In our previous blog we discussed a possible sequence of events when a new Oven company enters the scene.  The production structure has been deepened, with a benefit for consumers who are able to consume more or better products in the future. In this blog we will discuss on what basis investors and entrepreneurs deserve their returns or profits.

We will discuss this question based on table 11, where we ended blog 3 (apologies for the odd signals, please find below a different version). Based on the final outcome in period 21, we concluded this to be a process, where all parties benefitted.

The Bakery benefits by being able to increase her profits. In periods 13 and 17, she invested 4 into a new oven. She could have consumed this money, but preferred to invest. Would she require a 10% (or more0 return on this investment or could we conclude differently?

The Bakery workers invested 3 in the Oven Company. In blog 3 we assumed they required a return of at least 10% annually, due to time preference and in order to be compensated for not being able to use (exchange) this money.

Table 11

First, we have to discuss the concept of profits and returns.

In Austrian theory, it is assumed that perfect knowledge is not available. This means there are opportunities for entrepreneurs by being alert to unnoticed opportunities and to act upon them. The entrepreneur plays an important role in the market process in moving towards a (new) equilibrium situation. In an equilibrium world there is no need for entrepreneurs, because there are no unnoticed opportunities left. In this equilibrium, people apparently know exactly what they want and what resources and possibilities are available. In reality however, the means and the ends are not given or known to everyone and unnoticed opportunities always exist[i].

Every person can be an entrepreneur. No capital is required for being an entrepreneur, just the ability to being alert and to act on opportunities. Ownership and entrepreneurship are separate functions. People with money can provide the entrepreneur the capital to pursue their entrepreneurship. In return for providing capital, investors  will receive a sufficiently attractive interest rate return. Kirzner (in Competition and Entrepreneurship) explains that in reality it is difficult to make a perfect distinction between capital providers and entrepreneurs. For instance, lending the money to the right entrepreneur also requires skills.

According to for instance Mises[ii] the required return on investments consists of:

–       Time preference, or the ‘natural interest rate’: Austrian theory explains time preference applies to any time market and for all capital. So, interest not only applies to the loan market. It is even the other way around, the interest rates as established on the loan market follow the natural rate as established on the ‘time market’.

–       Risk compensation: the more riskier a venture or counterpart, the higher return is required to compensate for this risk.

–       Inflation: investors will take into account any possible loss in purchasing power, due to price changes and will require to be compensated.

In summary:

Rr = Rn + Rrisk + Pe                                                                           (A)

Rr is the Required Return.

Rn is the natural interest rate. Rn applies to both equity and bond investors. The natural rate applies to all time markets.

Rrisk is the risk premium (additional return to compensate for counterparty risk). Rrisk will be different for bonds versus equities, even if this applies to the same lender (such as the Oven company), with a higher risk premium for more risk equity ventures. This is due to the subordinated nature of bonds versus equities. In general this should also result in better upside potential return of equity investments.

Pe is the loss in purchasing power (price increases). Pe is related to price levels and can only be determined by each investors individually. A rough estimate could be the CPI number published by governments. In our examples so far, this number would have been negative.

According to CAPM the Required (or Expected) Return (Re) is as follows:

Re = Rf + Beta * ( Rm –  Rf)                                                                 (B)

Rf is the risk free return.
Rm is the market return. Usually Rm applies to the returns on the equity market or the credit bond market. Beta is an indication of riskiness: the more risk you take, the more you want to be compensated for taking this risk.

I believe a risk free rate as such does not exist. Obviously, any government could print money and ‘ safely’  return any money. However, in that case you will not get the same money back, but probably money with less purchasing power. For that purchasing loss, a lender wants to be compensated. The Beta equals 1 in case the risk of the counterpart is the same as the risk of the entire ‘market’. Beta equals more than 1 in case of more risky ventures. B can then be rewritten as:

Re = Rm + Risk* Rm + Pe                                                                   (C)

If we assume Rm to be the natural rate, in formula C we have linked formula A to B. By the way, Pe could also be negative in formula C. However if investors expect a significant price decline, they would not invest. Rr always has to be positive. This is one of the fundamental assumptions of Human Action: a person always prefers a good now, rather than in the future. In case of expectations of severe price declines, there would be less investing in capital. This would reduce the supply of goods over time, driving up prices again. This is another reason, added to the ones mentioned in blog nr 2 of these series, that a downward trend in prices would not occur in a free market.

