When Ray Dalio speaks, I listen.
Dalio, the billionaire founder of hedge fund Bridgewater Associates, has obviously earned a hearing based on his success, both personally and as an investment manager. But more so than his financial success in life, Dalio has earned a hearing based on levelheaded and clear-eyed assessments of economics and the winsome way in which he presents his views. He comes across both in writing and in interviews as a guy who has "made it" and now wants to give back to society, to ensure that others have the same opportunities he did.
I admire that about him, even if I don't agree with him on everything.
Dalio's most recent report on How Capitalism Needs to Be Reformed is a good case study in what makes the man admirable, even if one disagrees with some of his conclusions. The purpose of the present article is twofold: (1) To draw attention to Dalio's thoughtful report, but also (2) to critique some aspects of it in order to achieve greater clarity about some crucial economic realities.
First, let's cover some basic points in Dalio's report.
What Makes Capitalism Effective
What makes capitalism effective, according to Dalio, is the incentive structure that motivates hard work and efficient allocation of capital.
I’ve had exposure to all sorts of economic systems in most countries and have come to understand why the ability to make money, save it, and put it into capital (i.e., capitalism) is an effective motivator of people and allocator of resources that raises people’s living standards. It is an effective motivator of people because it rewards people for their productive activities with money that can be used to get all that money can buy. And it is an effective allocator of resources because the creation of profit requires that the output created is more valuable than the resources that go into creating it.
What Makes Countries Succeed or Fail
In a nutshell, poor education, a poor culture (one that impedes people from operating effectively together), poor infrastructure, and too much debt cause bad economic results. The best results come when there is more rather than less of: a) equal opportunity in education and in work, b) good family or family-like upbringing through the high school years, c) civilized behavior within a system that most people believe is fair, and d) free and well-regulated markets for goods, services, labor, and capital that provide incentives, savings, and financing opportunities to most people.
In Dalio's estimation (backed by quite a bit of data), America is suffering from a suboptimal education system, cultural polarity (that prevents Americans from working together to solve our problems), poor infrastructure, and excessive debt. I wrote about more problematic issues plaguing average Americans in How the American Consumer is Worse Off Today Than in Previous Decades. Real (inflation-adjusted) wages are stagnant for the bottom 60% of earners, labor force participation is not improving, reliance on welfare programs like disability is rising along with single-parenthood, and debt burdens continue to pile up.
Dalio highlights one more way in which the situation of average Americans is not improving, and that is the meager savings rate: "For example, only about a third of the bottom 60% save any of their income in cash or financial assets." Indeed, the personal savings rate across all income groups has fallen to less than 3% of personal disposable income.
Though lots of factors affect the personal savings rate, it's clear that higher interest rates encourage more saving. It rewards savers. Larry Summers presented a compelling case for the "interest elasticity" (sensitivity to changes in the interest rate) of the personal saving rate, concluding that higher rates result in increased personal saving. Increased personal saving then results in higher capital formation, devoting more resources to productivity enhancement and the development of future products. If debt is future spending pulled forward in time, saving is deferred spending — a signal about the capacity of the consumer to spend in the future.
The Federal Reserve Board itself came to a similar conclusion based on the available data in a 1996 paper, concluding that "the models that likely describe the behavior of the people who account for most of aggregate saving imply positive interest elasticities." In other words, the people who do the most saving respond to changes in interest rates, and the "positive elasticity" part means that people save more when rates are higher and less when rates are lower.
Since most Americans have no interest in or exposure to financial assets like stocks or real estate, higher interest rates disproportionately benefit those whose preferred savings vehicle is a savings account. Lower and middle income earners — the bottom 60% — happen to be those who prefer savings accounts to higher risk assets like stocks, bonds, real estate, and private businesses preferred by the rich. While ultra-low rates have been a boon to the upper 40%, they've hurt the lower 60% by reducing to near-zero the returns on their preferred savings vehicle and inducing them to consume more instead of save, leaving them in a more precarious financial position.
