Why invest in investment when you can invest in growth?

Come with me to the fictional economy of the future.

The year is 2030. The price of gold has passed $1 million (in today's dollars) per ounce. Nevertheless the world economy is shrinking badly. There are high levels of unemployment, massive poverty and starvation everywhere.

So how did we get to the point of $1 million per ounce? It could be argued that with the economy tanking so bad, investors have taken refuge in the only thing worth investing in. Why invest in companies that produce goods and services? No one is buying! Everyone is poor! It makes no financial sense to invest in such a scheme because the returns are just so low.

But the reality is that investors have gotten it backwards: It isn't that the economy is bad so we need to invest to gold, it's because we invested in gold that the economy is bad. Gold in the fictional world of 2030 has become another Tulip mania phenomenon - a massive investment bubble that drives itself bigger and bigger because people with money make rational decisions about where to invest it - and anything which rises in value should be invested in. Of course we would expect that, just like Tulip mania, this gold bubble would've burst, except that in the year 2030 the entire financial world has become so dependent upon it that any drop in the gold price is fixed simply by loose monetary policy. It isn't as though the central banks in the year 2030 are creating inflation - they're not - they're increasing the money supply via quantitative easing and keeping inflation within acceptable levels. Governments, sadly, have cut spending in line with their receipts, which have dropped faster than their country's GDP.

The problem here is simple. Past occurrences of investment bubbles have oftentimes resulted in huge busts. These days they do not. Instead, the investment bubble gets re-inflated because the ones who inflated it in the first place have not been removed from the financial system. Why is this? It is because any losses incurred by the bubble's deflation have been minimised through monetary policy - an increase in the money supply due to stimulation enacted by a central bank.

But there's something rather insidious about an investment bubble that has been going on for decades. The problem is not whether the investment itself gives a return to the investor (as is the common belief), but whether the investment itself actually creates economic growth.

Say you have $20 million to invest. You could invest it in gold. Alternatively, you could invest it in a biotechnology company that grows human body organs in a factory to be used in transplants. Now if the return on gold is higher than the biotech company, you would naturally invest in gold. But what growth comes from gold? Well apart from gold mining companies employing workers to mine the stuff, there is very little growth at all. Of course there will be a knock-on effect as gold mines are begun and people get employed and secondary industries and retail enterprises start up - but with everyone investing in gold, very little of the wealth created gets turned into economic growth. Investing in the biotech company, on the other hand, does the same thing in employing people directly and indirectly, but has the added feature of creating economic growth. How? With transplants cheap and plentiful, people will live longer and happier and be more productive.

So on the one hand you could invest in something that will make you money. Or you could invest in something which makes money for you and a whole bunch of people. We could, of course, choose to "invest ethically" but most investors simply throw their money at whatever is performing.

Now understand that I'm not having a go specifically at gold investors here (though to be honest with you I see absolutely no reason for people to value something that has no real usefulness). Instead I'm being critical of the entire financial system itself which values rising equity prices far more than returns - and whose "returns", by the way, are simply the result of accounting tricks and high equity prices traveling through the broader system.

Try to understand it like this. You give $1000 to investment company A so you can see a return on your investment. Investment company A invests it with industrial manufacturer B, who in turn decides not to use it to make anything but gives it to its own financial department to invest in Investment Company C. Company C then places it in Bank D, who lends it out to Investment Company E. Company E, a small financial company, then hands the money back to Investment Company A as part of an industry investment fund... and then the process begins again.

From a fractional banking system you can see here that each step of the way from A to B to C to D to E back to A will increase the money supply and the money velocity. Yet nothing of value has actually been created in this process. In the past such situations would quickly result in financial crash - but these days central bank monetary policy has moderated any damage and ended up perpetuating the growth of the bubble.

You see it is my belief that most western countries have been building a huge, unsustainable investment bubble for the past 30 years. The world of finance has grown exponentially in that time but economic growth itself has begun to slow down. Even when you account for the effects of lower birth rates, GDP per capita in most western nations has significantly slowed down since the mid 1970s and early 1980s. Credit market debt in the US over this period has grown from about 150% of GDP in 1976 Q1 to a peak of 375% of GDP in 2009 Q1 (it has fallen slightly since then to around 250% in 2011 Q1).

So what should the solution be? I have pointed out recently that, in the US at least, there should be a higher level of government spending along with increased taxes to support it. Yet the current economic malaise is not just suffered by America but also by the European Union, whose governments have already spent up big. This is where regulation needs to come in. There needs to be firm and easily enforced financial regulation to prevent the growth of investment bubbles:

  • A market capitalisation tax should be instituted so that publicly traded companies are forced to pay higher taxes when their value goes up - which would also punish companies with high p/e ratios (in fact the market cap tax rate should be increased across all public companies when the p/e ratio average for the whole sharemarket increases, with a commensurate decrease in the tax rate when the average p/e ratio drops). The idea here is that the market should be punished whenever signs of over-investment become clearer.
  • The property market needs to be subject to the same investment regulations as the financial market. It may even be necessary for a government agency to be created that will enter the market directly to buy and sell properties in order to keep house prices at a reasonable level (buying up houses when the housing market drops, selling houses and/or building houses when the market rises)
  • The financial industry needs to stop profiting from investing in the financial industry. The important thing to remember is that financial companies need to invest in companies that produce goods and services - but not invest in companies that produce financial services. One way to do this would be to remove financial companies from major stock indices. Another solution would be to prevent financial companies from being publicly tradeable altogether, forcing them to become private companies or even non-profits. In any case, stricter regulation and tax disincentives should be enacted to ensure that financial companies divert their funds towards industries that actually produce things.
  • Ensure that monetary policy keeps prices low. Even though I have criticised monetary policy in this article it is only because the current system has been able to take advantage of it. Once financial regulations have been improved (as per my suggestions here), monetary policy will be more effective. I still believe in "hard money".
  • Ensure that government debt does get paid off. Better regulations and more investment in industries that actually produce things will create economic growth - growth that will be accompanied by higher tax revenues to pay off debt. Governments need to be restrained once a sustainable recovery gets underway (which is unlikely for some time now that the US is about to go into recession again). Instituting a market capitalisation tax would help increase revenue too.
  • Higher taxes on the rich. It has been the rich who have driven much of the investment bubble since the early 1980s. Tax cuts for the rich since that time have led to great wealth amongst the wealthy but little in the way of economic growth.

Read this.