In our Bakery and Oven world this would be applied as follows:

The Oven Company earns a profit due to the skills of the employee. The employee-entrepreneur buys materials cheaply and sells it at a higher price to the Bakery, in a few years’ time. For this skill the entrepreneur-employee receives a salary and a bonus (in period 18). The employee needs money though to invest in capital. This money is received from the investors.

The investors are making an absolute money return of 2 on their investment of 3. They require such a return, based on the formula’s A, B and C. They may require this return, but they cannot be sure what return to expect. Part of the realized return of 2 is due to the skills of the entrepreneur-employee they have hired. The investor’s realized return depends on this entrepreneurial skill, but also on their own skills and alertness in hiring the right employee.

The Bakery is also the entrepreneur. In blog 1 she received capital from all other persons in the economy. Her profit was purely entrepreneurial skill. In period 13, in table 11, the Bakery invested 4 into buying an oven (and in period 17 even 5). She could have consumed the 4, in period 13, but decided to invest the money. What compensation does she require? She will start generating higher profits in the periods after the investment. As such, she prefers a compensation, in our case of 10% a year. This is more complicated to calculate, because each period she receives a somewhat higher profit (An Internal Rate of Return, IRR, should be calculate). For sure however, in period 17, she will have received the required returns (10.4), based on which she comfortably invests another 5.

Interesting question is, how long can the Bakery extend her profit growth?  Can she expect to keep on generating 10% a year from period 13 onwards? In period 38, her profit would then be 43.  This is not possible, because there is only 40 of money available in the economy. In the next blog we will discuss if or how all investors and participants can keep on generating (real) returns and how this is related to improving the welfare of all people.

Last month, September 7,  we introduced the concept of capital in numerical blog 2. In that blog, we explained what happens to ‘our economy’ when the Bakery bought a readily made oven. In this blog we will discuss how investors can be remunerated and how all participants in the economy benefit from investing in capital. We will build on the example developed in numerical blog 2.

In reality, the Bakery has to maintain her capital, the oven. The oven will probably wear down or in the worst case stop functioning after a good number of years/periods. This requires investing. We assume the oven the Bakery bought in period 13 wears down in 4 years. So in 4 years’ time the Bakery needs to invest another 4.

This is shown in table 10 below.  Instead of wage going up to 0.6 in period 16 (as we did in blog 2) we here assume it goes up to only 0.575, because the Bakery needs to save some money to invest in a new oven in 4 years’ time.  Otherwise, the Bakery would not be able to increase her own profits. From period 13 to 17, her profits increase by 50%, so more than 10% a year.

Table 10

In period 14, the consumers consume 24 (60 bread at a price of 0.4) and receive total salary of 20 (40 times 0.5). In period 17, we see their total salary rising to 23. The situation in period 21 is the same as  in period 17. Consequently, a new sort of equilibrium arises in this example in period 21. From period 17 to 21, the Bakery’s profits has not gone up, despite her investment in the oven.  The consumers can still only buy 60 bread. Also, it is highly unlikely the Bakery can keep on buying readily made ovens. We therefore create another scenario, in which all parties stand to benefit AND we will introduce an Oven Company.

We assume 1 worker leaves the Bakery company and joins the new Oven company in period 13, as illustrated in table 11. The ‘hoard’ will be assumed to be equally divided between all people, so 19.5 belong to the people working at the Bakery and 0.5 at the Oven maker. Instead of the Bakery buying a readily made oven in period 17, she will buy an oven which has been produced in 4 years’ time. This requires savings to be invested in a new capital structure.