Source: Ray Dalio, economicprinciples.org
Notice how the income and wealth share of the bottom 90% tends to correspond with a prolonged period of high real (inflation-adjusted) interest rates from the last 1970s to the early 1990s. For a number of years in the 1980s, savers could get a 5-6% real return just from savings accounts. And the savings rate as a percentage of GDP topped out at 8.2% in 1982, falling steadily thereafter.
For a more in-depth look at this subject, see my articles, Blame (Or Thank) The Fed For Meteoric Wealth Inequality & Blame the Fed for the Plight of the Average American.
Where Does productivity Growth Come From?
Writes Dalio: "One’s income growth results from one’s productivity growth, which results from one’s personal development."
The above is true but misleading. Personal development tells only part of the story. Of course whether one develops a strong work ethic and drive to lead a successful, well-balanced life is important. Of course developing job skills is important. Of course emotional and psychological wellbeing is important. And of course school is important. Without a basic education and wellbeing in life, one's ability to achieve success is severely stinted.
But most people do finish high school. And most people who want a job are able to get one. More important for most people, then, is how productive one is able to be in any given work environment, and that has more to do with the investments made by the employer in the employee's productivity.
Compare, for instance, the work environments of an employee of McDonald's and an employee of Google. At McDonald's, workers perform their jobs more or less the same way they did in 1980. Maybe the cooks can put out a few more burgers and orders of fries per hour, but not orders of magnitude more. The software wizards that Google employs, on the other hand, perform their work many orders of magnitude faster than they could in the 1980s because of improvements in technology. Google employs just shy of 100,000 workers, and browsing the average salary of each position, you'll see that most have six digit salaries. Even the interns make $41 an hour.
Okay, the comparison isn't really fair. Google employees have to go through many years of school and be high-achievers to land a job there. McDonald's has less stringent requirements for entry-level jobs. So let's compare apples to apples: Walmart (including Sam's Club) employees vs Costco employees. It's well-known than Costco pays it's employees quite well — $13-14 for most positions, but much more for specialized roles. Walmart, on the other hand, pays its workers a more modest $11 an hour (as of last year). Why the difference? Is Walmart just stingier than Costco?
No. The reason is that Walmart employs almost twice as many workers per floor space than Costco. The latter's employees (even entry level) are expected to be more productive than Walmart employees. Costco has more stringent standards for hiring than Walmart, preferring even new employees to already have retail experience. The company offers various training programs, which allow for greater upward mobility. In four or five years, a worker can go from entry level to a specialized position like butcher, cake decorator, or forklift operator — jobs that command much higher wages. The increased worker productivity shows up in revenue per employee (RPE): Costco's RPE is nearly three times that of Walmart.
Wages for the bottom 60%, then, are primarily driven up by business investment. It's either on-the-job training or innovative machines, equipment, and automation (or both) that make average workers more productive (thus more valuable to their employers) and lifts their wages. Business investment tends to track with revenue growth, and revenue growth tends to correspond with the health of the average consumer. Consumer spending currently makes up about 68% of GDP, according to Lacy Hunt in Hoisington's latest Quarterly Review and Outlook.
One important way in which the bottom 60% of America could be helped in the longterm, then, would be to return interest rates to historically normal levels to induce a higher savings rate. Along with historically normal interest rates, Universal Savings Accounts (USAs) could be introduced in order to further reward savers. So as not to be a disproportionate boon to the rich (who currently do almost all saving), the untaxed income and gains from these USAs could be capped at a moderately low number. This would target the benefit to those who need it most — the bottom 60% of earners.
Higher interest rates combined with some sort of tax-advantaged savings vehicle disproportionately beneficial to the bottom 60% would go a long way in closing the wealth gap and lifting longterm economic growth prospects.
