equally heretical Y rule,
probably count as both although Becker came within a step of getting there first.
Depreciation theory is likely to be both. Other possible candidates might include my
observation that holds by money managers reveal prices as clearly as trades do, and
my hawks-and-doves analogy inferring from this that index funds should
outperform managed ones when aggregate AUM held by money managers, not
trades by them, exceeds a critical percentage of the market to be determined. There
may also be both surprise and novelty in my suggestion of monetary policy by
establishment of real dollars as legal tender. In my wannabe biologist role, I just
may have been first to the point out the gaffe in the math of Hamilton’s rule.
Free growth theory takes Mill a little farther by ruling out growth by thrift at the
collective scale. It should prove a major surprise to lawmakers, who incentivize
thrift in the name of growth, and a milder one to economists already prepared by
the insights of Solow. My possible originality here was in the simultaneous rates
equations I derived to test them, and the test itself accessing data for market-valued
capital as well as consumption from the Piketty-Zucman website. My definitions of
market-valued net investment and net output, substituting for the book-valued
versions used in national accounts, were essential for testing. I suppose these rank
as novelties but not surprises.