Wealth Can Not Grow Faster Than GDP Forever
Summary of Absolute Return Partners' November 2021 Letter
Niels Jensen of Absolute Return Partners argues in his November 2021 letter that wealth cannot grow faster than income. He says it is a mathematical impossibility.
I summarized his letter below, delving into the reasons why.
The change in GDP is a measurement of income growth. This can be called growth or g.
ΔGDP ≈ g
Rate of return on financial assets = r
If r is the rate of return on financials assets and if r is used as a measurement for the growth of wealth, then Niels is arguing that the growth rate on wealth can’t exceed income growth forever.
One reason why the rate of return on financial assets (wealth) can’t grow faster than income growth (the change in GDP) forever is that it creates inequality in society.
Governments want to prevent too much inequality because it can eventually lead to a crisis.
For example, one of the causes of the French Revolution in the 18th century was a result of the rich getting richer and the poor getting poorer.
Therefore, governments are more likely to create regulation that will eventually prevent the rate of wealth from increasing at a faster rate than income growth if it gets too out of hand.
Another reason why wealth can’t grow faster than income has to do with the tradeoff between risks and reward for the owners of capital.
To understand this, first let’s look at the rates of return of the stock market.
The long term mean value of the price-to-earnings ratio is around 15.
Here’s why:
The price-to-earnings ratio is a measure of how expensive and cheap stocks are. It takes the market cap of a company or an index divided by its earnings.
For more mature and established companies that have more stable earnings, the P/E ratio can signal future returns on the market.
The higher the P/E ratio, the less likely the future returns of the market are likely to be and vice versa.
(Note that we are talking about the S&P 500 here which includes more established and mature companies as opposed to venture companies with little or no earnings that may grow at very high rates)
If you take the reciprocal of 15 (1/15) you get 6.6%.
This 6.6% is equal to the long-term average of interest rates on bonds (5%) plus the long term average of risk premium that investors require for taking more risk by investing in the stock market.
Just as equity investors require a risk premium to incentive them to take more risk by investing in stocks, capital owners also require a risk premium when making their capital available for economic growth.
Since wealth is the total amount of capital available for investment in the real economy and since GDP is the total output, the wealth-to-GDP ratio is a measure of capital-to-output.
According to Niels, the capital-to-output mean value is 3.8 times and the range is always between 3.5-4.5 times regardless of how developed an economy is as long as it is an open market economy. This is due to economic growth theory, a very complicated topic that Niels doesn’t get into.
With all of this being said, we are currently in an interesting period of time where the wealth of the very rich has risen more than three times faster than the wealth of average people over the last 35 years.
The very rich have seen their wealth grow 6.8% per year over the last 35 years compared to 2.1% for average people.
Since the financial crisis, wealth in the U.S. has grown faster than it has in all other countries.
According to Niels, one proxy for wealth is global equity market capitalization. Another proxy is the value of real estate markets.
As you can see below, the global equity market capitalization as of June 2021 is at an all-time high.
Niels says that this large rise in wealth-to-GDP is unsustainable.
In summary, the two reasons that Niels says that wealth cannot grow faster than GDP forever is because:
1. It leads to inequality and too much inequality will eventually lead to the government stepping in and preventing too much inequality. If the government doesn’t step in then there will be social unrest or revolution that will put an end to wealth continuing to grow faster than GDP.
2. Wealth represents the total amount of capital available and GDP represents output. If the wealth-to-GDP ratio keeps rising then it will eventually reach too high of a level where it doesn’t make economic sense for capital owners to invest their capital because the output won’t justify the risk for capital owners to invest.