Dalio goes on to write: "Low incomes, poorly funded schools, and weak family support for children lead to poor academic achievement, which leads to low productivity and low incomes of people who become economic burdens on the society."
While business investment is a bigger factor in wage growth for those who have a job, the factors Dalio mentions here are more pertinent to the ability to get and keep a job. I agree that significant steps should be taken to reverse the continual poor performance of students in poorer schools.
A decent first step, in my estimation, would be to institute a regulated school choice system so that parents can pick which school to send their children to instead of being forced into a certain school based on one's neighborhood. Every child should receive a voucher for the same amount as every other child in his or her grade, and all schools that receive government funding — public, private, charter, trade, or otherwise — should be held to the same standards depending on the school's education goals.
I agree with education researcher Ashley Berner that there is "no one way to school." Schools that are preparing kids for college should all be held to the same standard. But schools that are preparing kids for work in a specific trade that does not require a bachelor's degree should be held to a different standard. Thirty percent of high school graduates in 2016 did not go on to enroll in college, and a large portion of those who attended college either didn't finish or took jobs that didn't require a degree, so why should they be taught the same curriculum as everyone else in high school?
School choice should ease the problem of channeling poor kids into underfunded and overcrowded schools, but in itself it won't necessarily improve student outcomes. New Zealand, for instance, has had a school choice system since 1989 that parents are very happy with, but this system has not improved test scores.
Other steps should be taken to raise student outcomes. Most obviously, teacher standards should be raised, and more should be invested in teacher training and support. As Dalio points out, teachers earn only 68% of what fellow college graduates make. This gap should be closed with at least moderately higher teacher pay. High-performing teachers (as measured by their students' standardized test scores) especially should be rewarded with higher pay or bonuses. Teacher networks should be fostered to facilitate information-sharing between teachers around the nation in order to ensure best practices are spread quickly. And on the parents' side, college savings accounts (or the modified USAs described above) should be encouraged and perhaps helped along with yearly federal matches.
Which is New: Profit-Seeking or the Pace of Change?
"That is because capitalism is now working in a way in which people and companies find it profitable to have policies and make technologies that lessen their people costs, which lessens a large percentage of the population’s share of society’s resources."
Capitalism has always done this. It's called "creative destruction." Employers seek to maximize profits through enhancing worker productivity, but in so doing they destroy the need for many of these workers. The tractor gradually destroyed most farmhand jobs. The motor car gradually destroyed most jobs for carriage drivers and stable boys. Specialized calculators and programs like QuickBooks diminished the number of jobs needed for accountants. And so on.
Creative destruction has been taking place for a long time, but it hasn't always resulted in worse job prospects or stagnant wages. Indeed, during the period after World War II up to the mid-1980s, America experienced job-killing technological advancement at the same time as an increasing share of the national income channeled into the pockets of the bottom 60% of earners. Though technological advancement didn't stop, the trend of an increasing share of income and wealth for the bottom 60% reversed in the 1970s-1980s.
The difference between now and the past is that change is now happening faster and across many industries simultaneously, destroying jobs at a faster rate than society can train people to take new jobs. There is a skills mismatch between job openings and people seeking work. (And it doesn't help that around 30% of professions in America require a license.) This means that we should make a commensurate effort to retrain and retool the American workforce. We as a nation should be laser-focused on this issue, but we aren't.
Why don't high schools require basic programming and personal finance classes? Why aren't there apprenticeships for young adults to enter trades or specific professions? Why aren't there national campaigns to dignify the honest and gainful work of dental hygienists, paramedics, welders, painters, plumbers, mechanics, policemen, firemen, air-traffic controllers, or electrical technicians (none of which require a college degree)?
Moreover, when it comes to financing collegiate pursuits, why do we treat all degrees equally when some degrees provide much better prospects for financial success in the economy? Just like riskier debtors, shouldn't students seeking degrees with overwhelmingly poorer job prospects have to pay a higher interest rate than those seeking degrees with better prospects? Why are we doing so little to channel university students into career paths that will benefit them (and the economy) in the long run?
