01_

Save Now, “Saving inflows from abroad can be beneficial if the country that
Invest Later receives those inflows invests them well. Unfortunately, that was not
always the case in the United States and some other countries.”

—Ben Bernanke

“I spent a lot of money on booze, birds, and fast cars. The rest I just
squandered.”

—George Best

August Not only did we spend beyond our means, but what we saved lost value, too. From vacation
2009
houses to Pets.com to the Nikkei, the bubbles of the last two decades have burst. As we nurse our
hangover, we are hungry to save more, but we have lost our appetite for investment. Before we
can make more intelligent choices for the future, we need a theory that accurately explains the
past. A natural impulse is to preach the need to consume less and save more. Another approach is
to analyze the basis of investment.

A basic fact of economics is that the sum of all savings and investment around the world must be
equal.1 If you want to increase your savings, you must find more investment opportunities (or a
willing foreign dance partner). But how do you save when you don’t know where to invest? The
traditional answer is not to worry about it and to let the bank managers sort it out, but when
the global banking system has just been saved from its own excesses by taxpayer bailouts, one
is inclined to question the judgment of most banks. Perhaps the ideas that motivate investment
really do matter after all. The Industrial Revolution, for example, was good, but building surplus
houses was not.

As Mr. Bernanke says, people need to invest in things of real value.When Mr. Best spent his money,
at least he knew what he was getting. Now that the party is over, everyone wants to invest wisely,
but the scope and nature of this challenge are not broadly understood.The problems are too global
to be cleaned up by micro-economic tweaks or better regulation. In fact, the developed world has
nearly ceased to form new physical capital. Perhaps the West counts on the immense deepening
of physical capital in China to power global growth; or perhaps the West believes its investment in
intangible capital will have high economic returns.2 We argue that both ideas are mistaken. Indeed,
the world is suffering from both the failure of old ideas and a dearth of new ones.

1. They must equilibrate in the sense of the GDP identity, Y=C+I+G. I is equal to S, savings,
because all of the income (Y) in society must be either consumed (C), invested (I), or used by
the government (G). Economists differ on what to count as investment (for example, whether
education is investment or consumption).

2. Intangible capital stock is primarily a nation’s human and technological capital. We define
tangible and intangible more fully below.

This document is confidential, for qualified individuals only, and not for further circulation. This is not a solicitation
or recommendation to buy, sell, or hold any securities or commodities. Certain statements contained herein may be forward-
looking. Information contained herein is believed to be accurate and/or derived from sources which Clarium Capital Management
LLC believes to be reliable, but such information may not be independently confirmed. Graphics contained herein are purely
representational and do not reflect any hypothetical return from an investment in the depicted instruments. 3lkka


 02_

TAXONOMY OF SAVINGS AND INVESTMENT

In order to think clearly about how people form expectations and how these expectations affect
savings demand and investment demand, we need new terminology. Our terminology describes
individuals’ and societies’ demand to save and demand to invest for given interest rates. We will
use this terminology to categorize the beliefs that determine the amount of savings on one side
of the scale, and both the amount and type of investment on the other. These terms will allow us
to distinguish four archetypal societies that match the recent behavior of the largest economies
in the world. In each archetype, a fundamental question has emerged. So far, none have been
answered.

SAVINGS DEMAND

First, let us develop a stylized model of savings demand for a given interest rate.

A cautious society will save more for a given interest rate because it does not value current
consumption much more than future consumption and because it has doubts about its future
income stream. A cautious society has a high demand for savings.

Conversely, a consumerist society will save less for a given interest rate because it values current
consumption much more than future consumption and is sanguine about its future income. Its
demand for savings is low.3

These terms are meant to describe the demand to save for all parts of society; the intentional
effects of governmental policies also affect the supply of savings in aggregate.

INVESTMENT DEMAND

Second, let us develop a stylized model of investment demand for a given interest rate. Society’s
demand to invest is a function of confidence in the future income stream of investment (which
affects the quantity of investment demanded) and personal preferences (which affect the type of
investment demanded).

A tangible society4 seeks to invest by adding to the physical capital stock. By physical capital stock
we primarily mean things measured in the national accounts of given countries as fixed capital
formation. Obviously, tangible investment requires intangible know-how. The construction of an
oil refinery, for instance, demands a great deal of technological expertise.

3. While our model could have derived savings demand from consumption preferences and
income certainty independently, we derive our model from a union of these two notions for ease
of analysis.

4. We focus on the supply of savings and the type of investment demanded for pragmatism’s
sake. While tangible societies generally have empirically higher rates of investment than
intangible societies, this empirical reality does not describe a more fundamental truth. Much
of this difference is simply definitional: for example, the treatment of education and health care
spending. Other examples include the failure of the Bureau of Economic Analysis to include R&D
as capital expenditure in the national accounts of the United States.
 03_

An intangible society seeks to invest by adding to human capital or to technological capital.Whereas

the tangible society is most concerned with solving today’s problems with today’s technologies,
the intangible society aims to expand the technological frontier.

MACRO ARCHETYPES

If we map our concepts onto real societies, we can begin to predict whether a given society is
likely to be a net demander or a net supplier of capital to the rest of the world.

Tangible

THE MIRACLE CASTLES IN THE SKY

Chinese society in the era of
capitalist growth.
Can China’s investment machine
power the developed world onward?
Asset-based societies in the era of
the housing and leverage bubble.
Can Americans find a home for the
investment previously used in
housing?

