20 June 2019

Why cash might not be king

Whilst I don’t think I have the answers to why populism is prevalent now...

by James Godrich

Fund Manager

Whilst I don’t think I have the answers to why populism is prevalent now, I do find it interesting that the rise of a type of politics that, according to the Oxford English Dictionary, ‘strives to appeal to ordinary people who feel that their concerns are disregarded by established elite groups’ comes at the same time as ordinary labour workers see their share of overall income diminish.

In economics terms, the functional distribution of income describes the division of income between labour and capital. Between 1950 and 1995 that share of US national income being paid to labour workers has averaged slightly above 63%, with a fairly strong tendency to mean revert on a short time horizon. Since the turn of the century though, that number has fallen steadily and today stands at more like 57%. All of this is to say that a greater proportion of profits are being taken by capital providers (i.e. shareholders). The question for us is why this has happened, whether this trend might continue and how it could ultimately end?

Crucial to the divergence in the share of income has been the weakening bargaining position of workers. This has come about through a combination of labour off-shoring, technological replacements and the diminishing power of the Trade Unions. If I, as a worker, was worried that my employer could off-shore my job to a lower cost region or country, replace my output with that of a computer or that I could no longer join with my colleagues as part of a union, my ability to bargain for higher wages and share in any productivity gains would be significantly reduced.

A greater proportion of profits are being taken by shareholders.

At the same time as weakening labour power, there has been a rise in corporate power driven by industry consolidation and growing oligopolistic power amongst some firms, particularly in the tech sector. For example, Google in web searches, Facebook in social media and Amazon in online retailing.

There has been some research into the formation and break up of cartels, a market structure similar to what economists might describe as a ‘rational oligopoly’. After studying over 500 cases between 1961 and 2013, economists Margaret Levenstein and Valerie Suslow concluded that the most important factor was interest rates; where interest rates are low, market participants more easily show the necessary patience to build up market dominance. When interest rates are higher, there is greater emphasis placed on immediate rates of return and thus, increased competition. An interesting observation given the extended period of historically low interest rates that we are currently experiencing.

Given that it is difficult to see any of these trends reversing any time soon, it is not unreasonable to assume that income shares between labour and capital are set to continue to diverge resulting in increased wealth and income inequality. In fact, in his book ‘Tracing the global history of inequality from the Stone Age to today’, Walter Scheidel argues that, according to thousands of years of history, mass violence and catastrophes are the only forces that can seriously decrease economic inequality.

Whilst this has been the case in the past, I believe that there may be differences in modern day society which could lead to a different result. These included improved healthcare which should reduce the chances of pandemic illness, greater understanding of the no-win situation that is global warfare, but most importantly the introduction of universal suffrage, which in the UK was only introduced as recently as 1918.

When interest rates are higher, there is greater emphasis placed on immediate rates of return and thus, increased competition.

Where the working class were only important to the elite to the extent that their health and well-being would be a key component of any country’s military strength as foot soldiers, universal suffrage has introduced a more democratic society in which political agendas are driven by the will of ordinary people as well as the established elite. The kind of environment that might encourage a rise in populist politics perhaps.

So given the conditions of rising inequality and the will of the people in place, what could be the possible outcomes of populist political intervention? Whilst socialism and nationalisation is a clear risk that is getting much airtime at the moment, I would argue that a greater threat would be government policy targeting higher inflation. This could occur through the break-up of deflationary tech firms (Amazon can charge low prices in their Retail operations because they make vast profits in their Cloud Computing business) or through the reformation of the Central Bank mandates which, generally speaking, target low and stable inflation.

A Major Divergence in Income Shares

Higher inflation acts as a wealth transfer from lenders to debtors by reducing the real value of debt. This would also significantly reduce the real value of cash balances and any equity investments whose underlying business doesn’t enjoy strong pricing power. The impact would clearly be a reduction in wealth inequality and perhaps a return to central politics.

Whilst this isn’t something that is going to happen overnight, it is not unreasonable to prepare for a world where cash might not be king and capital preservation is the name of the game.

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