Macro Roundup

“…The average venture-capital fund launched in 2011 outperformed the S&P 500 by 7% per year. But that statistic understates the astronomical returns earned by a few top performers—and the mediocre returns earned by the rest. Between 1979 and 2018, the median fund underperformed the S&P 500, while the top 5% of funds nearly tripled the index’s performance. The investor Bill Gurley, of Benchmark, describes venture capital as a “grand-slam business.”In “The Power Law,” business journalist Sebastian Mallaby argues that venture is defined by its most extravagant successes. A few deals explain the majority of returns, a few funds drive the majority of asset-class performance, a few wild ideas change the world. Venture’s contribution to innovation and entrepreneurship is massive. Mr. Mallaby notes that between 1995 and 2019 venture-backed companies accounted for nearly half of U.S. nonfinancial IPOs. These firms are orders of magnitude more likely to launch an IPO than startups that don’t receive venture backing….Mr. Mallaby believes this success is the result of a unique mind-set: “the patina of the counterculture” combined with “a frank lust for riches.”…”

Daniel Rasmussen, “‘The Power Law’ Review: Chasing Unicorns,”Wall Street Journal, February 2, 2022, https://www.wsj.com/articles/the-power-law-review-chasing-unicorns-11643842474

‘The Power Law’ Review: Chasing Unicorns

The average venture-capital fund launched in 2011 outperformed the S&P 500 by 7% per year. But that statistic understates the astronomical returns earned by a few top performers—and the mediocre returns earned by the rest. Between 1979 and 2018, the median fund underperformed the S&P 500, while the top 5% of funds nearly tripled the index’s performance.

The investor Bill Gurley, of Benchmark, describes venture capital as a “grand-slam business.” In “The Power Law,” business journalist Sebastian Mallaby argues that venture is defined by its most extravagant successes. A few deals explain the majority of returns, a few funds drive the majority of asset-class performance, a few wild ideas change the world.

Venture’s contribution to innovation and entrepreneurship is massive. Mr. Mallaby notes that between 1995 and 2019 venture-backed companies accounted for nearly half of U.S. nonfinancial IPOs. These firms are orders of magnitude more likely to launch an IPO than startups that don’t receive venture backing. The U.S. economy’s dynamism depends in large part on the Silicon Valley ecosystem.

Mr. Mallaby believes this success is the result of a unique mind-set: “the patina of the counterculture” combined with “a frank lust for riches.” Venture capitalists will fund almost any idea, no matter how seemingly crazy or unreasonable. But the checks stop coming if measurable results are not forthcoming, forcing every company to constantly confront the harsh realities of a competitive marketplace.

Boston was once the leader in venture capital. The legendary Georges Doriot, who taught at Harvard Business School, is considered the father of venture capital for his role in founding American Research and Development in 1946. But Doriot couldn’t bear to see the companies he invested in fail, and his focus was more on people and patriotism than profits. “Capital gains are a reward, not a goal,” he told his underpaid employees.

Silicon Valley, by contrast, developed into a ruthless ecosystem that accelerated corporate evolution by killing off the weak while helping the strong to pursue technological and market dominance. Mr. Mallaby tells a gripping fly-on-the-wall story of the rise of this unique and important industry based on extensive interviews with some of the most successful venture capitalists.

Arthur Patterson, the “self-consciously cerebral” co-founder of Accel, devised a systematic approach centered on the idea of the “prepared mind.” In an off-site meeting in 2003, the firm’s partners identified social networking as one of the most promising new innovations and a focus for the firm’s deal makers. Months later, a young partner named Kevin Efrusy persuaded Mr. Patterson to visit a new company called Facebook. The firm would invest about $13 million—and earn a profit of $12 billion when Facebook went public.

In contrast with Accel’s patrician intellectualism, Sequoia Capital built its reputation on immigrant grit. Three of the firm’s top deal makers hail from abroad: Michael Moritz from Wales, Douglas Leone from Italy and Roelof Botha from South Africa. Sequoia’s partners first connected with Arash Ferdowsi, the co-founder of Dropbox, through a Persian rug merchant whom the firm had hired to network with the Bay Area’s Iranian-American community. Patrick and John Collison, two brothers from a small town in Ireland, founded Stripe, the fast-growing payments company. They partnered with Sequoia, John told Mr. Mallaby, because of the firm’s reputation for backing “young immigrant founders with pluck.”

Though the book focuses on the winners, Mr. Mallaby doesn’t shy away from criticism, especially in his description of the decline of Kleiner Perkins. The firm was successful in the 1990s, but lead partner John Doerr became more interested in virtue signaling than in profit making. He started a cleantech fund, based on a conversation with his teenage daughter about saving the planet, that put a significant dent in the firm’s long-term track record. And he embarked on a highly publicized gender-equity campaign to hire female partners, only to see some of the most talented women quit and then see the firm be sued by a disgruntled employee for gender discrimination.

Telling stories of rich investors betting on young visionaries and earning insane profits could become tediously repetitive, but Mr. Mallaby writes a fast-paced narrative. He also has a journalist’s eye for revealing details: Mr. Patterson, of Accel, serves a new recruit a dinner consisting of nothing but 12 ears of grilled corn and a bottle of Bordeaux; an executive assistant at Sequoia scrambles a replacement Porsche for a chief executive when his car breaks down at 3 a.m.; one bigwig uses a silver bell to summon his waiter at his San Francisco mansion.

Mr. Mallaby’s “More Money Than God,” published in 2010, was a narrative history of the hedge-fund industry based on extensive insider interviews. “The Power Law” can feel, in part, like a spinoff of the earlier book, substituting venture funds, which have profited from the rise of smartphones and cloud computing, for hedge funds, which have struggled to keep up with a soaring S&P 500.

In his closing words in “The Power Law,” Mr. Mallaby warns that it’s “unwise” to bet against venture. But public markets have recently turned against IPOs and other venture-backed companies, sending venture-style portfolios like Cathie Wood’s ETF into steep losses. With the IPO window closing and tech stocks selling off, some venture investors might well be thinking: “There but by the grace of God go I.” Only time will tell if Mr. Mallaby has timed the publication of his book with the peak performance of the venture-capital asset class.

Justin Fox highlights just how progressive American income taxes are overall, outside of the top.1%, "...The very fine slices at the top of the income distribution are a relatively new addition — before 2015 the top 0.1% was as narrow as it got, although the IRS subsequently updated the numbers back to 2001 — and they allow one to see an interesting characteristic of the federal income tax. On the wholequite progressive, in the sense that those with higher incomes face higher rates. But this progressivity reverses within the top 0.1% (taxpayers with adjusted gross incomes of $2.5 million or more in 2019),with the very highest earners paying out a markedly smaller share of their income in taxes than those in the bottom nine-tenths of the top 1%....For taxpayers in the top 10%, the federal income tax is what matters most, and changes in income tax rates within the top 10% over the past two decades make for an interesting tale. Rates haven’t ended very far from where they were at the beginning (this is the same data as in previous chart, with everybody in the bottom 90% combined into one group)...here’s the percentage of adjusted gross income going to each of the income groups from the bar charts at the beginning of this column, in 2001 and 2019. Every group in the top 10% has seen its income share rise, while every group below it has seen its share fall. But the top 0.01%, the group that faces lower average tax rates than those just below it in the income distribution, still accounted for just 4.4% of all adjusted gross income in 2019, and the top 1% accounted for 20.1%. Again, that may understate those groups’ true income shares somewhat, especially that of the 0.01%, but it’s an indication that despite their gains since 2001, the very highest incomes still represent a pretty small share of overall incomes...."

Justin Fox, "How U.S. Income Tax Policy Became Mostly About the 1%," Bloomberg, January 29, 2022, https://www.bloomberg.com/opinion/articles/2022-01-29/u-s-income-tax-policy-is-mostly-about-the-1

How U.S. Income Tax Policy Became Mostly About the 1%

There have been some major changes to the U.S. individual income tax code over the past two decades — notably the tax cuts of the early 2000s, their partial rollback in 2012 and the 2017 tax reform/cuts. The net result of them all is maybe not what you’d expect: federal income tax rates fell for every income group since 2001, with the very highest earners seeing the smallest decline (in percentage terms at least) and those with incomes in the 50th to 60th percentiles down the most.