Cautious Consumerist
THE POST - INDUSTRIALIST THE AGE OF DREAMS

Japanese society in the Lost Decade
and the current crisis.
What will Japan do now that the
world no longer demands its savings?
American society during the Internet
bubble and at the cusp of the
future.
Will the intangible capital stock of
the U.S. actually increase?

Intangible

THE POST-INDUSTRIALIST

That Japan should be the archetypal cautious-intangible economy seems counterintuitive.5 How
could one of the world’s major manufacturing and exporting countries be considered intangible?
The cautiousness of Japanese savers is not matched by an investment demand that allows this
savings to be used domestically. The previous model has not failed; its very success has spawned
tremendous competition from less developed economies. Some of Japan’s businesses have
benefitted from this regional growth, while others have been harmed, but the winners have not
offset the decrease in capital formation in the housing, commercial real estate, and lower-value-
added sectors. To increase its investment at home, Japan needs a new national business plan. At the
same time, as certainty about the previous model has fallen away, figure 1 shows that Japan has
begun to look more and more like the United States. A post-industrial society is, by definition,
an intangible society.

5. The following analysis excludes Japan’s serious demographic challenge from a capital
formation perspective. We ignore this to focus on the relative difference between savings
demand and investment demand, which, while related to demography, is not driven by it.
 04_

Fig. 1 Japan Becoming Like the U.S. Source: National Accounts

80% Japanese Consumption % of GDP Excess U.S. Consumption Compared 20%

with Japan, % of GDP

76% 16%

72% 12%

68% 8%

64% 4%

60% 0%

1989 1993 1997 2001 2005 2009

While Japan has become more like the United States in its domestic economy, the two
countries differ in their external balances. Investment in the United States has been sustained
by importing foreign savings (buying the present with the promise of the future); the Japanese
demand to save has been sustained by exporting savings abroad (selling the present for claims
upon the future). What economic flows have been sustained by this savings, and what ideas in
the rest of the world have demanded this investment? A common answer is that the savings
were consumed by profligate countries such as the United States, Britain, and those of

Fig. 2 U.S. Change in Yearly Trade Deficit and Residential Construction Source: Bureau of Economic Analysis

$450 U.S. Residential Construction

U.S. Trade Deficit

$350
Billions USD

$250

$150

$50

$0

-$50

2001 2003 2005 2007 2009

 05_

southern Europe. A competing theory is that these savings were not consumed, but simply
invested by those with a better bubble machine. Figure 2 shows a version of this correlation.

Given energy constraints and the burst asset-bubbles in the rest of the developed world, perhaps
Japan determined that funding such expansions on favorable terms was more compelling than
pursuing the same strategy at home. Japan’s savings preferences, including a relative preference for
government and government-guaranteed securities, reflect the level of safety demanded to fund
investments of which they were likely skeptical. As these imbalances unwind, what will happen to
the economic flows that were created out of Japanese savings?

The fundamental question engendered by the post-industrial economy is, can Japan overcome the
global decline in tangible capital formation? What will Japan do now that the world no longer
demands its savings?

CASTLES IN THE SKY

The broad outlines of the global housing bubble and bust are well known. Observers correctly
label the housing bubble the era of asset-price-based economies.6 While asset prices always
influence economic decisions, this phrase highlights the precariousness of an economy that relies
on the rising prices of long-lived assets for economic growth. While the first-order effect is to
produce more of the assets as they increase in price, this approach is akin to making a desert
bloom by drawing down the aquifers. If someone discovers a substitute for water, the gamble
will have paid off. If not, the well will run dry, and the harvest will fail. The magnitude of the

Fig. 3 Simple Economics Sources: Case-Shiller; Census Bureau

200

170

140
Index Level

110

80

U.S. Home Price Level

50 U.S. Residential Construction Completions

2001 2003 2005 2007 2009

6. For example: “You’ve inherited an asset-based economy whose well has been pumped nearly
dry with lower and lower interest rates and lender of last resort liquidity provisions that have
managed to support Ponzi-style prosperity in recent years. Bill Gross, “Dear President Obama,”
PIMCO (July 2008). http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/
IO+July+2008.htm.
 06_

error is proportionate to the scarcity of the resources misused. Having learned a lesson, society
can then move on to producing new assets of more enduring worth. Figure 3 simply shows the
working of economics: price signals encourage the production of more of what is valued and
less of what is not.

While we do not minimize the value of these wasted resources, we also do not underestimate
the problem faced by global society at the onset of this boom. The problem has become clearer.
The actual amount of investment done by a society always occurs at the intersection of the
savings demand curve and the investment demand curve. Because economists think investment
is generally beneficial, it is unusual to worry about having too much actual savings. Therefore,
when there are no good investment ideas, it is polite to speak of a savings glut.

The fundamental question engendered by the Castles in the Sky analogy is, can Americans find
a home for the investment previously used in housing?

THE MIRACLE

The success of China’s economy since the late 1970s is well known. The formula is simple: take a
billion people with no capital and grow by relentlessly building up the capital stock. This capital
deepening creates a significant catch-up effect and very strong growth. Normally, this high growth
should attract foreign investment to China and lead to significant capital inflow, as it does in India.
But China has experienced net capital outflow even as its domestic investment7 has continued to
increase as a share of total output.

