Wriston, Walter B.
It has been said that when Gertrude Stein was dying, Alice B. Toklis inquired of her,"What is the answer?" to which Gertrude Stein replied,"What is the question?" The importance of asking the right question about capital formation and its market allocation is crucial to an understanding of the topic we are discussing today.
Whenever the regressive tax of inflation rises to the point where it becomes politically intolerable, each sector of our society attempts to explain our common dilemma in terms of how it affects them. The housing sector talks of disintermediation and depression. Labor avers that it is a victim and not the cause of the problem. Since business and finance need a constant injection of new capital investment, it is not unnatural that we see the continuance of capital flow as a problem. Questions are raised about where the necessary capital is going to come from to sustain employment and the output of goods and services. If all other things remain equal, the reasoning runs that increased capital investment means more production. More goods and services would relieve shortages, and thus ease pressure on the price level and drive down the rate of inflation. This scenario has a natural logic which commends it, but the hooker is in the qualifying phrase, "all other things remaining equal." Since most things in this world are comparative, it becomes pertinent to research and then to point out the higher investment being made by other industrial countries.
When the numbers are assembled, the suggestion is made that if America raised its rate of investment, this action might help hold our price level down. When we look around the world, it becomes clear that comparative totals of gross fixed investment as a percent of GNP put the U.S. at the bottom of the list with a rate of 18.2%. Japan is at the top with 36%, then France with 28%, and Germany with 26%. Unfortunately, these higher investment rates do not produce lower inflation. The fact is that Japan, the country with the highest rate of investment, also has the highest rate of inflation. France with the next highest rate of investment produces the next highest rate of inflation. Of all these countries the United States actually had the lowest inflation rate in 1973. In each country inflation has worsened this year. As we reflect upon these numbers, it becomes clear that unfortunately there is nothing in the relationship between levels of investment and inflation in this country or abroad to suggest that higher levels of capital formation - desirable as that goal must be - will save any nation from inflation.
It is inflation itself which produces the distortions in society which fuel the arguments being advanced about the present or impending capital shortage. On the one hand, inflation automatically increases the demand for credit to finance the same unit volume, and on the other hand, discourages anyone from saving his money - the only way to increase capital formation.
A recent study, released by the N.Y. Stock Exchange, indicated that there is now or soon will be a capital shortage or a capital gap of some $650MM. The language is graphic, recalling the famous missile gap which apparently disappeared the day after the election. The projected "capital gap" is a concept which is built upon a misconception. Each one of us in our business has a list of capital projects. Each division executive believes the project in his area, if not essential, is at least desirable. The aggregate total of all these division managers' lists of capital projects always exceeds our corporate resources. Similarly, if we were to compile a national shopping list, not of cost-justified demands, but rather of capital investment aspirations, the estimate of the financial resources to fulfill them would always fall short. It is a truism that if all the investments business might wish to make over the next ten or twenty years were compared with the expected volume of savings, we would today, as was always the case in the past, come up with a shortage.
There is nothing new about this concern. Worry over a perceived future shortfall of capital funds always surfaces during periods of high inflation. The frustration with problems spurs the search for explanations. The scenario is then presented that strong bidding by industry for funds to build plants and equipment is the major factor in driving up interest rates. Looking ahead to worse shortages of productive facilities produces fear of even higher rates. Implicit in this conclusion is the assumption that corporate management will be driven to raising capital at costs higher than can be justified by the rate of return on invested capital.
Interest rates are high today primarily because of inflation. Most of today's short-term borrowing goes to finance growing high-priced inventories and short-term working capital needs. This point stands out starkly by looking at just three numbers. The GNP of all the OECD nations in 1972 rose by $351 billion, of which about $225 billion, or almost 2/3rds was inflation financing and only $126 billion was real growth. The bidding for funds is strong and the rates are high because a great many borrowers believe that they can justify the costs against today's inflation-fueled profits.
Severe inflation has distorted the world money markets enormously. It has stimulated demands for short-term credit, and also increased the well-known inflation premium demanded by long-term lenders. Our monetary authorities have now cut the growth rate of money supply well below current inflation rates. These remedies are painful, but relatively short run. If prices were to rise at 10% over the next 10 or 15 years, inflation would have to be fed by an appropriately expansive money flow. As a result all the numbers would be bigger -- prices, accounting profits and interest rates. A lot of money would have to go simply to finance prices. It is popular now to talk in so-called "real terms," and to take the rate of inflation out of any wage or price numbers. If we play that game and subtract the effects of inflation from today's interest rates, there is no evidence that the remaining real rate is much higher than it was 15 years ago. Furthermore, it is not likely to be much higher 15 years from now unless the productivity or yield from capital investment increases. If inflation in 1990 is significantly higher than it is today, then market interest rates will also be higher. But this rise will not be due to some extraordinary demand for real capital in excess of supply. Borrowers are not knowingly going to bid interest rates beyond their ability to service debt from the return on capital.
The fear of a capital shortage is exacerbated by characterizing the problems of our present financial markets as symptomatic of our inability to finance capital inflation. Behind the scare headlines our markets are functioning. You should know that through the first eight months of 1974 business borrowings from banks increased at a compound annual growth rate of more than 16%. During the same period, long-term bond markets have provided nearly $16 billion, or 15%, more than in the comparable period last year. Todays low values in the stock exchanges make it appear uneconomic to raise equity money. The low price-earnings multiples reflect, to some extent, the market's perception of the irrelevance of FIFO accounting in an inflationary economy. Since capital is what we save out of our income, it is clear that the limit of its formation is the limit on how much we produce. The efficiency of the financial markets that collect and then distribute this capital is important. One of the major, but largely unspoken problems in achieving a better rate of capital formation in our country is the fragmentation of our savings streams.