QE: Necessary Evil or Part of the Problem?
"Central banks’ printing of money and buying of financial assets (which were necessary to deal with the 2008 debt crisis and to stimulate economic growth) drove up the prices of financial assets, which helped make people who own financial assets richer relative to those who don’t own them."
I agree with all of this except for the parenthetical clause. There has been a distinct shift among intellectuals (especially in the investment community) from the belief that the prevailing monetary policy regime (primarily quantitative easing but also low interest rates) is necessary and good to the belief that it is a necessary evil. Sure, they say, historically low interest rates and trillions in digital currency credits have pushed up financial assets, thereby increasing the wealth of the already wealthy and putting home prices out of reach for average earners, but these measures were necessary in order to save an economic system on the verge of collapse.
George W. Bush's famous line comes to mind: "I had to abandon free market principles in order to save the free market system."
But as I've shown in a previous article, there is no evidence that QE produced better economic growth than we would have otherwise had. This is as true for Europe and Japan as it is for the US. The current expansion is the slowest since the Great Depression. Moreover, the prevailing monetary regime has affected capital allocation in some other malignant ways — ways that have elevated debt burdens across the board, eroded productivity growth, and drastically diminished the savings rate of average earners. This lower savings rate has made less resources available for the production of real capital, even as there is a QE-fueled glut of financial capital sloshing around in the markets.
What's Needed is Fiscal Realism
"While focusing on the budget is what fiscal conservatives typically do, fiscal liberals have typically shown themselves to borrow too much money and fail to spend it wisely to produce the economic returns that are required to service the debts they have taken on, so they often end up with debt crises."
I agree with this sentiment wholeheartedly. The majority of the federal budget is devoted to Social Security, health programs, and interest on the debt, each of which provide zero (or negative) return. That is, they do not increase GDP and tax receipts enough to exceed the additional interest payments on debt taken out to finance them. There are forms of government spending that can produce a positive return on investment, such as education, infrastructure, preventive healthcare, and basic research. But these make up a very small part of the budget.
Running federal deficits is harmful in the long run, but in the short term, it can be beneficial if it is used to invest in positive-return projects such as the above. In that sense, too narrow a focus on deficits (as fiscal conservatives are often guilty of) can be harmful as well. Fiscal realism, rather than mere parsimony or largesse, is what's needed.
Why Does This Matter To Investors?
The previous discussion of education reform matters to investors because Dalio is right: effective education will, in the long run, elevate worker productivity and economic growth, and ineffective education does the opposite. If the American education system continues to perform poorly, leaving a large portion of kids behind, the social safety net and justice system will incur greater costs while ensuring lower GDP than we would otherwise have. Lower GDP and greater costs to the government generally translate to lower returns on investment assets.
So, too, with business investment: If businesses are not investing in the productivity and success of their employees, then wages will not rise very quickly. If wages aren't rising for most people, then they will have to turn to consumer credit in order to make purchases, but there is a limit to the amount of purchases on credit consumers can do. This ultimately stints revenue growth and hurts investors.
The same can generally be said about the effect of monetary policy on the financial health of the average American. The marginal propensity to spend is much higher for the bottom 60% than it is for the top 40%. If we can find a way to make capitalism work better for the bottom 60%, the top 40% should also indirectly benefit. Keeping interesting rates in a historically normal range balances the benefits between rich and poor.
In one sense, we are all individuals. But in another, we are all in this together. We all share an economy, a culture, and a government budget. If we don't find a way to improve the economic prospects and opportunities for everyone, the rising tide of populism will eventually erode the economic prospects and opportunities for all of us.
Ray Dalio's fundamental point for investors is this: We are looking at a permanently low-growth, low-rates future if substantial steps are not taken to change the current situation.
But, in my judgement, investors should be prepared for the plausible future in which nothing is done until it becomes a crisis.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.