Fig. 4 Chinese Gross Capital Formation Source: National Bureau of Statistics Fig. 5 Chinese Trade Surplus Source: National Bureau of Statistics

45% % of GDP Real Growth Rate YoY 25% 10% % of GDP Real Growth Rate YoY 160%

42% 20% 8% 120%

39% 15% 6% 80%

36% 10% 4% 40%

33% 5% 2% 0%

30% 0% 0% -40%

1996 1998 2000 2002 2004 2006 2008 1996 1998 2000 2002 2004 2006 2008

While this is unusual, China’s export dependency has varied considerably over time. Capital
formation, on the other hand, has secularly increased as a share of total output. China’s level of
tangible capital formation is astounding. No other country in modern history has allocated such

7. Gross investment and gross capital formation are used interchangeably throughout this
paper. They are equal to each other when gross investment includes gross investment of the
government. This paper adds U.S. government investment to private investment for comparison
with other countries unless explicitly noted.
 07_

Fig. 6 Chinese Gross Capital Formation Driving Growth Source: National Bureau of Statistics

9% Contribution from Capital Formation Real GDP Growth YoY 14%

12%

10%
6%

8%

6%

3%
4%

2%

0% 0%

1996 1998 2000 2002 2004 2006 2008

a significant portion of its total income to future production. Japan was able to achieve capital
formation averaging 35% of GDP per year for roughly one economic cycle ending in the 1974
recession, during nearly a decade of double-digit increases in real output. But Chinese capital
formation has averaged 38% for the last twenty-five years—and is accelerating, as figure 6 shows.
The growth in the output from that investment has been remarkable, but the ability to direct an
increasing share of that output to create more capacity is unprecedented.

Such an effort demands tremendous certainty of vision. Chinese society can be confident about
capital deepening of technologies and advancements the West made long ago. While investment
in innovation is risky, one may copy with confidence, and this confidence is driving explosive
investment.Yet with equal confidence in higher incomes tomorrow, Chinese people should want
to consume more today. We know, however, that Chinese savings rates are increasing. How can
certainty drive such high demand to invest on the one hand but such low demand to consume
on the other?

Observers often attribute China’s high savings to its lack of a social safety net,8 but the analysis can
be extended one step further. Because savings is defined simply as all of society’s income that is
invested, a social safety net leads to higher total consumption only if the government takes wealth
from people who do not want to consume and gives to others who do. This is a political rather
than an economic choice. With the same money available for transfer payments, the government
could instead build highways with the promise that all will benefit. This building of national
highways would rightly be considered investment, and therefore savings. China’s consumption
and investment behavior can thus be seen as a decision rather than a deficiency.

In this interpretation, China’s government coordinates society such that short-term needs are
largely abandoned in favor of long-term goals. What makes the model work is growth. The belief
in future growth coordinates a high level of investment in the present, and past investment has

8. See for example: Paul Krugman, “Revenge of the Glut,” New York Times (March 1, 2009).
 08_

so far fulfilled its promise to raise incomes. If we grant that China can continue to achieve high
growth rates, at least over any foreseeable horizon, then what does this portend for the West? Can
the developed world expect China’s success to drive strong global growth?

The fundamental question engendered by the Miracle is, can China’s investment machine power
the developed world onwards?

THE AGE OF DREAMS

Under what societal model does it make sense to lend money indefinitely to one country for nearly
thirty years running?9 A variety of explanations have been proffered over the years, but the one that
interests us is the idea of an intangible society. Investment in America usually begins with someone
saying, “I’d love to drop by and run an investment concept past you.” Venture capital spending
suggests Americans care intensely about what the future will look like. This is the great strength
of the intangible. The weakness is that focusing on the far future easily blurs the problems of the

Fig. 7 2008 Global Venture Capital Spending 10 Source: VentureSource

US
69%
4% UK

11% Europe ex UK

10%
China
2%
India
4%

Israel

9. The United States has run a deficit in foreign trade from the bottom of the 1982 recession
until the present. There was a quarter in the early 1990s recession where this measure shifted
into surplus, but this was due to unusual transfer payments and quickly reversed. The deficit
tends to expand at the peak of an economic cycle and contract as activity retrenches.

10. Perhaps the U.S. has a comparative advantage in venture capital and thus a more accurate
measure would be total R&D spending by U.S. corporations in comparison to R&D spending of
the world. In 2008, the U.S. represented over 38% of total R&D spending despite representing
just 30% of world market capitalization. Japan was the other disproportionate spender with
18% of total R&D spending despite being only 10% of world market capitalization. Héctor
Hernández Guevara, Alexander Tübke, and Andries Brandsma, “The 2008 EU Industrial R&D
Investment Scoreboard,” Joint Research Centre and Research Directorates-General of the
European Commission (2008).
 09_

Fig. 8 U.S. Goes from Exporter to Importer of Computer Goods Source: Bureau of Economic Analysis

20 Net Export of Computer Goods

15

Real Quantity Index

10

-5

-10

1995 1996 1997 1998 1999

present. Figure 8 shows that even as the Internet boom was hitting its stride, America was relying
ever more on foreigners for the goods the boom demanded.