The very fine slices at the top of the income distribution are a relatively new addition — before 2015 the top 0.1% was as narrow as it got, although the IRS subsequently updated the numbers back to 2001 — and they allow one to see an interesting characteristic of the federal income tax. On the whole it’s quite progressive, in the sense that those with higher incomes face higher rates. But this progressivity reverses within the top 0.1% (taxpayers with adjusted gross incomes of $2.5 million or more in 2019), with the very highest earners paying out a markedly smaller share of their income in taxes than those in the bottom nine-tenths of the top 1%.

But that’s a story for another day! For taxpayers in the top 10%, the federal income tax is what matters most, and changes in income tax rates within the top 10% over the past two decades make for an interesting tale. Rates haven’t ended very far from where they were at the beginning (this is the same data as in previous chart, with everybody in the bottom 90% combined into one group):

When there are few capital gains to be realized — as in the wake of the global financial crisis in 2009 — this effect is much reduced. Tax rates fell for everybody else that year because incomes were lower, but the top 1% saw their rates rise because they were more dependent than usual on ordinary income.

The content of reconciliation laws is limited in the Senate by the Byrd rule, which generally disallows items that do not affect outlays or revenue. The Byrd rule also prohibits initiatives that would increase the deficit beyond the fiscal years covered by the budget resolution.

With most of the tax cuts from a decade earlier set to expire, Congress passed the American Taxpayer Relief Act of 2012, which is technically the biggest tax cut in U.S. history but didn’t feel like because it simply made the Bush tax cuts permanent for all but the highest earners. The result was a big tax increase for the 1% and no change for everybody else.

It also wasn’t entirely uncomplicated. To comply with reconciliation rules, most of the individual income tax provisions in the 2017 law were temporary. The AMT break is due to expire in 2025, which if allowed to happen will affect an estimated 7.6 million taxpayers that year, according to the Tax Policy Center. It also didn’t deliver its benefits evenly across the country. Thanks to another provision of the 2017 law that limited deductions for state and local taxes, HENRYs in low-tax states benefited much more from the AMT changes than those in high-tax states — although on average even the latter saw their federal income taxes reduced.

The permanent changes in the 2017 tax law were on the business side, with the biggest being a reduction of the top corporate income tax rate from 35% to 21%. Opinions differ on how a cut like that affects personal incomes. The mainstream view is that corporate shareholders bear most of the burden of the corporate income tax, and as high earners own most corporate shares, they pocket most of a corporate tax cut. But some economists argue that corporate taxes weigh most heavily on the incomes of rank-and-file workers because they’re less mobile than investors and thus less able to escape high rates. Income changes since the 2017 law actually give a little support to the latter view, with the share of overall adjusted gross income going to the top 1% falling in both 2018 and 2019.

Compared with the 2001 and 2003 tax cuts, then, the 2017 edition wasn’t all that skewed toward the very rich. Occasional Democratic claims that it was assume that (1) the corporate tax burden falls mostly on the highest earners and (2) all the temporary provisions in the 2017 law are allowed to expire, which given past experience seems unlikely to happen.

Yet the regressive turn at the top of the income distribution, while smaller than a decade ago, remains. A bit of it, to be sure, is an inflation-caused illusion: A $1,000 capital gain from the December 2021 sale of an asset purchased a decade earlier, for example, represents not $1,000 in real income but $809 in income and $191 in inflation, if you go by the consumer price index. Also, there are economic arguments for keeping capital gains taxes low (and some against) that I’m not going to get into here. On the other hand, the very wealthy have ways to reduce their taxable income that aren’t available to the rest of us, meaning that the above charts probably overstate the share of their true income going to taxes.

With that in mind, here’s the percentage of adjusted gross income going to each of the income groups from the bar charts at the beginning of this column, in 2001 and 2019.

Given the information presented above, it’s understandable that some Democratic lawmakers want to find new ways to tax billionaires. Doing so might well make the tax system fairer. But it should also be clear that the bipartisan consensus that seems to have emerged over the past two decades that no one outside the top 1.5% or so should have their taxes increased (the Biden administration’s stated cutoff is an income of $400,000) limits how much money can be raised from the income tax.

The across-the-board reduction in effective tax rates since 2001 has brought with it a commensurate reduction in individual income tax revenue, from 9.4% of gross domestic product in fiscal year 2001 to 8.1% in 2019 (it fell even further, to 7.7%, in 2020 but some other things were going on in 2020). 1 Fiddling around with the taxes of the 1% isn’t meaningless in this context — individual income tax revenue went from 7.1% of GDP in fiscal 2012 to 8% in fiscal 2014, after the tax increases on the highest earners had taken full effect — but it won’t pay all the bills.

1) Yes, tax cuts may sometimes boost GDP,(1) I’m aware of no credible economic model in which the reductions in taxes since 2001 would have boostedGDP enough to pay for themselves and(2) actual GDP performance since 2001 has been dismal, with annual real growth of just 1.9%.

“…We continue to expect persistent pandemic-driven efficiency gains, for three reasons: 1) Strong cumulative productivity gains in 2020-21 in both official and alternative metrics, 2) The incidence of these gains within digitizing industries, particularly those where Work-from-Home is effective, and 3) The sheer scale of the changes to the workforce and to company business models since 2019. Productivity in the nonfarm business sector has increased at a 1.7% annualized pace over the last two years—compared to the +1.0% trend pre-pandemic. GDP data are often revised around recessions, and both our ISM productivity proxy and Gross Domestic Income per hour suggest an annualized pace closer to +3% over this period. We also find that the incidence of productivity gains is skewed towards industries ripe for digitization, such as IT services (+11.9% annualized productivity growth since 4Q19) and professional services (+5.5%). Additionally, we find that Work-from-Home adoption and the scope for labor automation correlate positively with productivity acceleration across 54 subindustries—even after controlling for negative pandemic demand shocks. The sheer scale of pandemic-driven changes to the workforce and to company business models also argues for a large and long-lasting productivity inflection. These changes include 600 million fewer hours spent commuting every month, as well as possibly 1.4 million fewer cashiers, in-person salespeople, and office maintenance staff. Many of these workers and hours will be reallocated to more productive uses—especially at a time of labor shortages and near-record job vacancies. We also estimate around $900bn worth of home offices and $300bn of consumer IT equipment is now available for business-sector use. This echoes the output and productivity boom in the ride-sharing industry during the 2010s, when Uber and Lyft successfully monetized the household capital stock of cars….”
Incorporating these four baseline estimates into a top-down production function of the economy, we estimate a persistent boost to the level of private-sector productivity of 3-4% (or 1.0-1.3pp per year during 2020-22). We expect these efficiency gains to offset the decline in labor supply caused by the pandemic, in turn implying a longer runway for expansion. They also support our forecast of a more normal inflation environment in the medium-term once pandemic dislocations begin to recede.

Jan Hatzius, Alec Phillips, David Mericle, Spencer Hill, Joseph Briggs, Ronnie Walker, "Productivity Gains Will Outlast the Pandemic," Goldman Sachs, January 16, 2022, https://www.gspublishing.com/content/research/en/reports/2022/01/16/03f2d793-bc7c-48a4-824c-8cb0ebb75ddd.html

Productivity Gains Will Outlast the Pandemic

We continue to expect persistent pandemic-driven efficiency gains, for three reasons: 1) Strong cumulative productivity gains in 2020-21 in both official and alternative metrics, 2) The incidence of these gains within digitizing industries, particularly those where Work-from-Home is effective, and 3) The sheer scale of the changes to the workforce and to company business models since 2019.

Productivity in the nonfarm business sector has increased at a 1.7% annualized pace over the last two years—compared to the +1.0% trend pre-pandemic. GDP data are often revised around recessions, and both our ISM productivity proxy and Gross Domestic Income per hour suggest an annualized pace closer to +3% over this period.

We also find that the incidence of productivity gains is skewed towards industries ripe for digitization, such as IT services (+11.9% annualized productivity growth since 4Q19) and professional services (+5.5%). Additionally, we find that Work-from-Home adoption and the scope for labor automation correlate positively with productivity acceleration across 54 subindustries—even after controlling for negative pandemic demand shocks.

