AMERICAN STOCKS HAVE PERFORMED WELL, ENRICHING AMERICANS
One way of boosting returns is to distribute the benefits of equity to a greater and more diverse set of individuals. Since the mid- to late nineteenth century, American stocks have delivered some pretty astonishing returns. It depends on the exact time period under consideration, but by many common measures American equity returns have averaged about 7 percent a year, and that is after adjusting for inflation. To put that in context, a 7 percent annual return means that the value of a portfolio doubles about every ten years. Those same returns may or may not hold over the future, but for the purposes of this discussion let’s focus on what we know, and that is the returns from equity holdings from the historical past.9
Of course, the 7 percent figure is only an average—most years, stocks bring either more or less than 7 percent. Furthermore, not every American holds a diversified bundle of stocks, and many investors squander some of their gains through excess trading and incurring the associated trading costs. Advisor fraud is a problem too. According to one recent study, 7 percent of active financial advisors have a misconduct conviction or settlement on their record. The median settlement in such misconduct cases is $40,000, only half of advisors involved in such cases are fired, and of those fired, about half find a new job in the financial services sector.10
Still, over any thirty-year period in American history, the return on stocks is remarkably high, especially compared with the return on bonds. To make that concrete, if you had bought a representative bundle of stocks right before the crash of 1929, thirty years later, relative to what would have been available on Treasury bills, you would have earned over 6 percent a year on your money.11 For a comparable thirty-year period, safe government securities tended to yield only about 1 percent a year, which is much less than one could earn in the stock market. With returns of 1 percent, it takes about seventy years for an investor to double his or her money.
The United States is, quite simply, one of the countries that encourages its citizens to invest the most in equities. As of 2015, 55 percent of Americans had money invested in stocks. That is a major benefit from the American financial system, and for ordinary American citizens it is worth hundreds of billions of dollars. Even if you do not personally own many or any equities, there is a good chance your retirement fund or pension fund does. While much of the world has been catching up with the American system in this regard, that global spread of equity ownership is yet another benefit of America’s pioneering efforts.12
It’s not that all Americans have used these returns to squirrel away wealth. In fact, the United States is known for its consistently low rate of household savings, typically running under 5 percent and sometimes under 4 percent. That is a major problem for the United States, but in fact it reflects too little engagement with financial intermediaries, not too much. In any case, high equity returns allow Americans to engage in more consumption.
One reason Americans buy so much equity is that U.S. financial markets have made so many financial assets fairly liquid. American equity markets are considered relatively fair and supportive of liquid trading, more or less on demand, with accurate record keeping. That means an investor can opt for higher-yielding assets without sacrificing much in the way of liquidity, and indeed, helping individuals liquefy their wealth is one of the main functions a financial sector should serve. For instance, cash management accounts and money market funds are easy to obtain and charge relatively low fees. It is also possible to hold stocks and have ready access to those funds. The American system performs well in this regard, as there is a dazzling array of investment products at virtually all levels of risk. Furthermore, Americans can borrow against relatively illiquid forms of wealth, such as homes, cars, and other possessions, with relative ease through a variety of competitive lenders. Banks, investment banks, portfolio managers, and other institutions all have helped make equity investing a legitimate strategy, thereby mobilizing funds in that direction.
When it comes to consumption, arguably the American financial system has succeeded all too well in liquefying wealth. As just mentioned, the American household savings rate is relatively low, compared either with other wealthy countries or America’s historical average, and there is a disturbing new trend of individuals borrowing against their retirement savings. If anything, American finance is too responsive to what people want, in this case a lot of new debt. That criticism may be a case of “blaming the waiter for obesity,” but it remains one of the most significant and mostly correct charges that can be leveled against American business. American business as a whole is better at talking people into spending money than helping them save money.
Marketers have had a strong influence on American financial markets, mostly for the better. For instance, consider the mutual fund. Its exact history is debated, with examples running back to the seventeenth century or possibly earlier, but it is the American economy that realized the idea on a very broad scale in the 1980s, allowing ordinary investors to invest in diversified stock portfolios at relatively low cost. American financial marketers promoted mutual funds with savvy over the following decades, thereby making Americans feel more comfortable about these largely profitable investments. You could say that Madison Avenue helped Americans boost their wealth. It also seems that the much-maligned marketing activities of professional asset managers increased household participation in equity markets. During the period 1980–2007, the share of household assets in either mutual funds or other marketable securities rose from 45 percent to 66 percent. The percentage of households owning stock rose from 32 percent in 1989 to 51 percent in 2007 and 55 percent in 2015, again with nudging from financial intermediaries along the way.13
Note also that the costs of equity investing are coming down over time. For instance, from 1980 to 2007, the average fee on equity mutual funds dropped from about 2 percent to about 1 percent. That was driven largely by the greater use of no-load funds, as investors learned—albeit slowly—that higher-load funds do not offer superior performance overall. I expect this learning process to continue and for fees to fall further, due to competition and the general spread of information.14
If you look at the major criticisms of the American financial system, they are intertwined with some more general features of the American culture, such as a willingness to take risks and an openness to new products and ideas. For instance, the subprime crisis wasn’t just caused by the banks; rather, it stemmed from a more general American culture of the intense marketing of get-rich-quick schemes, going well beyond banking and real estate. That said, these rather open and optimistic cultural tendencies create a corresponding upside, as reflected in the high returns American citizens have received through equity.