The convergence between Japan and the United States that was illustrated earlier in figure 1 has
another aspect. Companies cannot maintain high capital expenditures when forward growth
expectations decline significantly. Japan’s corporations demanded capital through the bubble, but
supplied capital thereafter. In the United States, corporations have likewise become net suppliers
of cash to the rest of the economy since the 2000 market collapse.11 The magnitude of this change
is striking. Corporations went from demanding an average of $275 billion a quarter in 2000 to
supplying $175 billion a quarter in 2005. Even with the private equity boom and the largest
commodity price increase since the 1970s having led to a vigorous capital expenditure cycle in
2007 and early 2008, the corporate sector was only a net demander of capital on the order of $75
billion a quarter over this time period. The corporate sector has since switched back to being a
net supplier of capital, even while profits have fallen.

Without the household sector to pick up the slack (for it also is now a net supplier of capital),
there are only two candidates left: foreign business and the government. Japan’s government
originally borrowed money to fund exactly the same type of capital formation (buildings and
infrastructure) that the private sector was abandoning. Eventually it gave up on this approach and
simply recycled the money through the economy as consumption.

11. By net, we mean the difference between the cash flow generated by corporations and the
sum of their expenditures on their own internal investment needs. This measure is not biased
by what is counted as investment and what is counted as expenses as both these measures
subtract from free cash flow. The way this difference is equilibrated is either through the direct
return of cash to shareholders in the form of dividends or through the indirect transfer of funds
to the rest of the economy through the net acquisition of financial assets.
 10_

As noted above, American corporations have been a net supplier of capital throughout the decade,
so their sensitivity to a collapse in forward expectations is smaller than was the case in Japan. The
downside is simply the reverse: the United States has already put more of its hope in the promise
of growth through intangible capital formation. We will later examine the two largest candidates
for this intangible capital formation: education and health care.

The fundamental question engendered by the Age of Dreams analogy is, will the intangible capital
stock of the United States actually increase?

ARCHETYPAL FAILURES

Two things drive long-term per capita economic growth: capital formation and increases in
productivity. Each of the questions engendered by the macro archetypes concerns the formation
of either tangible or intangible capital. Capital formation often fails because people mistake it
for innovation. Producing more houses and more quants to finance them is not innovation; it is
simply building up the residential capital stock. Creating physical capital (say, an office building)
is correct to the degree that innovative ideas can produce new companies to occupy the space.
Without a true story, the capital formation becomes a bubble. Without true capital formation, the
innovation proves a mirage.

Tangible

A LOCAL TRIUMPH , FALSE OPTIMISM

A GLOBAL FAILURE
Even if China’s growth is not a
bubble, its model will not help the
developed world address its deeper
problems.
Americans need to increase savings
in light of lost wealth. W ithout a
credible plan for how to likewise
raise investment, the demanded
savings will not materialize.

Cautious Consumerist
A FAILURE OF IMAGINATION FAILED OPTIMISM

Japan lacks an obvious way to invest Because U.S. resources are

its savings domestically. increasingly being directed towards
consumable goods, the intangible
capital stock is not increasing.

Intangible

Note that the question about China is not its ability to form capital, but rather what the future
consequences of doing so will be. China has 1.3 billion people and a society that up until the
modern age was among the richest on earth. Even if nothing is invented in China this century,
China can increase its wealth simply by catching up with the West. But optimism about China as a
local triumph exposes a complementary pessimism about innovation in the world. If China is the
 11_

new frontier, then the frontier is not innovation but new demand for tangible capital. China has
been a rising economic force for a generation now and still the benefits to the developed world
have been modest. The relative gains accruing to the West from increased trade may have been
overstated because the losses from slowing tangible capital formation have been understated.

Moving away from forming tangible capital is a problem unless the developed world has been
forming intangible capital instead.12 Under this scenario, the capital stock has grown more than
people think. But if the capital stock is greater than currently measured, this means that the
corporate return on capital is lower than currently measured. This could explain why business has
been a net supplier of cash even as conventionally-measured profitability has increased over the
long term. A competing explanation is that a large part of the West’s capital stock, tangible and
intangible, is not reproducible: the prohibitive cost of reproducing a global brand or the inability
to build a new oil rig offshore California. The economic rents earned by the controllers of the
existing capital stock are thus being returned to their ultimate claimants. As we will see, this cash
is increasingly spent on health care and education. If these are investments, then the human capital
stock is being built up and society will reap future dividends. If not, the money is being consumed.
In that case, it will be difficult to increase actual investment rates, and therefore savings rates.

A FAILURE OF IMAGINATION

Japan has punched well above its weight-class during the last twenty years in two important ways.
It has become a remarkably efficient producer of what the world wants, and it has taken the
ensuing export surpluses and plowed them back into the world’s economy by funding its trading
partners.

Japan’s defining event in the last generation was the asset bubble and subsequent Lost Decade. An
asset bubble collapse, by dramatically changing the price level of long-lived assets, and therefore
people’s expectations, decreases the demand for capital formation. Japan’s gross capital formation is
now lower than at any time since 1987,13 which is more historically unusual than even the woeful
performance of the Nikkei over that time. Capitalist societies continue to build more and more
stuff over long periods, whether they need it or not; there is no precedent for their stopping.