We assume an investment of 3 in the Oven Company is required. The people with money are the Bakery workers. They decide to invest 3. The production structure has been deepened. The investors want to be remunerated, based on their time preference, by at least 10% annually. We assume some (hopefully realistic) assumptions how this money gets invested.

Of this 3, 1 will be invested in materials. The money invested in materials has to end up somewhere. We assume that in period 14 this amount will be added to the money owned (hoarded) by the Bakery consumer/workers. Their cash hoard will as such increase by 1. In table 11, the Hoard of the Bakery workers declines from 19.5 to 13.6, due to
– the investment of 3 in the oven maker
– the fact that the consumers consume 3.9 more than they earn in salary
– The increase of 1 in materials
The remaining 2 is needed for salary, for a 4 year period. So, the Oven maker receives 3 in period 14, pays 0.5 a salary each period and 1 in materials in period 14. The money invested in the Oven maker is invested via equity. We could have introduced a bank to arrange a loan to the Oven maker, if the Consumer Bakery workers had deposited part of their hoarded money at the bank. We will discuss required returns of equity versus bonds in the next blog.

We here assume the Bakery is willing to buy the oven for 5, in period 17. Because the oven maker is owned by (all) Bakery workers, all proceeds will be theirs and their cash hoard goes up by 5 in period 17 (and 21). The return of 2 to the Oven Company investors is almost 14% annually, based on their investment of 3.

In period 14, the Bakery workers consume 23.4 of bread and the oven  worker consumes another 1 ½ bread at 0.6. In other words, total bread consumption stays 24. Consumer Bakery workers make 21.4 in salary, based on a salary of 0.55. The oven worker makes 0.5 of salary. In period 18 this person receives a bonus of 1, from the equity owners for an outstanding performance (we assume here that the proceeds of selling the materials will be awarded to the over maker, simply because all parties involved believe this is well deserved).

In period 21, the Bakery buys another oven at 5. You can check if the total money supply equals 40 in each period, by adding up the amounts in possession by all market participants each period.

We assume the price of bread goes down to 0.3 in period 18 and that the Bakery produces 80 bread. This is made possible by the excellent ovens and improved productivity. Bread turnover remains 24. Based on the final outcome in period 21, this looks like a balanced out solution, where all parties stand to benefit.

Table 11

The profits of the Bakery firm rises gently.  Her purchasing power has improved as well, because ‘prices’, in this case the price of bread, have declined. Also, the oven worker has been able to improve his position.

The cash hoard of the workers decreases throughout the whole period, ending up at 6.6. This obviously, is the counterpart of increased profits.  Total money supply remains the same. But, is it logical for consumers to be willing to reduce their cash holdings?  Wouldn’t their demand for money develop differently?

At a price of bread of 0.3, the final purchasing power of the consumers (hoarded cash plus salary), in terms of number of bread has increased significantly. In period 13 consumers had 40 of money (20 salary and the rest hoarded in possession). At a price of 0.5, this results in a purchasing power of 80 bread. For other periods this looks as follows:

Table 12

If the money supply does not increase and if profits are rising, due to required return on investments and time preferences, the way to make it worthwhile for all parties involved is for prices to drop OR for the quality of products to have improved (very important to emphasize).

It could well be that the new oven makes it possible to produce much better quality of bread, but not to produce more bread. In that case, prices could have remained the same. But, consumers would probably be equally happy. In table 12, in period 21, their purchasing power numerically would have gone down though. This illustrates that (subjective) values cannot be measured.

It also illustrates the shortcomings of calculating price indices (CPI). How to take into account quality improvements? Same applies to GDP. Maybe people prefer to work less (leisure as an economic good) and prices as well as GDP could decline. People could however still feel to be better off.

Obviously, no one knows the course of events. According to Austrian theory, in a free market entrepreneurs know well the potential consumer demand and investors are able to make the right investment decisions. In a competitive world, if consumers prefer more bread instead of better quality bread, the Bakery that produce more and cheaper bread stands to benefit.

In the next blog we will discuss profits and returns in relation to CAPM and the above mentioned.

