Rutledge Institute for Capital and Growth is a forum for the analysis
and discussion of capital and growth, for the dissemination of research
on the impact of government policies on capital and growth, for tracking
the impact of policy changes on the economy and financial markets,
and for developing strategies to help businesses and investors increase
value and build wealth.
people asked Leonardo da Vinci the secret of his creative and
inventing genius, he replied "Saper Vedere," to know how
to see. Our objective is to help people see the link between government
policy, capital formation, and growth, then help them see strategies
for growing their businesses, increasing the value of their investments,
and improving their economic lives.
Thirty years of traveling
the world have convinced me that growth is the answer. Economic
growth is the only reliable engine for lifting people out of poverty
and improving their lives. Access to capital, along with the people's
focused productive energies, are the principal drivers of growth.
Capital comes in many forms; modern equipment, efficient factories,
new technologies, high-speed communications networks, and improved
education. All represent the stored energy of previous generations
of investors, innovators, entrepreneurs, and workers. All make
workers more productive, increase output, and provide the resources
for people to achieve their economic, personal, and social goals.
Incentives for creating capital and for the productive use of energy
are the keys to increased growth.
Later I ventured into the real world where I learned the models
were not always up to the task of helping policy makers, business
managers, and investors understand change. While keeping my healthy
respect for the limitations of economic models, my colleagues and
I developed a framework of our own to guide our thinking. That
framework-which is, of course, a permanent work in progress--underlies
all of our work.
As a young economist I
taught graduate and undergraduate students in macroeconomics, monetary
theory, international trade and finance, and econometrics. Like
other academics, I taught students how to build and manipulate
all the textbook models of economic behavior. I did so for three
reasons. The models were mathematically elegant, which made them
both beautiful and easy to teach. Publishing journal articles about
them was the key to advancement in the profession. And, having
never set foot in the real world, it was all I knew how to do.
The first pillar of our
thinking is also the simplest: Stuff Matters. No macroeconomic
analysis is complete without accounting for people's multi-trillion
dollar holdings of Stuff. Stuff describes the items on our balance
sheets, including tangible assets (land, office buildings, collectibles,
used cars, and other claims on future services), financial assets
(stocks, bonds, bank accounts, and other claims on future cash
flow), and all forms of liabilities (credit card debt, mortgages,
and the obligation to service and repay the national debt).
Analyzing the income statement alone, i.e., GDP and its components,
is just not good enough. That's because there is so much stuff
out there. This year US GDP will be just over $11 trillion, compared
with total assets (not including more than 700 million acres of
government-owned land) worth more than $120 trillion at market
matters because the values of the individual items on our balance
sheets determine our net worth, and our solvency, collateralize our
obligations, and influence our behavior. Those values are set in
markets based on the relative risks and after-tax returns of different
assets and liabilities. Government policies that result in abrupt
changes in relative risks and returns induce massive responses from
private investors. These responses are the most important channels
of economic and financial change.
policies influence our lives in many ways. Their biggest and longest-lasting
impacts on the economy happen when they drive a wedge between the
returns on some assets relative to others. These balance sheet
effects dominate all other events in driving economic change.
In the late 1970's, for example, rising inflation added an artificial
capital gains component to the return on tangible assets, while
rising income tax rates artificially depressed the after-tax returns
on financial assets. The resulting shift of investor demands drove
a boom in hard asset prices and destroyed three-quarters of the
real value of the stock market.
As a second example, the 1981 Reagan policies of falling inflation
and falling tax rates reversed this shift by boosting financial
asset returns relative to returns on tangible assets. This led
to a decade of restructuring in US industry, and to an eighteen
year bull market in bonds and stocks which triggered a huge wave
of investing in the 1990's.
As a third example, the 1996 Telecom Act artificially subsidized
the returns of some communications companies--cable operators and
CLECs (Competitive Local Exchange Carriers, such as MCI and AT&T)-at
the expense of the regional Bell operating companies. The resulting
wedge driven between their respective returns on capital led to
massive overinvestment in the former, and to a multi- trillion
dollar loss of market value for the latter, and contributed to
both the stock market bubble of the late 1990's and the severe
recession since then.
Shift happens internationally too. The opening of China to foreign
investors has exposed the gap between Chinese returns and ours.
The result has been a massive flow of capital out of the US , the
EU, and Japan and into China , millions of unemployed manufacturing
workers, and growing trade tensions.
Our valuation approach
is simple. Investors own securities for one reason-to get paid.
Stocks and bonds are simply claims on the future cash flow generated
by the underlying assets. The present value of those future free
cash flow streams is the Intrinsic Value of the securities.
Intrinsic Value estimates will only be as good as the estimates
of the value drivers for the underlying business--sales, price,
cost, margins, tax rates, capital requirements, and cost of capital-behind
the calculations. These value drivers are strongly influenced by
From time to time the interactions of buyers
and sellers in the asset markets result in market prices which
we find to be significantly above or below the Intrinsic Value
of the securities. That's when stocks or bonds are over-valued
or under-valued. Investors who consistently buy securities when
they are undervalued, and/or sell securities when they are over-valued,
will earn a higher-than-market return.
For a more detailed discussion, see Tracking
Risk does not mean volatility;
risk means losing your money. That happens when a business fails
to deliver the operating performance embodied in the price an investor
paid to acquire it. We call this Intrinsic Risk, and we measure
it by explicitly estimating the probability the Value Drivers that
underlie a market price fail to deliver the implied free cash flow
In physics, when two objects
are brought into contact heat flows from the hotter to the colder
object until the temperatures are equal, after which point there
is no further change. This is known as the First Law of Thermodynamics-the
most inviolable law in science.
Thermodynamics explains the weather, where temperature and pressure
differentials cause storms. They explain chemical reactions,
which are thermodynamic cooling processes. And they explain
economics, where price, wage, or return differentials lead to the
arbitrage behavior that moves prices and changes the allocation
of resources. Our Shift Happens methodology is nothing more than
a restatement of the First Law of Thermodynamics in the language
of economics and portfolio analysis.
Thermodynamics deals with systems, not with particles. Recent
work demonstrating the formal equivalence of far-from-equilibrium
physics and irreversible (entropy producing) thermodynamic processes
has led to a fuller understanding of the situations in which systems
fail to adjust smoothly to change. These situations of system failure
(blackouts) help us understand recessions, depressions, currency
collapse, credit-market failure, and other discontinuous events
in economics. Ironically, Irving Fisher, Knut Wicksell, and John
Maynard Keynes studied these topics a century ago.
For a more detailed discussion, see Supply-Side