The sheer scale of pandemic-driven changes to the workforce and to company business models also argues for a large and long-lasting productivity inflection. These changes include 600 million fewer hours spent commuting every month, as well as possibly 1.4 million fewer cashiers, in-person salespeople, and office maintenance staff. Many of these workers and hours will be reallocated to more productive uses—especially at a time of labor shortages and near-record job vacancies. We also estimate around $900bn worth of home offices and $300bn of consumer IT equipment is now available for business-sector use. This echoes the output and productivity boom in the ride-sharing industry during the 2010s, when Uber and Lyft successfully monetized the household capital stock of cars.

Incorporating these four baseline estimates into a top-down production function of the economy, we estimate a persistent boost to the level of private-sector productivity of 3-4% (or 1.0-1.3pp per year during 2020-22). We expect these efficiency gains to offset the decline in labor supply caused by the pandemic, in turn implying a longer runway for expansion. They also support our forecast of a more normal inflation environment in the medium-term once pandemic dislocations begin to recede.

Productivity Gains Will Outlast the Pandemic

Year-on-year productivity growth slowed sharply in Q3 (from +1.9% to -0.6%), but we continue to expect pandemic-driven efficiency gains to persist into the next business cycle, for three reasons: 1) Strong cumulative productivity gains since 4Q19 across both official and alternative metrics, 2) The incidence of these gains within Work-from-Home-friendly and digitizing industries, and 3) The sheer scale of the changes to the workforce and to company business models. In this edition of the Analyst, we discuss each argument in turn, then conclude with the implications for the medium-term growth and inflation outlook.

Crisis-to-Date Productivity Trends

Realized productivity growth remains quite strong cumulatively, with +1.7% annualized growth since 4Q19 in the official measure—real output per hour in the nonfarm business sector (blue line in Exhibit 1). This compares to just under 1% annualized during the last business cycle (2010-2019).

The 2021 outperformance of gross domestic income (GDI) relative to GDP also suggests underlying productivity gains may be larger than officially reported (grey line). Relatedly, we note the possibility that GDP and productivity were temporarily depressed last year by the microchip shortage and other supply chain constraints.

Industry Composition of the Productivity Pickup

This higher level of labor productivity is not the result of pandemic demand shifts away from lower-wage consumer services industries. As shown in Exhibit 2, the industry mix shift within the labor force has mostly unwound, and it accounts for only 0.3pp of the 0.7pp-2pp acceleration in the aggregate productivity trend indicated in Exhibit 1.

The productivity cross-section discussed above reveals losers as well as winners, with several notable laggards across virus-sensitive services: retail -3.2% annualized since 4Q19, leisure and hospitality -3.2%, other services/personal care -4.4%; see Exhibit 5. While not reflected in our baseline estimates, we note scope for a post-pandemic reversal in some of these productivity declines as demand returns to normal and business models continue to evolve.

The scale of post-pandemic workforce changes—specifically those related to Work-from-Home, the digitization of the workplace, and the monetization of the household capital stock—is large enough to significantly and permanently boost productivity, in our view.

The prevalence of remote positions - including flexible workforce arrangements that involve in 2-3 days per week in the office—steadily increased in the years leading up to the pandemic (see right panel of Exhibit 6). The remote share peaked at 42% during the April 2020 lockdowns and has oscillated in the 29%-33% range during the subsequent ebbs and flows of the virus.

Combining this estimate with a likely rise of flexible workforce arrangements on the order of 25-30mn, we assume 23% of private-sector hours worked will ultimately migrate from the workplace to the household (relative to 2019). This would be roughly half the peak pace in April 2020 (46%), and it compares to the most recent Census Pulse reading of 30.5% in December (shown in the right panel). Put another way, we assume roughly a quarter of December’s Work-from-Home share will return to the office after the pandemic ends.

This five-fold increase in remote computing does not simply reflect changing worker preferences. It has likely benefited the business sector as well, on net. Comparing productivity data across 54 subindustries with the Census Survey of Income and Program Participation, we find a positive relationship between the 2020 share of remote workers in a given industry and the 3Q21 deviation of productivity from trend in that industry (GDP per worker-hour relative to the 2014-2019 trend; see blue scatter in Exhibit 7). The relationship is robust to controlling for the large output declines associated with the pandemic shock (see red scatter). This relationship is most pronounced in industries where tasks can be executed remotely, such as credit intermediation and data processing.

Another consequence of Work-from-Home is the business-sector monetization of some of the $25tn of the residential capital stock—home offices—as well as some of the $600bn of consumer-owned IT equipment—laptops, desktops, smart phones, and tablets. We view the ride-sharing industry in the 2010s as a useful analog. Exhibit 10 plots the output and productivity boom in that industry as Uber and Lyft successfully monetized the household capital stock of cars.

In part reflecting this, this household capital will not be utilized as frequently as its business-sector-owned equivalent, on average. We scale down our estimates accordingly based on work-from-home share data. Taken together, we estimate around $900bn of home offices and $300bn of consumer IT equipment has become available for business-sector use.

Room to Run

The sheer size of these changes to the workforce and to company business models argue for visible economy-wide productivity effects over the medium term. In Exhibit 11, we attempt to incorporate the above baseline estimates into a Cobb-Douglas production function of the private-sector economy, in order to illustrate the scale of the opportunity. These top-down estimates complement our previous bottom-up estimates.

Specifically, we assume 1.4 million fewer in-person sales staff in the private sector economy, 600 million fewer hours spent commuting each month due to full- and part-time Work-from-Home, and $900bn worth of home offices and $300bn of consumer IT equipment available for business-sector use (see blue bars in Exhibit 11).

While some of these changes could partially reverse in future years, GDP has now exceeded its pre-crisis level for two quarters. And as we imagine the post-pandemic economy, we place considerable weight on the crisis-to-date evolution of the workforce and on business-sector expectations as they stand today.

We see multiple takeaways from this analysis. First pre-pandemic GDP levels need not be a cap on economic activity in the medium-term, and these productivity gains will help offset the decline in labor supply experienced during the pandemic, in turn implying a longer runway for expansion. As shown in Exhibit 12, our productivity and labor force assumptions are consistent with 1.3% of spare capacity at year end, assuming GDP growth is similar to our and consensus expectations. This 1.3% year-end output gap reflects the further recovery in labor supply and additional productivity gains in our baseline forecast. We caution that these estimates reflect the long-run concept of spare capacity and do not map directly into near-term inflation outcomes. Indeed, we believe the risks to core inflation in the spring and summer center around the microchip shortage and the virus—for which the economy-wide output gap is of little relevance.

Francisco Amaral, Martin Dohmen, Sebastian Kohl, and Moritz Schularick report on their research we previously highlighted (Attached)) on housing appreciation in superstar cities which found that despite housing prices growing faster in larger cities total returns are lower as rental returns outside of the superstar cities were greater. "...While house prices have grown faster in the large cities, the rental returns are substantially higher in more remote locations, leading to overall higher returns in the rest of the country. Average total returns have been 5.75 log points per year in the national superstars, compared to the national average of 6.68 log points.In other words, an investment in the most important cities within a country comes with a negative return premium of approximately 90-100 basis points relative to national average returns. We call this the negative “superstar premium.”The return differencesare a robust feature of the data across countries and time periods, and statistically highly significant. A negative return premium of around 1 percentage point accumulates to substantial return differences in the long run. For instance, an investment in the superstar portfolio earned only about half the cumulative return of the national average portfolio over the past 70 years...The key finding across international and U.S. data is that the big cities tend to underperform the rest of the country in terms of total returns. On average, investments in residential real estate in a national superstar city (such as New York, London, or Paris) yielded lower returns than investments in the rest of the country. Investors buying real estate outside of the large cities earned higher returns. The reason is that superstar real estate is comparatively safe. The returns are less strongly correlated with income growth, and market liquidity is higher, leading to lower sales price uncertainty. Higher returns outside the big agglomerations are a compensation for higher risks...."