You might think these high equity returns in the United States stem from the performance of American companies and not from American capital markets, but actually it’s both. American equity values have been (generally, not each and every year) high and rising because companies have had relatively high earnings. Still, funds must be mobilized and brought into loan and equity markets and into other channels of funding, such as venture capital. Mutual funds and hedge funds must be willing to take chances, and they need the opportunity to funnel savings into equities and also into relatively new ventures. Pension investors must consider American capital markets to be sufficiently fair and transparent that they are willing to funnel their trillions into American equities.
One issue is whether those high equity returns for American citizens represent net gains or just a reshuffling within the American economy. It could be, for instance, that American citizens are earning 7 percent on some investments, but this cuts into returns that otherwise would accrue to shareholders inside the businesses themselves. Still, if the American financial system redistributes high equity returns away from insiders and to a broader group of citizens, most of us regard that as good.
Furthermore, Americans hold a lot of their equity in foreign concerns. Foreign equities were only 2 percent of the portfolios of U.S. residents in 1980, but by 2007 this had risen to 27.2 percent. Part of that change stems from the aggressive marketing of overseas equities by American brokers and fund managers, as well as the more general growth of foreign and emerging markets. This American overseas investment probably represents a significant net gain to the citizens of the United States.15
One way of thinking about this net gain is to consider that domestic U.S. firms invest a good deal overseas, and at fairly high rates of return. The gains from these investments are sometimes called “dark matter,” because the gains cannot be observed easily and thus their size is the subject of debate. In economics, the “dark matter hypothesis” first became popular in 2005–2006, when the U.S. trade deficit was unusually large but, contrary to many predictions, the dollar showed no signs of collapsing and most of the time was not even falling. How could this be? Some economists, most notably Ricardo Hausmann and Federico Sturzenegger, suggested a new hypothesis: that America’s actual trade deficit might be much lower than measured if we took into account intangible American exports overseas, typically bundled with American investment abroad. To make that more concrete, if there is a McDonald’s franchise in Europe, America is also exporting some brand-name capital, some organizational know-how, and some managerial expertise, but these will bring future rather than current returns, unlike exports narrowly measured. The upshot is that America’s net foreign position is much better than it looks on paper. And that is why the phrase “dark matter” is used, as a hat tip to a hypothesis in physics that says most of the matter in the universe is essentially invisible to our measuring instruments. Of course, this point about economic dark matter is a restatement of the earlier observation that American capital markets help bring higher rates of return to this country.
I once had a chat with a leading Korean economist, who lamented to me: “We work so much harder than you do to export! But we give it all back by just investing in your T-bills. You Americans earn more by investing in businesses overseas.” That is another way of putting the “dark matter” point, and again it reflects the American willingness, and indeed eagerness, to seek out higher-yielding (and riskier) equity-based investments.
There is no general agreement on how large this “dark matter” phenomenon might be. Hausmann and Sturzenegger in their original work suggested a figure as high as 5.6 percent of GDP per year, with an accumulated stock of dark matter as high as 40 percent of GDP (a 2006 estimate). If that is true, rather than foreigners having a net claim of $2.5 trillion on the United States in the form of capital assets (a 2005 estimate), the United States has a net claim of $724 billion on foreigners—a big difference in value.16
A lot of subsequent writers have expressed skepticism that dark matter gains could be so high, and the dark matter hypothesis fell out of favor during the financial crisis, when American investments overseas lost a lot of their value and the chaos made a lot of these values yet harder to measure. Now, though, that value has mostly come back, and even the skeptics admit that American investments earn higher rates of return abroad than do foreign investments in the United States. There is also plenty of independent evidence that American corporations are especially well managed, as I discussed in chapter 3.17
So how large is the return to the American strategy? One economist, Pierre-Olivier Gourinchas, estimates that since 1973 the overseas assets chosen by Americans have yielded between 2.0 and 3.8 percent more than what foreigners are holding in the United States. These higher returns, in his view, allow America to run a trade deficit of about 2 percent of GDP a year without losing ground in terms of the country’s net asset position. In other words, that is about 2 percent of GDP each year as a kind of international free lunch—in absolute terms, about $334 billion a year. That is a pretty big gain to reap from the U.S. financial sector.
In essence, you can think of America as the world’s largest and most successful hedge fund. That involves some risks, but it has made us a much wealthier nation.