As explained by ‘the Austrians’, as long as central banks intervene by monetary stimulus, interest rates will be depressed and kept below the ‘natural rate’.  The Austrian Business Cycle Theory (ABCT) explains how this results in mal-investments, over-consumption and a welfare opportunity loss.  As soon as central banks stop their inflationary policies, interest rates will tend to rise towards the natural rates.  The natural rate means as determined by a free market, based on time preferences.  In general, these natural interest rates are higher than the low interest rates as manipulated by central banks.

On September 18, the FED decided not to taper and decided not to change their Quantitative Easing (QE) program.  Markets assumed the FED would taper, by starting to reduce their monthly buying program of $85 billion worth of US bonds each month.  The weeks before September 18, interest rates went up. This is logical, because the market assumed the FED would intervene less, so interest rates in the US and Europe started rising towards ‘their natural rates’.

However, the decision not to taper meant the markets were no longer sure if or when the FED would stop quant easing. Interest rates went down again after September 18.  Generally speaking, long interest rates globally (say 10 year rates) are higher than they were the beginning of 2013, but rates are around 0.2% below their year highs.  Markets were  confused. Gold prices rose at first, after September 18,  but came down the weeks thereafter. Equity markets are now below the levels just before September 18, although still significantly up since beginning 2013. The FED is playing games with the market, by first signaling to taper and then not to taper. It is highly likely Mrs. Yellen will succeed Mr. Bernanke and be the next FED-boss. She is even a bigger fan of QE than Mr. Bernanke.  If the FED keeps on easing, they may well be able to succeed in keeping interest rates low for a long time. 

Mises and ‘the Austrians’ are very clear about inflationary policies (as in to ‘quant ease’):  an increase in money supply confers no (direct) identifiable social welfare.  In Human Action (p417) Mises pointed out that all that ‘cash induced changes in purchasing power bring about are shifts of wealth among individuals’.  This is without taking into account the impact of over-consumption and mal-investments, due to the lower interest rates, on our current welfare, as explained by the ABCT.

Inflationary policy (quant easing) therefore is almost like a zero-sum game, at best. Because a free market always maximizes the utility of the existing money supply, changes in the money supply have zero-sum game characteristics.  Some individuals are made better off; others are made worse off.  Mises argued that the losses of the late-coming losers are the source of income for the early arrival winners. However, because social welfare cannot be measured, we cannot be sure if it is precisely zero-sum. We can say though that institutions close to the money creation process will win. This may be the reason why it is very difficult for the FED to taper: they may start losing when they start tapering. The FED grew nervous when interest rates started to rise, the weeks before September 18. Maybe (who knows) they were worried about:

–         The upcoming Federal budget challenges and impact on the economy
–         US bank high reserves with the FED ($2200 bln). When banks want to increase lending, there is hardly any room to raise deposit rates to control price inflation.
–         With rising rates, the FED will realize a loss on their bond investments. If the FED wants to reduce bank reserves (possibly to control inflation) by selling bonds, they will realize these losses.-         The FED’s capital ratio’s are extremely low and will not improve when rates rise.

 This all could mean QE will be with us for quite some time to come. So far this year, QE was good for equity markets.  How long can the FED hold on to their inflationary policies and keep interest rates low?  One thing is for sure:  the public at large rightfully FEELS they are losing this game.  Especially when taking into account the consequences of over-consumption and a loss in future purchasing power, due to lack of productive investments. But the public at large appears not to realize this is mainly due to central bank inflationary policy. The government is very good at playing games.

Heiko de Boer

This month, September 2013, the FED is meant to start winding down the Quantitative Easing program, by commentators described as tapering. This means the winding down of a continuous buying program, in which the FED buys for US$ 85 billion of US bonds each month. Markets responded enthusiastically. Major developed equity indices have risen 10% to 15% year to date. US and European Interest rates are ‘normalizing’ and have bounced from all-time lows.