Francisco Amaral, Martin Dohmen, Sebastian Kohl, and Moritz Schularick, "Housing Returns in Big and Small Cities," Liberty Street Economics, February 2, 2022, https://libertystreeteconomics.newyorkfed.org/2022/02/housing-returns-in-big-and-small-cities/

Housing Returns in Big and Small Cities

Houses are the largest asset for most households in the United States, as is the case in many other countries as well. Within countries, there is substantial regional variation in house prices—compare real estate values in Manhattan, New York City, with those in Manhattan, Kansas, for example. But what about returns on investment? Are long-run returns on real estate investment—the sum of price appreciation and rental income flows—higher in superstar cities like New York than in the rest of the country? In this blog post, we present new and potentially surprising insights from research comparing long-run returns on residential real estate in a nation’s largest cities to those experienced in the rest of the country (Amaral et al., 2021), covering the U.S. and fourteen other advanced economies over the past century.

A New Regional Housing Return Database

For the analysis, we compiled a new long-run city-level data set covering annual house prices and rents in twenty-seven large (“superstar”) cities in fifteen OECD countries over the past 150 years. We borrow the “superstar city” terminology from the well-known paper by Gyourko, Mayer, and Sinai (2013) for the U.S., but take it global in the sense that we study the main economic agglomerations in each of these fifteen countries. For each national superstar city, we calculate long-run total returns on residential real estate investments as the sum of price appreciation and rent returns—and compare them to returns in the rest of the country. For the construction of the data set, we partly drew on existing historical research for individual cities. In most cases, however, we hand-collected new house price and rental series from city yearbooks or primary sources such as newspapers, tax records, and notary archives.

The data show that, over the long-run, superstar cities have witnessed lower total returns on residential real estate than other parts of the same country. The table below shows average capital gains, rent returns and total returns for the superstar cities (Column 1) and for the national housing portfolios as defined in Jordà et al. (2019) (Column 2). Column (4) shows the implied population-weighted return for the rest of the country, excluding the superstars.

Housing Returns over the City-Size Distribution in the U.S.

To better understand the negative superstar premium we take a closer look at the U.S. housing market, for which we have comprehensive return data across the entire city-distribution since 1950. We combine the data compiled by Gyourko, Mayer, and Sinai (2013) with data from the American Community Survey for the 2010-18 period. The chart below shows average log total returns by increasing MSA size for the U.S. The key result is that in the postwar U.S., total returns to housing decrease with city size. There is an almost monotonic negative relation between total returns and city size with the biggest differences between the largest and smallest MSAs. We calculate a return premium of small vs. large MSAs in the U.S. of about 80 basis points annually. This estimate is statistically highly significant.

Why are housing returns lower in large cities than in the rest of the country? Our key finding can be rationalized in a standard asset pricing framework where excess returns are a compensation for higher risk. Observable long-run return differences between different assets must be attributable to differences in risk, or to violations of standard assumptions (such as behavioral biases in expectations).

Now suppose that everything that makes a national superstar city-its diversified economy, its large market, its amenities, the international demand (Black and Henderson (1999), Desmet and Henderson (2015))-also makes it a safer place as an investment. A consequence would be that the present value of future housing services will be subject to less risk so that buyers are willing to pay a higher price and accept a lower return for housing investments in large agglomerations. In turn, higher returns outside the superstars would be compensation for higher risk. For remote locations to attract capital, they have to offer higher returns.

There is empirical evidence for differences in housing risk across locations. On the one hand, the co-variance between housing returns and income growth is lower in large cities. The table below shows the differences in the co-variance between large and small MSAs for the U.S. The co-variance between MSA-level income growth and MSA-level housing returns has been significantly larger in smaller MSAs.

Houses are the most important asset for families. They typically hold nondiversified real estate assets in specific locations. The distribution of housing returns across space therefore plays a central for household finance and consumption, the evolution of household wealth and its distribution, as well as financial stability risks. Our study takes the first steps toward a better understanding of spatial risk and return patterns in housing markets over the long run.

In particular, this blog post presented a novel data set covering housing return series for twenty-seven superstar cities. The key finding across international and U.S. data is that the big cities tend to underperform the rest of the country in terms of total returns. On average, investments in residential real estate in a national superstar city (such as New York, London, or Paris) yielded lower returns than investments in the rest of the country. Investors buying real estate outside of the large cities earned higher returns. The reason is that superstar real estate is comparatively safe. The returns are less strongly correlated with income growth, and market liquidity is higher, leading to lower sales price uncertainty. Higher returns outside the big agglomerations are a compensation for higher risks.

"...In 1999, Mr Bernanke had chided the Bank of Japan for failing to rekindle Japanese growth after a bubble burst, despite reducing interest rates to zero. Yet in the 15 years after he christened the saving glut, finance ministries and central bankers around the world became familiar with the struggle to maintain steady growth in the context of zealous saving. Since 2000 alone, the value of global wealth held by households, firms and governments has roughly tripled, from $160trn to $510trn, or from about 460% of global gdp to 610%, according to McKinsey Global Institute, a think-tank…The contribution of growth in reserves to savings was most pronounced around the time Mr Bernanke sounded his warning. From 1998 to 2008, official foreign-exchange reserves jumped from 5.2% of global gdp to 11.5%, powered by a steady rise in oil prices and reserve accumulation by China. During this period, reserve growth probablydominated other sources of saving; research by Francis Warnock and Veronica Cacdac Warnock of the University of Virginia suggests that reserve-accumulation in the year to May 2005 alone reduced the yield on ten-year Treasury bonds by 0.8 percentage points.Reserve growth paused during the global financial crisis, then resumed in the years after, reaching a peak of 15.2% of global gdp in 2013(see chart 2).... Work by Lukasz Rachel, of the London School of Economics, and Larry Summers, of Harvard University, reckons that over the past half century, rising government debt across rich economies pushed up interest rates by about 1.5 percentage points.This effect was more than balanced out by other factors in the past, but might not be in the decades ahead....Increased inequality accounts for about 0.6 percentage points of the decline in rich-world interest rates since the 1970s, say Messrs Rachel and Summers...High-rolling households have not been alone in stockpiling savings. For decades, corporations have been hoarding money as well, retaining a large share of their hefty net profits. According to Peter Chen, of the Analysis Group, an economic consultancy, and Brent Neiman, of the University of Chicago, and Loukas Karabarbounis, of the University of Minnesota, annual global corporate saving rose from less than 10% of world gdp to nearly 15% between 1980 and 2015. The corporate sector has been acting as a net lender to the global economy, rather than as a net borrower from it...Corporate saving, in contrast, rose relatively slowly before 2000, then much faster thereafter, as firms salted away cash from increased profits. In America, for instance, corporate profits have hovered above 10% of gdp for most of the period since 2006, after never rising above 8% over the prior quarter century....In a recent paper examining the effects of demographic change on saving,Etienne Gagnon, Benjamin Johannsen and David López-Salido of the Federal Reserve Board suggest that ageing in America may account for about one percentage point of the drop in interest rates since the 1980s.(Other recent work finds still larger effects, of as much as three percentage points.) If past is prologue, rates seem sure to remain low. Barring a surge in procreation, or the embrace of a dystopian “Logan’s Run” approach to the aged, the world’s population will continue to get older. The share of global population over the age of 50 rose from 15% in the 1950s to 25% today, say Adrien Auclert and Frédéric Martenet, of Stanford University, Hannes Malmberg, of the University of Minnesota, and Matthew Rognlie, of Northwestern University. It is expected to rise to 40% by 2100(see chart 3). That may well turn out to be an underestimate, if recent fertility trends are anything to go by. In 2021, India’s birth rate declined to just 2.0 children per woman—below the rate at which births and deaths are in rough balance. Indeed, a growing number of emerging markets have flipped to the slow population growth common in rich countries. Recent research by Matthew Delventhal of Claremont McKenna College, Jesús Fernández-Villaverde of the University of Pennsylvania and Nezih Guner of the Universitat Autònoma de Barcelona concludes that such transitions—the switch from high mortality and fertility rates to low ones which accompanies economic development—are happening faster over time. The transition took a half century or more 100 years ago, but now tends to be compressed into just two or three decades. Some 80 countries have completed this transition, and in virtually all the rest it is under way....Recent work by Noëmie Lisack, of the Banque du France, Rana Sajedi, of the Bank of England, and Gregory Thwaites, of the University of Nottingham, estimates that this habit of leaving behind savings will by mid-century depress interest rates by nearly half a percentage point relative to current levels. With neither inequality nor the level of reserves showing signs of sustained fall, the ineluctable force of demography should continue to drive savings growth. The world, in other words, may come to look ever more like Japan. There, the median age is 48, more than a quarter of the population is over 65, and the yield on a 30-year government bond is a cool 0.8%, despite a government debt load of 259% of gdp. A generation ago, Mr Bernanke reckoned that Japan’s lacklustre growth and subterranean rates of inflation and interest were the consequence of “self-induced paralysis” by the central bank. Today, such realities seem more like the dull fate of a world with more savings than it quite knows what to do with...."

