Friday, February 19, 2010

U.S. Capital Productivity Declines

Byron Wien, senior Managing Director at Blackstone Advisory Partners, brings to the forefront a very important fundament to economic growth: the productivity of capital. Now for those who may not familiar with economic jargon, capital is defined as factors of production. Capital in economic terms is not money or things related to such; but rather those things that are used to produce other things, such as land and labor.

Economists have a term that measure how productive capital is in an economy. It is call the marginal product of capital (MPK). MPK is the additional output that is produce for each additional use of capital. In other words, for each investment made how much gross domestic product increases. This is in essence what MPK measures. The higher the (relative) measure, the more productive is capital, and therefore the richer society gets. For example, a society that uses $1 of capital to product $1 of additional GDP is more productive in relation to a society that uses $2 of capital to produce $1 of additional GDP.

Having said that, this is what Mr. Wein writes in the Financial Times:

"The biggest problem the US is facing is the productivity of capital. After the end of the second world war it took less than $2 of investment by government, corporations and individuals to produce $1 of GDP growth. The productivity of capital continued to be impressive until 1980 when Europe had recovered and Japan was producing cars and consumer electronics products that found wide acceptance in world markets."

"In the single decade of the 1980s, the productivity of capital declined from a level where it took less than $2 of investment to produce $1 of growth to one where about $3 was needed. If you assign a 30 per cent gross margin to that revenue growth, the return on investment declined from 15 per cent to 10 per cent."

"That level of return proved to be satisfactory, but in the first decade of the current century capital productivity declined seriously in the US. Because of profligate spending on over-priced housing and other assets that declined seriously, as well as deficit spending by the government, by the end of the decade it took $6 of capital to produce $1 of growth. The return on that would only be 5 per cent and few would put money at risk for that reward."

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