Apparently, we now believe Quant Easing is a normal and beneficial practice. I disagree: End 2013, the FED will own bonds with value equaling about 18% of US GDP.  This is a ridiculous situation. We have never experienced the winding down of programs this size, in history. We are in uncharted territory, and should follow developments critically. My main question is: will the public at large benefit?  Does the consumer benefit from any quantitative easing policy on the long run?

Commentators say the US is recovering nicely, Europe is lagging a bit behind, but Euro growth is expected to pick up again. High current stock prices are illustrative of this expectation. Politicians and governments need growth to be able to pay back their debts. But, what is growth exactly?  To them it is merely an increase in (nominal) GDP? Do the common people also care about this nominal growth? I do not think so, and believe the people care much more about:

–       Real growth. The ECB (and others) report that real GDP in Euroland contracted 0.5% in 2012 and will probably be negative in 2013 as well.

–       Growth in purchasing power : In the end, consumers want to consume more in the future. In general, this means their purchasing power should go up. With ongoing inflationary policies and money not invested properly, it is almost impossible for real income to go up. I think this is what most people in almost all European countries are experiencing today.

–       Items as clean air and leisure are also economic goods, but are not included in GDP. Throughout the developed world, people have to work longer (retirement age is on the rise) and more. 10% of working people in Germany have a ‘second job’. So, nominal GDP may be up, but among others at the expense of leisure, which is also an economic good.

The consumers in my opinion do NOT benefit from inflationary policies.

In May 2012, the ECB published an interesting article comparing the recent financial crisis in the US and the Euro area with the experience of Japan in the 1990s. In the entire article, nowhere is mentioned the impact of central bank’s policies on the position of consumers. As if the position of consumers is totally irrelevant in analyzing consequences of any economic policy.

The article describes differences between Japan then and US and Euro Area now. In Japan the corporate sector was heavily indebted. In the US and Euroland it was households followed by governments who were heavily indebted. The similarities are equally obvious. In first instance, there was a boom due to huge credit growth, followed by a bust. Fiscal stimulus and quantitative easing did not work optimally in Japan. All developments were and are illustrations of the classical Austrian Business Cycle Theory (ABCT).

The article mentions that ‘Structural reforms are the solution’, ‘The debt crisis has brought to the fore structural shortcomings in institutional arrangement’ and ‘Concrete measures aimed at a return to sound public finances, …, represent welcome steps in the direction of a durable recovery’.

But, what do economist and central bankers mean by structural reforms?  It’s a magic word, but I have no clue what this means. More regulations?  How do reforms improve shortcomings in ‘institutional arrangements’ and what does this mean or how would it prevent a credit boom a next time? Public debt has only gone up in Europe the last years, so all policies have not led to sounds public finances.    Yes, nominal GDP is on the rise, but this is not the way for the public at large to benefit.

The article, the reports on declining real growth and declining purchasing power (in the Netherlands in any case) confirm to me that quantitative easing and other inflationary policies have not worked. In any case, the consumer does NOT stand to benefit.

To me it is obvious, the only way to increase a country’s welfare is to properly invest in productive capital. This improves our productivity, based on which in the future we can produce more with our given resources. This is the only route towards a sustainable recovery, improving the position of the public at large and the consumer specifically.

One way to look at trends in investing in capital, is by monitoring the gross fixed capital formation. In the developed world we see that, (even nominal) gross fixed capital formation in various developed markets is on the decline, for a very long period already. See http://data.worldbank.org/. US is in decline and Germany and France hardly improving. China (and probably various other emerging markets) are adding to their capital formation. However, the main source of this and the main source of upwards revisions in Chinese GDP forecasts (to more than 7.5% in 2013) has been an increase in quasi-state enterprise spending. Nonetheless, for now, Chinese consumers seem to be better positioned for the future.

Consumers in developed markets will be in a difficult position for many years to come. Politicians and central bankers do not seem to realize. However, the public at large does. To me this makes sense and explains why for instance Dutch consumer voters are not happy with their government. Were they only to realize that the solution is less (inflationary) government (policies), this would make even more sense to me. Hopefully this blog contributes to this notion.