Economist Staff, "Why the world is saving too much money for its own good," The Economist, February 5, 2022, https://www.economist.com/briefing/2022/02/05/why-the-world-is-saving-too-much-money-for-its-own-good

Why the world is saving too much money for its own good

In 2005, ben bernanke, then a member of the Federal Reserve’s Board of Governors, wondered at a tide of money washing over American shores—and worried about its consequences. Grasping in a speech for a way to describe the phenomenon, he coined a phrase. “Over the past decade,” he noted, “a combination of diverse forces has created a significant increase in the global supply of saving—a global saving glut.” Savers of all sorts—from older Americans preparing for retirement to oil-exporting countries accumulating sovereign-wealth funds—were shoving more money into stocks and bonds than could be put to use by those looking to invest in plants and equipment.

Now the pandemic has shaken pillars of the global economy in ways which could fundamentally alter saving patterns. Tight labour markets are shifting money to workers who are eager to spend, contributing to the highest inflation in a generation. Central banks which had found themselves unable to push interest rates down enough to keep inflation from falling below their targets are beginning to push rates up to keep inflation from soaring. Yet while new enthusiasm for government borrowing or a retreat from globalisation could help to drain savings and establish a new normal, it seems more probable that Mr Bernanke’s glut will persist, thanks to old habits and old people, who are a growing share of the world’s population.

The rising reservoir of global savings, most of which is held in bank deposits, bonds, corporate equity and property, has been fed by three main tributaries: governments hungry for foreign-exchange reserves, penny-pinching households and firms, and workers nearing retirement age. It was the first flow, saving by governments, which preoccupied Mr Bernanke. Governments’ accumulation of foreign-exchange reserves adds to saving in two ways. Resource-exporting economies save part of the windfall earned from their exports and plough it into stocks and bonds. Some of these piles are held as official reserves; the Russian government has reserves, excluding gold, valued at $460bn, while Saudi Arabia’s are worth $440bn. Windfalls have also been shifted into sovereign-wealth funds; that of Abu Dhabi is worth almost $700bn, while Norway’s is valued at more than $1.3trn.

Other economies pile up foreign-exchange reserves as they intervene in markets to reduce the value of their currencies, to boost exports or to build up a hoard of safe assets which can be drawn upon in times of financial stress. In effect, these interventions squeeze consumption in their home economies, reducing spending relative to production and thus contributing to current-account surpluses which must be absorbed by the rest of the global economy. Reserves held by South Korea, Singapore, Taiwan and India have grown into the hundreds of billions. No country has engaged in such practices to more disruptive global effect than China, which holds some $3.2trn in foreign-exchange reserves.

Reserves plateaued thereafter (and indeed fell slightly as a share of gdp), and a decline in the years ahead cannot be ruled out. A protracted period of post-pandemic financial stress could force some emerging economies to deplete their reserves. If economic strains and geopolitical tensions force Russia and China to draw down their hoards, that might place upward pressure on interest rates.

Yet it is also possible that the pandemic will lead to a new surge in reserves. Yes, a shift to zero-carbon energy may eventually doom fossil-fuel windfalls, but the transition might well mean high prices for oil and gas, since new production is likely to stagnate. Meanwhile, the pandemic and its aftermath will probably reinvigorate the appeal of defensive foreign-exchange reserves. During the financial panic of March 2020 and again in recent months, as straitened global conditions squeezed emerging markets, the economies which weathered stresses best were those with ample foreign-exchange reserves. This lesson has already been put to use. By the autumn of 2021, reserves were roughly $1trn higher than they were before covid-19.

The effects of reserve accumulation could also be offset by increased government borrowing. Government debt loads, already high pre-pandemic, have exploded over the past two years; in 2020 alone, public debt as a share of gdp surged by nearly 20 percentage points across advanced economies, to 123%, and nearly ten points across emerging economies, to 63%. Work by Lukasz Rachel, of the London School of Economics, and Larry Summers, of Harvard University, reckons that over the past half century, rising government debt across rich economies pushed up interest rates by about 1.5 percentage points. This effect was more than balanced out by other factors in the past, but might not be in the decades ahead.

A first-class problem

A second stream of saving has flowed from the households and firms which have done best over the past few decades. Since the 1970s, inequality has risen across many economies. Wealthier households have a higher propensity to save, so this shift in the distribution of income contributed to the saving glut, according to work by Atif Mian, of Princeton University, Ludwig Straub, of Harvard University, and Amir Sufi, of the University of Chicago. From 1983 to 2019, the share of American income going to the top 10% of the income distribution rose by 15 percentage points, they reckon. Because of this “saving glut of the rich”, average annual saving by the top 1% of American earners alone has outstripped annual average net domestic investment since 2000. Increased inequality accounts for about 0.6 percentage points of the decline in rich-world interest rates since the 1970s, say Messrs Rachel and Summers.

High-rolling households have not been alone in stockpiling savings. For decades, corporations have been hoarding money as well, retaining a large share of their hefty net profits. According to Peter Chen, of the Analysis Group, an economic consultancy, and Brent Neiman, of the University of Chicago, and Loukas Karabarbounis, of the University of Minnesota, annual global corporate saving rose from less than 10% of world gdp to nearly 15% between 1980 and 2015. The corporate sector has been acting as a net lender to the global economy, rather than as a net borrower from it.

As with reserve accumulation, the relative importance of such factors has waxed and waned. Income inequality rose sharply from around 1980 to 2000. In the years since, it has levelled off in some economies, like Britain’s, and increased at a slower pace in others, like America’s. Corporate saving, in contrast, rose relatively slowly before 2000, then much faster thereafter, as firms salted away cash from increased profits. In America, for instance, corporate profits have hovered above 10% of gdp for most of the period since 2006, after never rising above 8% over the prior quarter century.

Income inequality and corporate profitability cannot be forecast with any certainty. Both reflect the interaction of myriad forces, from the balance of corporate and labour power, to the state of technological progress and productivity growth, to government tax and regulatory policy. It is possible that the trends of the past half century might be upended by the pandemic and its aftermath. Over the past 18 months, tight labour markets helped push wages upward and strengthened workers’ leverage in bargaining with their employers. Slower growth in the labour forces of ageing societies could help to preserve these gains, and perhaps enable a resurgence by organised labour. Firms—especially big and profitable technology ones—are in the cross-hairs of regulators looking to boost competition. Better times for workers should also squeeze profits, in addition to reducing inequality.

A retreat from globalisation could amplify these trends. It would increase the earning power of the working masses in rich countries, while hitting the profits of multinational firms and the higher incomes of their white-collar workers. On the other hand, substantial reversals in inequality are relatively rare in recent economic history. The great compression in incomes that occurred from the 1910s into the post-war decades occurred as fortunes were hammered by the Depression and liquidated to fund wars, as taxes on the rich soared well above current levels. For now, such upheavals seem unlikely.

What is more, as Mr Mian and co-authors write, the effects of inequality on saving can feed on themselves. As high saving by the rich pushes down interest rates, they argue, poorer households increase their borrowing to sustain their consumption. But as debt piles up, they find themselves forced to reduce spending to pay back loans. Their debt payments, furthermore, represent a transfer of more money to rich households whose purchases of assets (like mortgage-backed securities) effectively finances the borrowing of the non-rich. The trap which results—of perpetually high inequality, low interest rates, and high debt among poorer households—could prove difficult to escape, sustaining the savings of the rich as a potent macroeconomic force.

Far more certain is the third great river of savings, whose flow, which has grown in importance, might well swamp other post-pandemic changes in behaviour. The world is not getting any younger, and in coming decades the savings of the old stand to apply relentless pressure on the macroeconomy. Across time and countries, household saving follows a reliable pattern. When workers are young, they save little or even take on debt. Their savings rise through their 30s and 40s before peaking a decade or so before retirement. As populations have grown older over the past half century, in the rich world especially, the share of workers in their prime saving years has risen as well, leading to ever more money in nest-eggs and ever lower yields on the assets therein.