Why can Japan find no domestic object for the savings its cautiousness demands? Because one
does not build more of what one does not need. Without new ideas, Japan does not need more of
its old capital stock. Further, Japan’s accumulated foreign assets have led to appreciations of the yen
at exactly the wrong times. The export sector is the most profitable part of Japan’s economy. This
profitability is affected by the level of the yen, and at times of global and Japanese weakness, the
yen has strengthened materially. This strengthening leads to decreased profitability expectations,
and, therefore, decreased demand for capital expenditure. These come when Japan’s ability to save
abroad is declining.This stranded demand for savings ultimately works through the system, usually
through government borrowing, as consumption.

12. We examine whether health care and education are investment below under Failed
Optimism.

13. This is in nominal terms. Because of deflation over that period, gross capital formation in
real terms is only the lowest for the last twenty years.
 12_

Fig. 9 Depression vs. Lost Decade Sources: Bureau of Economic Analysis; National Accounts

300 U.S. Real Gross Private Investment, Indexed to 1929

Japanese Real Gross Capital Formation, Indexed to 1989

250

200
Index Level

150

100

50

0
1 7 14 21
Years

As a significant energy importer, Japan does not want to add capacity that will obsolesce at higher
energy prices. While this long-term vision has sustained funding for long-term energy efficiency,
this has not been sufficient to offset the decline in capital formation that is energy-intensive. Japan
serves as a warning that, even from the perspective of capital formation, it is unclear whether
a global recognition of the energy problem would, on balance, create more new investment
opportunities or destroy more old ones.

What will Japan do now that the world no longer demands its savings?

An excess of savings in Japan funded an excess of investment in its debtor countries. As that
investment falls, this demanded savings must be invested at home. A failure of imagination means
this transition will not occur, and investment rates will not move higher in Japan. While some of
this previous income will be consumed, some will simply vanish.14

FALSE OPTIMISM

Asset bubbles can produce significant economic flows because the level of production is not
fixed. These flows are not mirages. Real houses are built and the income attributable to this
construction is truly earned.

14. It is not the stock of its previously accumulated savings that will vanish. In fact, the value
of the previous stock of savings probably increased due to Japanese preferences for relatively
risk-free foreign assets. What will vanish is the percentage of the increase in global income,
created by the use of slack resources in housing, which had consumed Japanese goods. This is
equivalent to saying that Japan’s falling trade surplus will not be met with increased investment
or consumption at home. Because of the link between capital formation and exports, capital
formation will fall the most significantly. The severity of the crisis means that consumption
will rise materially as a percentage of total output, even though it too will decline in absolute
terms.
 13_

Another effect is exhaustion. The income growth needed to meet expectations derives from the
economic flows to which the expectations themselves give rise. While the first-order effect is
still extant, society is directing more of its resources (borrowed or self-funded) than it otherwise
would toward an investment good. In so doing, it is saving more than it otherwise would. As this
bubble unwinds, we can observe one of two outcomes. Investment can fall more quickly than
income, in which case the actual savings rate goes down, or investment can fall more slowly than
income, in which case the actual savings rate goes up. To understand why, we have to understand
the supply of savings that funds investment.

Fig. 10 U.S. Supply of Savings, % of GDP Source: Bureau of Economic Analysis

Total Gross Savings Household Gross Savings Gov’t Gross Savings

25%
Business Gross Savings Foreign Supply of Savings

20%

15%

10%

5%

0%

-5%
1981 1988 1995 2002 2009

Figure 10 shows one phenomenon very clearly: as foreign savings in the United States declines,
American households are materially increasing their own contribution to overall savings. This
corresponds to the widespread notion that the savings rate is going up. The sum of investment
by households and from abroad remains about level. The other two suppliers of investment in
the economy are significantly reducing this supply.15 Government dis-saving (when government
borrows more than it invests) and corporate retrenchment are driving overall investment down
materially. In terms of the GDP identity, I is going down more rapidly than NX (total net exports),
which by definition means that either C or G as a percentage of Y must go up.16 Because the
formula deems housing to be an investment good, one might expect a decline in housing to drive
a decline in investment. Total investment outside of housing is also declining, however.

15. The other components are reducing their gross supply of savings. The business sector is
actually increasing its net supply of savings, which is remarkable given that corporate profits
have fallen so significantly.

16. This is our previous GDP identity, Y=C+I+G, with NX added. For individual open economies,
savings can be lent abroad or borrowed from abroad. Total consumption is simply C+G with the
parts of G that qualify as capital formation stripped out, to reflect the notion that government
spending on infrastructure is investment.
 14_

The above pattern is consistent across the asset-based economies. As the supply of savings from
countries like Japan returns home but fails to find profitable investment there, so too is government
dis-saving and corporate pessimism leading to a decline in domestic savings in countries like the
United States. In this context, we do not see higher actual savings rates as an impediment to future
growth, whether consumption-based or income-based. Instead, we see higher actual savings as the
most important sign that the world economy is sustainably healing. Creative destruction requires
creation to offset the destruction. If economics is working and the decline of housing construction
is a sign of health, then why has total investment continued to decline so precipitously? The
housing bubble had to burst; a misuse of scarce resources cannot continue indefinitely. The fact
that investment demand is falling everywhere simply highlights the challenge of re-expanding the
investment demand curve.

Fig. 11 U.S. GDP Composition Source: Bureau of Economic Analysis

90% Total Consumption: Non-Residential Private Investment 15%

Government and Households

88%
13%
86%

11%
84%

82%
9%

80%
7%
78%

76% 5%

1993 1997 2001 2005 2009

Can Americans find a home for the investment previously used in housing?