There is no logical reason why the housing business should be financed very largely by the savings institutions at a rate to the borrower which is subsidized by penalizing the working man. The small saver is told his savings cannot earn what an affluent person's can, so that a home buyer can get a mortgage at below market rates. The political perception has grown up that financing of housing at artificially low interest rates is socially good. The government has decreed, in effect, that the savings of the workers should be penalized through interest ceilings in order to provide home buyers with a low rate. Usury ceilings in many states are intended ostensibly to protect borrowers against paying excessive rates. In reality such restrictions simply prevent the borrower from bidding in free markets. The "protection" is so complete, he receives no credit at all.
On the other hand, industry, which supplies the majority of jobs in America, has little access to the savings accounts of the workers. Indeed even the U.S. government has one rate for the poor and a higher one for the affluent. This is the way a government-mandated credit-allocation system works -- it produces shortages and inequities.
The siren song of capital allocation according to social priorities is now wafting through the Halls of Congress. Much of the impetus to this cause is supplied by the wonderful people who brought us price and wage controls. We have only to read the papers to know that today's social priority is tomorrow's tax loophole. If you are skeptical, think of the attack on depletion allowances in the midst of an energy crisis or the criticism of tax shelters in housing with that industry slowed to a crawl. Our value systems will change faster than our Congress changes, but slower than our technology. Those who employ the erroneous shopping-list approach to establishing a capital shortage may unwittingly invite an equally erroneous solution -- capital allocation by government. Only a free market can efficiently and equitably allocate credit and capital. The so-called shortfall in capital produced b y comparing projected capital formation with our hopes and dreams will be resolved in the same way it has always been resolved: That is by canceling or reducing those capital investments which cannot be economically justified. This was the fate, for example, of the proposed $20 billion capital expenditure to return the Potomac River to its pristine state. As some capital investments terminate and others take their place, our living standards and life styles are shaped differently from what we might expect, or they might fail to rise to the expectations of business, government and consumers. But the failure of living standards to rise to our expectations will be determined not as much by the quantity of capital formation as by the quality of capital formation.
I suggest to you that the real question regarding capital formation and its market allocation is not the amount available, or in what time frame the capital may be formed, but rather what is its purpose. To my mind, at least, the purpose of capital is to put in place the various tools which will permit our society to increase its productivity. The productivity of manual workers is very largely related to the efficiency of the machines which they operate. While this appears to be self-evident, not too many people have taken the second step in the thought process. This point was made most cogently by Peter Drucker when he said: "A little reflection will show that the rate of capital formation, to which economists give so much attention, is a secondary factor. Someone must plan and design the equipment - a conceptual, theoretical, and analytical task - before it can be installed and used. The basic factor in an economy's development must be the rate of 'brain formation', the rate at which a country produces people with imagination and vision, education, and theoretical and analytical skills." The capital problems of the 70's and 80's can be divided into two categories: money capital and intellectual capital. The money needs of industry are generally reflected by numbers which appear to be finite even though the underlying input is often at best an educated guess. A few examples will illustrate the point:
In 1948 the Pennsylvania Turnpike, the grandfather of major American toll roads, floated a bond issue of $134 million. That year government and private borrowers raised a grand total of $14 billion in American capital markets. If some study group had forecast in 1948 that toll road construction would require $3 1/2 billion over the next eight years, certainly the specter of a capital shortage would have reared its head. But by the time the roads were built, the size of the capital markets more than doubled.
Similarly in the mid-1950's, when the capital markets provided an average of about $30 billion, the computer industry and the airlines, to name just two, did not figure prominently in any widely publicized list for capital investment. Yet, the airlines raised more than $7 billion and the computer industry more than $2 billion through underwriters in the U.S. capital markets in the 1960's.
In those industries where technology has been advanced and where productivity has been relatively high, capital investment has grown rapidly. On the other hand, when technology has failed to produce sufficiently large increases in the rate of return on capital invested, money has dried up. This is another way of saying that superior intellectual capital has always attracted the necessary financial capital over time because it produces a sufficiently attractive real rate of return.
Changes in our tax laws and changes in regulations which would remove some of the impediments to a higher savings rate would certainly contribute to enlarged capital formation. A number of specific proposals were advanced at the recent Economic Summit by leading businessmen. Many of these have great merit in and of themselves. But these changes, in my view, cannot honestly be sought on the grounds that they will prevent higher interest rates, or that they will close the so-called "capital gap," or that they will solve the problem of inflation. These are the wrong reasons to use to support a very desirable end. Instead, proposals to ease taxes on capital growth, to liberalize depreciation allowances, to remove restrictive government regulations which drive up prices, as well as a whole new strategy to encourage both intellectual and money capital formation, are desirable because they will produce an improved standard of living. They will help us to improve the ecology. They will help to provide more energy and more food for a world where political tensions are mounting because of both real and artificial inadequacies in these two areas alone.
As individuals must be encouraged to save their money, so also business ought to operate in an atmosphere which encourages its earnings potential. What we are seeing now is just the reverse. Various members of our government constantly talk about profits as if they were not part of our capital formation process. We have even witnessed the economic non sequitur of government regulatory agencies saying that industries should not concentrate on earning a profit, but instead should build up capital. Even in a booming stock market, very few people I run into want to buy a security of a company that doesn't earn money. If we want to achieve the necessary goal of expanding the capital pool, we have to concentrate on creating a climate by which both individuals and business are encouraged to save. People will only save their money if, as the saying goes, it will be worth something someday. Unless and until we get our inflation under control, there is no incentive to save.