That may well turn out to be an underestimate, if recent fertility trends are anything to go by. In 2021, India’s birth rate declined to just 2.0 children per woman—below the rate at which births and deaths are in rough balance. Indeed, a growing number of emerging markets have flipped to the slow population growth common in rich countries. Recent research by Matthew Delventhal of Claremont McKenna College, Jesús Fernández-Villaverde of the University of Pennsylvania and Nezih Guner of the Universitat Autònoma de Barcelona concludes that such transitions—the switch from high mortality and fertility rates to low ones which accompanies economic development—are happening faster over time. The transition took a half century or more 100 years ago, but now tends to be compressed into just two or three decades. Some 80 countries have completed this transition, and in virtually all the rest it is under way.

What is more, the pandemic further depressed birth rates in many countries. China’s birth rate touched a record low in 2021, potentially bringing forward the era of declining Chinese population. America experienced a baby bust too, which in combination with falling immigration depressed the population growth rate to just 0.1% in 2021—the smallest annual increase on records going back to 1900. The end of the pandemic could bring a rebound in birth rates. But there is no mistaking the broader trend: the world is greying, fast.

Innumerable shades of grey

Will the effect of ageing on saving necessarily remain the same in future as it was over the past half century? In an influential book, Charles Goodhart, of the London School of Economics, and Manoj Pradhan, of Talking Heads Macroeconomics, a research firm, argue that the greying of the population will depress interest rates only up to a certain point, after which there will be a “great demographic reversal”. Their view rests in part on the observation that while workers on the verge of retirement save heavily, those already retired begin to spend down their stores of stocks and bonds. An increase in the share of the population above retirement age, then, could mean that the proportion of workers in their high-saving years will peak and then decline, dragging down saving and pushing up interest rates.

A great demographic reversal seems intuitive, particularly in places like America where an oversize cohort—the baby-boomers—is easing into retirement. But other economists say there are reasons to expect ageing to continue to depress interest rates. They note, for example, that it is the age profile of a population as a whole which matters. Even as more people retire, the age of the typical working person will continue to rise toward those prime saving years. There are boomers aplenty, but the median age in America is still just 38. Another reason is that, in the emerging world, a larger share of workers have their prime saving years still ahead of them. The median age in India is only 28, for instance. So long as financial markets remain reasonably integrated around the world, higher saving anywhere helps to depress interest rates everywhere.

Perhaps most important, people in retirement do not tend to spend everything. Rather, for a number of motives—to avoid outliving their savings, or to provide for heirs, among others—they tend to maintain large stocks of wealth well into retirement. In Britain, for instance, as of 2018, people 80 or older held more wealth than those aged 45 to 49. Recent work by Noëmie Lisack, of the Banque du France, Rana Sajedi, of the Bank of England, and Gregory Thwaites, of the University of Nottingham, estimates that this habit of leaving behind savings will by mid-century depress interest rates by nearly half a percentage point relative to current levels. With neither inequality nor the level of reserves showing signs of sustained fall, the ineluctable force of demography should continue to drive savings growth.

The world, in other words, may come to look ever more like Japan. There, the median age is 48, more than a quarter of the population is over 65, and the yield on a 30-year government bond is a cool 0.8%, despite a government debt load of 259% of gdp. A generation ago, Mr Bernanke reckoned that Japan’s lacklustre growth and subterranean rates of inflation and interest were the consequence of “self-induced paralysis” by the central bank. Today, such realities seem more like the dull fate of a world with more savings than it quite knows what to do with.

".... Americans can expect to inherit $72.6 trillion over the next quarter century, more than twice as much as a decade ago, in the latest indication of how soaring markets are poised to bolster the next generation of the ultra-rich. Almost half of allU.S. wealth transferred from the end of 2020 through 2045 will come from the top 1.5% of households, according to estimates from research firm Cerulli.... Charitable organizations will get a significant influx of money through 2045: $11.9 trillion, or 14% of the $84 trillion projected to be passed on to heirs or philanthropies, Cerulli estimates. That’s a larger share than it was just three years ago. Households with more than $5 millioneachare giving away about $120 billion annually, and their donations could exceed $200 billion a year by the end of the 2020s....Overall, Cerulli projects 42% of transfers will come from the top 1.5% of households....While some forms of wealth, like real estate, are more widely held, the rich control the bulk of stocks, bonds and other investments. Cerulli estimates households with more than $2 million control 62% of these assets, up from 48% in 2010...."

Ben Steverman, "Tax-Free Inheritances Fuel America’s New $73 Trillion Gilded Age," Bloomberg, February 2, 2022, https://www.bloomberg.com/news/articles/2022-02-02/what-the-73-trillion-great-wealth-transfer-means-for-america-s-super-rich

Tax-Free Inheritances Fuel America’s New $73 Trillion Gilded Age

Americans can expect to inherit $72.6 trillion over the next quarter century, more than twice as much as a decade ago, in the latest indication of how soaring markets are poised to bolster the next generation of the ultra-rich.

Almost half of all U.S. wealth transferred from the end of 2020 through 2045 will come from the top 1.5% of households, according to estimates from research firm Cerulli. Using trusts and other techniques, the wealthiest Americans can shield the bulk of their fortunes from the federal government’s 40% estate and gift tax levy. President Joe Biden and Democrats in Congress have so far failed in efforts to plug such loopholes and otherwise boost inheritance taxes.

The growth in dynastic fortunes has become a flash point in Washington, with the advocacy group Americans for Tax Fairness warning in a report released Wednesday about the “return to Gilded Age levels of wealth concentration.” The 2017 Republican tax overhaul, which included a doubling of the amount the wealthy can pass to heirs without triggering the estate tax, caused revenue collected from the levy to plunge by more than half in the span of two years, with just 1,275 families paying $9.3 billion in 2020, according to Internal Revenue Service data.

“It’s easier to pass on wealth without facing as much taxation as even a decade ago,” said Chayce Horton, one of the authors of the Cerulli report. Trusts “are becoming increasingly popular over the last five to ten years as high-net-worth wealth has ballooned.”

Of the advisers surveyed by Cerulli, 93% cited trust strategies, with the most popular being grantor trusts. That category includes grantor-retained annuity trusts, or GRATs, used by Nike Inc. founder Philip Knight and the family of Walmart Inc. founder Sam Walton. Grantor trusts exploit a long-standing loophole that House Democrats had proposed closing before the provision was deleted from the Build Back Better package.

“This is yet another data point showing that paying taxes is essentially optional for the mega-millionaires and billionaires,” Senate Finance Committee Chairman Ron Wyden, an Oregon Democrat, said of the Cerulli estimates in a statement. “I’ve been increasingly concerned about how the abuse of trusts allows wealthy heirs to avoid paying any taxes at all. We’re continuing to work to get the votes to close these egregious trust loopholes.”

Still, even the most philanthropic families seek to reduce their tax bills. Wealthy Americans and their advisers spent much of last year making moves to avoid or minimize the hit from potential tax increases. Many rushed to set up trusts and transfer money into them by the end of 2021, just in case the rules were changed in 2022.

Overall, Cerulli projects 42% of transfers will come from the top 1.5% of households. Increasing wealth inequality boosts the level of bequests because the richest Americans are less likely than the middle class -- or even the merely affluent -- to spend down their fortunes before they die, Horton said.

While some forms of wealth, like real estate, are more widely held, the rich control the bulk of stocks, bonds and other investments. Cerulli estimates households with more than $2 million control 62% of these assets, up from 48% in 2010.

“If tax and other policies aren’t reformed soon, the wealth in dynasty trusts created by today’s billionaires will reach staggering heights,” the report said.