We remain convinced that the world must think up better ideas than the construction bubble. But
to say that society needs increased savings without proposing how to increase investment is not
a complete answer.

A LOCAL TRIUMPH, A GLOBAL CHALLENGE

While China has relentlessly increased its capital deepening, the developed world has nearly
stopped building new physical capital. There are only two ways of considering this contrasting
image. Either trade really matters or it does not. If trade matters, then China and the West are
anti-coupled. If trade does not matter, then China and the West are decoupled.
 15_

Start with the first case. In a world where trade is important, China’s comparative advantage has
the effect of hollowing out the West’s physical capital stock. As Chinese exporters become more
competitive, China adds both the logistical infrastructure necessary to manage complex supply
chains and the machinery necessary to produce the output the rest of the world demands. At the
same time, the West stops allocating capital towards industries such as manufacturing, where its
comparative advantage is decreasing, and instead focuses resources on industries such as services.

Fig. 12 China Increasing Capital Formation Source: National Bureau of Statistics Fig. 13 While the U.S., Japan, and Germany Move the Other Way 17
Sources: Bureau of Economic Analysis; National Accounts; Eurostat

40.0% Net Investment as % of GDP 9% Net Investment as % of GDP Industrial Output Relative to Trend 110

36.0%
100
6%
32.0%

90

28.0%
3%
80
24.0%

20.0% 0% 70

1992 1996 2000 2004 2008 1991 1994 1997 2000 2003 2006 2009

Housing is a capital good that is non-tradable. Why can’t the West deepen its capital by building
more houses? The problem is that building up the physical stock of houses does not increase
society’s long-term income. When you build a factory, you can produce more cars. When you
build more houses than you need, you just get vacant housing—and over the past decade the West
built many more houses than it needs.

In contrast, if trade does not matter, then factors other than comparative advantage are at work.
By this account the West needs more physical capital, but it is either difficult to profit from or
politically constrained. For example, the United States might need infrastructure investment in
airports and mass transit, but be unable to form this capital in the private markets because the
investment horizon is too long. Likewise, energy investment that would greatly benefit society
might be significantly curtailed by political constraints.

We are agnostic on whether China and the West are anti-coupled or decoupled. The West can
argue that because intangible capital is its competitive advantage, it must build more.The West can
also argue that it must form new physical capital to promote economic growth, precisely because
the success of China will not be the boon previously envisioned. Both arguments contradict
the conventional wisdom that the developed world will benefit materially from the increased
prosperity of China. In the next section, we analyze the position of the United States largely
from the anti-coupled perspective only because that seems to be the position from which policy
makers are beginning.

17. Index of U.S., Japan, and German capital formation with the following weightings: 60% U.S.,
20% Germany, 20% Japan.
 16_

The West would face serious challenges in either an anti-coupled or a decoupled world. China,
on the other hand, will have dramatically different outcomes depending upon which model
proves true. China analysts tend to be bearish if they hold an anti-coupled view, and bullish if
they hold a decoupled view. The bearish outlook on China is simple: Chinese exports were 32%
of GDP in 2008, and are down 22% year-on-year in 2009. How can China recover in the face of
such a collapse in external demand? The empirical answer so far is that China will compensate
for the drop in exports by ramping up its capital investment, as shown in figure 14. But if recent
experience has taught us anything, it is that a boom can be a bubble. If the anti-coupled account
is correct, then China’s growth is not sustainable because the export markets will not support it.
Only if the decoupled model is correct might China prove not to be a bubble.

Fig. 14 China Revving Up the Investment Machine Source: Bloomberg

40.0% Urban Fixed-Asset Investment, YoY

36.0%

32.0%

28.0%

24.0%

20.0%

Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09

The best argument for the decoupled account is the sheer volume of catching-up available to
China.The United States has twenty times more physical capital per person than China, and Japan
has nineteen. To approach the United States or the Japanese capital stock in aggregate, let alone
per capita, the Chinese must invest far more than they already have.18 Two conditions are necessary
for China to achieve this continued capital deepening: one, copying, and two, ensuring that
economic activity in the short run is largely consistent with Chinese society’s long-term vision.

18. The current U.S. capital stock is approximately $45 trillion. At market exchange rates, the
current Chinese capital stock is approximately $11 trillion. If Chinese capital formation grows
at 10% YoY in real terms and the capital stock depreciates by 5% per year, then the Chinese
could have a capital stock of $45 trillion in 2021. In 2021, gross capital formation would be $6
trillion in 2008 dollars. This would approximately triple current Chinese gross capital formation.
For reference, peak U.S. gross capital formation was $2.6 trillion in Q2 2007. Source: Goldman
Sachs estimate and BEA.
 17_

We share Beijing’s belief that China can profitably use substantially more physical capital than it
currently possesses.19 Therefore, China’s ability to make the decoupling account true will depend
upon its ability to invest wisely in whatever will make it more productive. This is a political
question.

Can China’s investment machine power the developed world onwards?

The task for the rest of the world is to re-expand the production frontier. Because any sustainable
China investment boom would require China to be decoupled from the rest of the world, its story
will not help in this task.