"...The stock of global debt has gone from $83trn in 2000 to around $295trn in 2021—a rate nearly double the pace of world gdp growth. Debt rose from 230% of gdp in 2000 to 320% on the eve of the pandemic, before covid-19 propelled it to the even greater height of 355% last year....Part of the reason for this explosion has been the steady decline in borrowing costs over the past two decades. In early 2000 a ten-year Treasury offered a yield of 6.5%. Today it pays 1.8%. The Federal Reserve’s effective policy rate has fallen from 6.5% to around 0.08% in that time. Benchmark rates in the euro area and Japan are sub-zero. Declines in government-bond yields and central banks’ policy rates have fed through to loan rates for private borrowers. As a result, even though global debt has rocketed over the years,the world’s interest costs, as a share of gdp, are well below their peak in the 1980s. In America, for instance, they stood at 12% of gdp in 2021, compared with 27% in 1989....The scale of the global interest bill is vast. The Economist estimates that households, companies, financial firms and governments worldwide paid $10.2trn in interest in 2021, equivalent to 12% of gdp. As a guide to the potential impact of rate rises to come, we consider a scenario where the interest rates faced by firms, households and governments in 58 countries rise by a percentage point over the next three years. (By way of comparison, the five-year Treasury yield has risen by a percentage point since spring 2021.)Our calculations suggest that the global interest bill would exceed $16trn by 2026, equivalent to 15% of projected GDP in that year. And if rates were to rise twice as quickly, say because inflation persists and forces central banks to take drastic action, the interest bill could rise to about $20trn by 2026, nearly a fifth of global gdp....To see which borrowers may be more sensitive to interest-rate rises, we rank the household, corporate and government sectors for our countries along two dimensions (for this exercise we exclude the financial sector, which intermediates lending). The first measure is the debt-to-income ratio, which gauges the extent to which debt is affordable. The second is the change in the ratio over the past decade, which captures the extent to which exposure to interest rates has increased over time. We then produce an overall ranking for each sector in each country (see chart)....Overall, our findings for the private sector are broadly consistent with an early indicator of financial stress, the credit-to-gdp gap, calculated by the bis, which measures the degree to which borrowing exceeds its long-run trend. On this measure, the Swiss and South Korean private sectors rank among the five most stretched in the world...."

Economist Staff, "The global interest bill is about to jump,"The Economist, February 5, 2022, https://www.economist.com/finance-and-economics/the-global-interest-bill-is-about-to-jump/21807488

Never before has the world economy been so indebted. The stock of global debt has gone from $83trn in 2000 to around $295trn in 2021—a rate nearly double the pace of world gdp growth. Debt rose from 230% of gdp in 2000 to 320% on the eve of the pandemic, before covid-19 propelled it to the even greater height of 355% last year.

Part of the reason for this explosion has been the steady decline in borrowing costs over the past two decades. In early 2000 a ten-year Treasury offered a yield of 6.5%. Today it pays 1.8%. The Federal Reserve’s effective policy rate has fallen from 6.5% to around 0.08% in that time. Benchmark rates in the euro area and Japan are sub-zero. Declines in government-bond yields and central banks’ policy rates have fed through to loan rates for private borrowers.

As a result, even though global debt has rocketed over the years, the world’s interest costs, as a share of gdp, are well below their peak in the 1980s. In America, for instance, they stood at 12% of gdp in 2021, compared with 27% in 1989.

All this could soon change. The era of super-cheap money is ending. Central banks are battling a surge in inflation. Those in some emerging economies have been raising interest rates for some time already: Brazil’s central bank raised rates by 1.5 percentage points after a meeting on February 2nd, its third consecutive such increase. At the time of writing, the Bank of England was expected to deliver its second interest-rate rise. The central bank with the most influence on global capital flows—the Fed—has signalled that it will probably put rates up as soon as March, and investors expect four further quarter-percentage-point increases this year. Real borrowing costs for governments, though still negative in many places, are inching up. In America the yield on the five-year Treasury inflation-protected security (tips), which hovered around -1.7% for much of 2021, now stands at -1.2%.

The scale of the global interest bill is vast. The Economist estimates that households, companies, financial firms and governments worldwide paid $10.2trn in interest in 2021, equivalent to 12% of gdp. As a guide to the potential impact of rate rises to come, we consider a scenario where the interest rates faced by firms, households and governments in 58 countries rise by a percentage point over the next three years. (By way of comparison, the five-year Treasury yield has risen by a percentage point since spring 2021.)

Our calculations suggest that the global interest bill would exceed $16trn by 2026, equivalent to 15% of projected gdp in that year. And if rates were to rise twice as quickly, say because inflation persists and forces central banks to take drastic action, the interest bill could rise to about $20trn by 2026, nearly a fifth of global gdp.

Working out the effect of rate rises on the interest bill is not straightforward. Some debt is tied to a fixed interest rate, such that higher borrowing costs are passed through only when it is rolled over. The median maturity of government debt, for instance, is five years. Companies tend to borrow for a two-year term; households typically borrow over a longer period. Incomes change over time, affecting borrowers’ ability to afford debt payments.

Borrowers could respond to higher interest costs by paying off debt, so lowering their debt-interest costs. But in aggregate, according to research by the Bank for International Settlements (bis), a club of central banks, higher rates raise total debt payments (ie, including interest and principal) relative to income. The higher the level of debt, the greater the squeeze, suggesting that the economy has only become more sensitive to rate rises.

Our calculations assume that interest-rate rises feed through over the course of five years to government and household debt, and over two years to company borrowing. We also assume that nominal incomes rise in line with the imf’s forecasts. As the fund’s projections assume that public debt rises at broadly similar rates, we let debt-to-gdp ratios stay flat. This implies annual budget deficits of around 5% of gdp—narrower than in the years immediately preceding the pandemic.

Picking up the tab

A higher interest burden would not fall on all borrowers equally. Private-sector borrowers in a country tend to foot a much bigger share of the bill than the government, which can borrow more cheaply, for instance. Financial firms and savers, such as wealthier households, receive as well as pay interest. The more exposed the borrower is to rate rises, in terms of higher debt levels, the bigger the interest bill they face, and the more likely it becomes that they cut back spending in order to meet their higher debt costs, or, in more extreme cases, that they fall into distress. That would in turn weigh on economic activity.

To see which borrowers may be more sensitive to interest-rate rises, we rank the household, corporate and government sectors for our countries along two dimensions (for this exercise we exclude the financial sector, which intermediates lending). The first measure is the debt-to-income ratio, which gauges the extent to which debt is affordable. The second is the change in the ratio over the past decade, which captures the extent to which exposure to interest rates has increased over time. We then produce an overall ranking for each sector in each country (see chart).

Our next set of borrowers comprises households. Those in South Korea, Norway and Switzerland have the most debt, relative to their income, in our group of countries. Mortgage debt in Sweden is also sizeable. House prices rose by 11% in 2021, and well over half of mortgage lending is done with variable interest rates. When rates rise, therefore, mortgage bills follow suit. Debt-to-income ratios have more than doubled in China and Russia.

Companies are the third set of borrowers. Those in France and Switzerland have the most debt as a share of gross operating profit, leaving them exposed to rate rises. Among emerging markets, Chinese and Russian firms are also weighed down by their bills. Overall, our findings for the private sector are broadly consistent with an early indicator of financial stress, the credit-to-gdp gap, calculated by the bis, which measures the degree to which borrowing exceeds its long-run trend. On this measure, the Swiss and South Korean private sectors rank among the five most stretched in the world.

Our rankings help illustrate who is most exposed to rising interest rates. But they cannot predict which sectors or economies will experience trouble as interest rates rise. That is a far more complex picture, which depends among other things on the prospects for economic growth and the reaction of policymakers. Strains in one part of the economy could interact with those in others, say by weakening the banking system.

China faces a combination of threats: the property market has deflated as Evergrande, a large and heavily indebted developer, unravels. Banks have become saddled with bad household debts. But the country’s policymakers have also responded to these risks. The resulting drag on economic growth probably helps explain why the People’s Bank of China is lowering interest rates, not raising them.

Policymakers in the rest of the world may be starting to move in the opposite direction, but the potential of highly indebted borrowers to drag down the economic recovery will nonetheless be weighing on their minds.

Correction (February 2nd): The figure for the total interest bill has been corrected, from $10.5trn to $10.2trn, equivalent to 12% of GDP. We have also edited the text in places to clarify that our ranking shows the exposure of various borrowers to interest-rate rises, rather than vulnerability. Sorry.