FAILED OPTIMISM

The bursting of the 1990s bubble was not the last disappointment from the tech industry. Many
second-generation technology companies do not even try to produce technological innovation.
Web 2.0 must be considered a productivity failure even if it is a business success.The United States
cannot count on greater prosperity if it is to get there on the back of Twitter.

Web 2.0 is an easy target. Tech companies may behave as if they are still levered to innovation,
but the facts suggest otherwise. The technology sector in the United States, despite acquisition of
new companies and new IPOs, supplies capital to the rest of the economy. If households are the
ultimate claimants upon these cash flows, then ultimately capital is moving from the tech sector
to consumers. This might make sense if households are using the money to build up their human

Fig. 15 Differential Inflation Source: Bureau of Labor Statistics

600 Education

Health Care
500
CPI ex Health and Education

400
CPI Index Level

300

200

100

1979 1989 1999 2009

19. Many other questions remain, however. It will be difficult for China to prevent damaging
bubbles from forming as hot money chases the investment boom. Natural resources such as
oil and water are potential bottlenecks. Externalities such as pollution may impose intolerable
costs. Such issues are critical but lie outside this analysis.
 18_

capital.Thus, to take seriously the promise embedded in an intangible model, we must analyze the
two serious candidates for intangible capital formation: education and health care.

The costs of education and health care are going up more rapidly than costs in the overall
economy. This change in relative prices makes sense if people are getting more for the increased
costs, or if their preferences for these two services increase as they get wealthier or older. If the
former is true, then this increased expenditure counts as investment because the human capital
stock is being built up. If the latter is true, then this increased spending will not produce future
dividends and should rightly be considered consumption.

Conceptual thinking has its own dogmata, just as concrete thinking does. None of these dogmata
are more strongly or more universally held than the claim that investing in human capital creates
both innovation and the jobs of tomorrow. The dogmatists rarely ask whether the students thus
empowered want these jobs. Figure 16 demonstrates that the real cost of primary and secondary
education has risen considerably.20 Real wages of employees with at least a high school degree
have stagnated. Either the education is not producing the skill set demanded by the market, or
people have failed to create new demands and uses for the human capital they are developing.
Both mean the return on education as “investment” is in crisis.

Fig. 16 U.S. Return to High School Spending Source: Bureau of Labor Statistics

350
Real Cost of Primary and Secondary Schooling

Real Wages of Workers with at Least a High School Degree

300
Index Level, 1978=100

250

200

150

100

50

1978 1988 1998 2008

20. This is defined as the difference between the general inflation rate and the inflation rate
for primary and secondary education. The difference between these two series over time is
the extra cost of education not attributable to real quantities such as the number of children
educated. As previously mentioned, extra inflation makes sense if the quality of education is
better in a way that statistics cannot capture or if people value education much more highly than
they did before. Increased quality would argue for the increase in education spending being a
true investment. Changing preferences would argue that it is correct to consider this to be an
increase in consumption.
 19_

The conceptual mind argues against this crisis in two ways: first, that increasing returns to college
education point a way forward, and, second, that a period of adjustment is to be expected as the
economy begins creating the jobs of tomorrow. We consider each of these responses in turn.

The return on college tuition did increase from the 1970s until about 2000. Figure 17 demonstrates
this by computing the number of years required to pay back the cost of a college education out
of the earnings differential attributable to that education. Relative to the past, students who go
to college do better than their peers who do not, but this is simply a mathematical result of their
peers doing worse than in the 1970s. The return on some levels of education, like college, is
high only because the return on other levels, like high school, is so low. This increase in relative
returns has reversed. What used to be an easy decision between a bad option and a good option
is becoming a more difficult choice between a bad option and a less bad one.

Fig. 17 U.S. Return to College Spending Sources: Bureau of Economic Analysis; Bureau of Labor Statistics

12
Years of Payback at Wage Differential

11
Years

10

1978 1988 1998 2008

The past two decades cannot be defended as a transitional period. In a state like California, where
the 1990s witnessed the largest boom in technology investment of at least a generation, it is easy
to see why. From the bottom of the 1993 California recession until the current recession, however,
the greatest areas for job growth in percentage terms have been construction and health care;
technology has been one of the worst. If the supposed land of innovation has an economy whose
job growth is driven more by housing than technology, then defenders of the educational system
ought to show what tangible benefits it is producing.

Health care seems to suffer the opposite problem: too many jobs and not enough growth.
This can be expressed in much the same way as the housing bubble. Increased spending on
health care adds to GDP by consuming more of GDP, a trend that cannot continue indefinitely.
One rough measure of the success of health care is the relationship between increases in life
expectancy and spending on health care.
 20_

Fig. 18 U.S. Paying More Every Year to Live Longer 21

Sources: Bureau of Economic Analysis; Center for Disease Control and Prevention

$100 Annual Spending per Person per Year of Life Expectancy, Real Dollars

$80

$60

$40

$20

$0

1960 1969 1978 1987 1996 2005

In 1960, the average American spent 1,000 real dollars a year on health care and died at 70. Today
he spends more than 7,000 real dollars per year and lives until 79. Given the choice, many people
would eagerly pay an extra 6,000 dollars per year to live for an extra nine years. The problem is
that this increased spending is both a real source of ever-increasing costs to the average American
(lower real wages plus higher spending) and a use of income that otherwise could have been saved
for retirement. In a real sense, higher spending on health care contributes to the savings crisis.
This spending can only be macro-economically sustainable to the extent the return to this health
care spending is actually investment. At no compounding, the person who lives until 79 instead
of 70 must replace $420,000 of foregone savings. This task is incredibly difficult for the average
American because the entire fall-off in the savings rate is simply a result of increased expenditure
on health care. Even working full-time for those extra nine years would not offset the increased
health care spending at the current median real wage. (The preceding math assumes no increase
in lifetime consumption due to living longer.) At low rates of compounding and with provision
for consumption in the additional years of life, the increase in the average American’s expenditure
on health care cannot be justified by our model, even if he never retired.

The United States is also experiencing fairly significant declines in drug productivity, defined as
new drugs per unit of spending on research and development.22 The causes are unclear, but rising
drug development costs likely play a role. Industry sources estimate that getting a new drug from

21. Figure 18 shows much spending has increased for every year of life expectancy. This helps
us understand the decreasing efficiency of buying more years of life. (Life expectancy does not
measure other significant benefits of health care such as relief from pain, mitigation of disability,
and other quality of life improvements. We use life expectancy as a rough proxy for health
outcomes because it is easy to measure objectively.) It is important to note that this is not the
marginal cost of an additional year of care, but rather the total cost of health care per year for
every individual divided by the number of years of average life expectancy. In 1960, Americans
spent much less and lived fewer years. The numerator (health care cost per year) has grown six
times faster than the denominator (average life expectancy).

22. Defined as new drug applications and new biologic license applications approved by the
Food and Drug Administration.
 21_

discovery to approval takes about a billion dollars.23 The solution is not as simple as admitting
failure and moving on to a different model. American drug companies spend about 70 percent
of the world’s drug R&D.24 Europe spends most of the rest. As the following chart shows, this
spending is higher than ever. Yet drug stocks have stagnated since the mid-1990s. Therefore, not
only is current R&D less innovative than it was, but the returns on R&D have declined. This
increases the implied opportunity cost of the capital invested in drug origination, and has given
rise to mergers as an alternative to in-house development.

Fig. 19 U.S. R&D Spending and Innovative Output Source: Congressional Budget Office

60 Total Number of Approved Drugs Pharmaceutical Industry R&D Expenditures $60

50 $50

Real 2008 Billion USD

40 $40
NME Approvals

30 $30

20 $20

10 $10

0 $0

1970 1977 1984 1991 1998 2005

There are no easy global solutions to the stagnation of health care innovation. If Americans spend
less on health research to account for declining innovation and embedded inefficiencies, then the
rest of the world will have to cope with the slowing down of its great innovator. Sub-Saharan
Africa benefits from antiretroviral drugs developed in the intense American research effort against
AIDS. But neglected tropical diseases rarely strike the West, stimulate less demand for new drugs,
and therefore receive much less investment.

Given the drug pipeline and the current lack of fundamental innovation in the United States, one
could argue that health care would be more efficient if government stopped enforcing patents.
Existing drugs would immediately become affordable, though new drug development would slow
down. Perhaps innovation is overvalued and affordability is undervalued.

23 . Health Affairs estimates that, depending on the type of drug being researched, the total
costs of a new drug are between $500 million and $2 billion. Christopher P. Adams and Van V.
Brantner, “Estimating The Cost Of New Drug Development: Is It Really $802 Million?” Health
Affairs 25, no. 2 (2006): 420-428.

24. Héctor Hernández Guevara, Alexander Tübke, and Andries Brandsma, “The 2008 EU Industrial
R&D Investment Scoreboard,” Joint Research Centre and Research Directorates-General of the
European Commission (2008).
 22_

Health care and education are key aspirations of many societies. Deepening a nation’s human
capital allows for continued increases in productivity and innovation. There is a fundamental flaw,
however, in how Americans want to increase human capital. When Americans justify spending
more on education and health care, they pretend that higher spending is correlated with better
outcomes.

Will the intangible capital stock in the United States actually increase?

The world continues to count on the United States to generate innovation, and it is not clear
who could fill this void if American ingenuity falters. If it doesn’t innovate, the United States
cannot continue to absorb the world’s savings. The technology bubble was at least an attempt at
innovation; the housing and finance bubbles were not even that. To continue as it has, the United
States will have to prove that the money it spent on intangible capital has been well-invested. The
states of education and health care are not encouraging in this regard.

A NEW STASIS

A world that is out of ideas must become a world of competing futures. China must create a
global narrative out of a local triumph and make itself and the world a more productive place, if
only for its own long-term growth. Japan can no longer claim that, by sending its savings abroad,
it will always be able to save more than it invests. The Japanese must consume the money, or
find ways to invest it profitably at home. The United States can no longer claim that the world’s
savings are being well-used in housing, health care, and education that look more like inefficient
consumption than intelligent investment.

Who will arbitrate these competing futures until sustainable new ideas emerge? Likely, government
will be the judge. And here lies the fundamental question that will be at the heart of valuation.
To the extent governments can weigh these competing claims effectively, the intangible stock
of society’s political capital will go up and we can be optimistic about medium-term growth.
But if governments fail in this task, political capital in the West will decline, and we ought to be
pessimistic about medium-term growth. Success or failure will be determined by whether the
political class clings to failed illusions. We have gone from a bull market in politics to wondering
whether politics can allow for a bull market.

TYLER McCLELLAN
Vice President
Clarium