"..For years after the global financial crisis the world economy was starved of investment. The aftermath of the covid-19 downturn has been drastically different. In America private non-residential investment is only about 5% below its pre-pandemic trend,compared with a shortfall of nearly 25% in mid-2010, the equivalent point in the previous economic cycle...The country has enjoyed the fastest rebound in business investment in any recovery since the 1940s, according to Morgan Stanley, a bank. In the rich world as a whole, predicts the World Bank, total investment will have overtaken its pre-pandemic trend by 2023. The lacklustre investment of the 2010s was largely blamed on slow output growth and dismal prospects for the economy. By contrast, the vibrant recovery this time is part of a v-shaped rebound encompassing growth, employment and—less happily—inflation. It helps, too, that investment fell less steeply than it did in 2008-09, even as gdp sank at rates not seen since the Depression. Economies shrank in spring 2020 mainly because consumption disappeared as people stayed home.... investment in computers in America is 17% above its pre-covid trend…. A composite indicator built by JPMorgan Chase, a bank, suggests that global capital spending rose at a underwhelming rate of 2.2% in the fourth quarter of 2021.....There are, however,three reasons why business investment might be stronger in the 2020s than it was in the 2010s. The first is that companies are likely to keep spending on their supply chains as they seek to strengthen and diversify them.... The second reason to expect more investment is the growing optimism about the potential of new technologies to boost productivity growth.Not long ago economists fretted that the world was running out of useful ideas. Yet firms are increasingly betting on technological progress. Intellectual property now makes up 41% of America’s private non-residential investment, compared with 36% before the pandemic and 29% in 2005. In 2021 the big five technology firms—Alphabet, Amazon, Apple, Meta and Microsoft—alone spent $149bn on r&d.... The third force driving investment higher is decarbonisation.A number of countries, together making up 90% of the world economy, have pledged to reduce carbon emissions to net zero over the coming decades in order to fight climate change. If that goal is to be achieved, the world will need everything from electric-vehicle charging infrastructure to battery storage and energy-efficient housing....But the pay-offs to r&d investment, at least, may be rising. In a recent research noteYulia Zhestkova of Goldman Sachs…found that in America between 2016 and 2019 there was a positive correlation between an industry’s investment in intellectual property and its labour-productivity growth.It would not take much of a productivity revival to significantly boost the outlook for growth, which is being weighed down by population ageing. So-calledtotal factor productivity growth, which measures increases in gdp that cannot be attributed to more capital or hours worked, averaged 1.2% a year between 1880 and 2020, notes Ms Zhestkova. By contrast, the figure was only about 0.5% in the 2010s.Simply returning to the historical average would create the prospect of a larger economy in the future, giving firms yet another reason to invest...."

Economist Staff, "Why the impressive pace of investment growth looks likely to endure,"The Economist, February 5, 2022, https://www.economist.com/finance-and-economics/2022/02/05/why-the-impressive-pace-of-investment-growth-looks-likely-to-endure

Why the impressive pace of investment growth looks likely to endure

For years after the global financial crisis the world economy was starved of investment. The aftermath of the covid-19 downturn has been drastically different. In America private non-residential investment is only about 5% below its pre-pandemic trend, compared with a shortfall of nearly 25% in mid-2010, the equivalent point in the previous economic cycle (see chart). The country has enjoyed the fastest rebound in business investment in any recovery since the 1940s, according to Morgan Stanley, a bank. In the rich world as a whole, predicts the World Bank, total investment will have overtaken its pre-pandemic trend by 2023.

Yet the investment rebound is not purely a cyclical bounceback. The changes wrought by the pandemic have necessitated more investment, too. The extent to which such investment continues will depend on whether those changes endure. One feature of the pandemic, for instance, has been soaring demand for everything digital. As a result, investment in computers in America is 17% above its pre-covid trend. Roughly a year ago the Taiwan Semiconductor Manufacturing Corporation announced that it would spend $100bn over three years to expand its chipmaking output. In mid-January 2022 it upped the stakes, saying it would spend $40bn-44bn this year alone. Days later Intel, another chipmaker, said it would invest more than $20bn in two factories in Ohio.

Blockages in the global supply chain for goods have also led to a splurge on new capacity. In 2021 shipping companies ordered the equivalent of 4.2m twenty-foot containers—a record, according to Drewry, a consultancy. Perhaps the archetypal business investment of the pandemic is being made by logistics companies testing whether autonomous cranes can increase throughput at ports and rail terminals.

As the heat of crisis has passed, the pace of the investment rebound has subsided a little. A composite indicator built by JPMorgan Chase, a bank, suggests that global capital spending rose at a underwhelming rate of 2.2% in the fourth quarter of 2021. Economists have recently marked down their forecasts for global gdp growth in 2022 owing to the spread of the Omicron variant of coronavirus and the prospect of tighter monetary policy, both of which might weigh on bosses’ willingness to splash out on risky projects.

There are, however, three reasons why business investment might be stronger in the 2020s than it was in the 2010s. The first is that companies are likely to keep spending on their supply chains as they seek to strengthen and diversify them. During the pandemic many have discovered the inconvenience of distant suppliers shutting down when lockdowns or staff shortages strike: factory closures in Vietnam last year, for instance, imperilled America’s supply of tennis shoes and yoga pants. Firms must also cope with increasingly fraught geopolitics, which increases the chances of tariffs on trade and state meddling. This may not be good news for economic growth, because fragmentation means duplication and inefficiency. But it does mean tying up more capital.

The second reason to expect more investment is the growing optimism about the potential of new technologies to boost productivity growth. Not long ago economists fretted that the world was running out of useful ideas. Yet firms are increasingly betting on technological progress. Intellectual property now makes up 41% of America’s private non-residential investment, compared with 36% before the pandemic and 29% in 2005. In 2021 the big five technology firms—Alphabet, Amazon, Apple, Meta and Microsoft—alone spent $149bn on r&d.

Impressive technological advances are everywhere, from synthetic biology and the “messenger rna” vaccines with which the world is battling covid-19, to areas such as virtual reality and decentralised finance. The advances in some frontier fields are headline-grabbing. In December Synchron, a medical-technology firm, revealed that a man with one of its chips implanted next to his brain’s motor cortex had sent a tweet just by thinking it. In January surgeons announced that they had successfully implanted a pig’s heart into a man for the first time.

The third force driving investment higher is decarbonisation. A number of countries, together making up 90% of the world economy, have pledged to reduce carbon emissions to net zero over the coming decades in order to fight climate change. If that goal is to be achieved, the world will need everything from electric-vehicle charging infrastructure to battery storage and energy-efficient housing.

Punters are pouring money into green-tinged investment funds, the assets of which amounted to $2.7trn in the fourth quarter of 2021, according to Morningstar, a data provider. Global investment spending on the transition away from fossil fuels reached $755bn last year, about half of which was spent on renewable energy, according to Bloombergnef, a research firm. Spending on electric vehicles has risen particularly quickly, by 77% since 2020 to $273bn, helped along by rapidly shifting consumer preferences and big orders from delivery and car-rental companies.

If net-zero targets are to be met, however, then the green-investment boom still has a long way to run. The Office for Budget Responsibility, Britain’s fiscal watchdog, estimates that achieving the country’s target by 2050 requires investment worth about 60% of its gdp today, three-quarters of which would have to be stumped up by the private sector. If that share were to apply across the rest of the rich world too, then its need for private-sector green investment would exceed $20trn at present values. Other estimates of what is needed are higher still.

An investment boom is hardly nailed on. The mass upheaval of supply chains is still a subject that is more often talked about than seen in the statistics. There were plenty of notable advances in the previous economic recovery, which began only two years after the launch of the first iPhone in 2007. Yet investment remained tepid (perhaps because many new technologies seem not to need much capital). Net-zero targets could always be missed.

But the pay-offs to r&d investment, at least, may be rising. In a recent research note Yulia Zhestkova of Goldman Sachs, another bank, found that in America between 2016 and 2019 there was a positive correlation between an industry’s investment in intellectual property and its labour-productivity growth. It would not take much of a productivity revival to significantly boost the outlook for growth, which is being weighed down by population ageing. So-called total factor productivity growth, which measures increases in gdp that cannot be attributed to more capital or hours worked, averaged 1.2% a year between 1880 and 2020, notes Ms Zhestkova. By contrast, the figure was only about 0.5% in the 2010s. Simply returning to the historical average would create the prospect of a larger economy in the future, giving firms yet another reason to invest.