Savings, Capital Gains, and Income

Arnold writes:

Suppose a corporation issues a bond, and a year later the market revalues the bond upward by 10 percent. It seems to me that the bond owners' gain is the corporation's loss. I think that is true in general for capital gains and losses in the economy--they net out.

Why is it the corporations loss? It does not cost them anything. Is Superman #1 a loss to DC comics becuase it is currently worth a lot of $$$$$, and the original newstand price was probably 10 cents?

The national accounts do not include capital gains as part of income. But we are seing capital gains finance consumption, so to a certain extent the decline in savings is overstated, but not by all that much.

Isn't it an issue of stocks vs flows. Assets are stocks, and savings or dissavings is a flow.

In the bond example, the corporation has a potential unrealized loss in that it is now more expensive to redeme the bond early. But if the corporation wait until the bond reaches maturity
all gains and loses are extinguished.

This brings up another complication in the issue of savings in that you need to distinguish between unrealized gains and loses. If an unrealized capital gain is savings should you have to pay taxes on unrealized gains. But our tax system does not generally tax unrealized gains. But we have people claiming we have no
savings problem but because of large unrealized capital gains in stocks and housing. But those unrealized gains can turn into unrealized loses.
So what would that do to savings.

The example of a corporate bond may be a bad one, since it is true that if the bond appreciates in value, that implies that interest rates went down, and the corporation is paying more in interest than it would otherwise. Issuing corporate debt is a zero-sum transaction, because every dollar gained by the investor is a dollar paid by the corporation.

But what about the current capital gains bubble, real estate? If a piece of property appreciates in value, there is only gain for the owner. There is nobody else (even in theory) who loses money because of that gain. Equity is not zero-sum (whether it is in real estate or the stock market), and so a capital gain on an equity position does not have to be balanced by a loss elsewhere. So it is reasonable to talk about capital gains for the nation as a whole.

It seems to me that the ups and downs of financial assets are quite properly excluded from national income and therefore from national saving.

It's interesting to note that in the early days of the income tax the Supreme Court repeatedly ruled (on the advice of the leading economists of the day) that capital gains are not income. E.g.:

"Enrichment through increase in value of capital investment is not income in any proper meaning of the term," Eisner v. Macomber, 252 U.S. 189.

That said, whether capital gains are "savings" really depends on how one uses the word -- specifically the function of savings one is thinking of -- and whatever dispute there is about the question arises I think from persons using different meanings at the same time.

I'd certainly agree that capital gains are not saving for the purposes of the national income accounts.

However, by "savings" people often mean a resource that will be available for use in lieu of income to fund future consumption.

Capital gains certainly do serve that function -- and are meaningful on the macro level in that to the extent they do, they will reduce future demands on future national income to fund such consumption (such as by feeding retirees and paying for their Alaska cruises).

Corporate bonds may also change in value because of credit rating chnages, and are not always redeemable early.

Does this mean then a large increase in, say, stock market investing, spurred by, say privitized SS accounts, might result in no actuall increase in national investment/savings? Only increases in unrealized 'capital gains'?

I'm not sure about the exact accounting definitions you want to use, but it seems to me that for many practical purposes the moral equivalent of a capital gain is possible within a single closed economy. Single nation? Why not even for a single person?

Consider me living marooned alone on an island somewhere. I build a fish trap. Now, Kyoto fails, and global warming increases the migration of fish through where the fish trap was, and like the more perceptive sort of person everywhere, I have a sufficiently accurate model that I can reliably predict this effect over the next five decades or so. Bingo, a more valuable fish trap, rather as though I had spent twice as much time constructing two fish traps with the old expected effectiveness.

Or for more dramatic examples, consider capital losses: tsunami, heart attack, nearby supernova, whatever. (Or, of course, global warming, since it's a bit weird to think of it as having a positive economic effect.:-) Then, if a capital loss is possible within a closed economy, why not a capital gain?

Actually, if you look at the data the stock market is more a shift of savings out of the corporate sector into consumption by the individual sector. Dividends, buy-backs, etc massively swamp IPO and other flows of funds from the individual sector to the business sector.

when you but a stock you are buying partial ownership in an already existing business, so for the most part it has virtualy nothing to do with new investments. Times like the 1990s when the stock market was giving new capital to business at essentially zero cost of capital are the exception, not the rule.

this is not to say the stock market is not an important element in the process, but its role as a source of capital is very small. The primary role of the stock market is to allow the owner of a successful startup business to liquify and diversify his original investment --
or course indirectly this provides significant incentitive to the start up.

C'mon people. There's an obvious way out of this puzzle.

Capital gains on real estate are not savings, they're inflation. And the best interpretation of the link between a real estate bubble and a lower savings rate is not that people are quasi-saving through the appreciation of their homes, but that rising house prices mean higher inflation, and therefore lower real interest rates, which obvious reduce the relative incentive to save.

Shivering Timbers writes:

If a piece of property appreciates in value, there is only gain for the owner. There is nobody else (even in theory) who loses money because of that gain.

But there is a loser: the potential buyer of the house, who will have to pay more for the same good. He doesn't lose (nominal) money. But the money he has now buys less than it did.

The mystery, then, is: Why are long-term interest rates so low?

The bond example is certainly correct, since the gain to the holder is directly offset by the loss, in the form of an increase in the actual (not accounting) market-value liability.

A similar argument applies to housing. When the value of my house rises so does my implicit housing consumption expense.

Equities seem a little foggier, though. If a gain is due to an increase in the size of the expected future cash flows, due to technological progress perhaps, then there is no offsetting cost that I can see, so that could be considered income even at the aggregate level. And once I have income, doesn't it have to go for consumption, savings, or taxes? So if I don't consume it, and it's not taxed away, why isn't it savings?

The reason that increased stock values are not savings is that they are an unrealized capital gain. But you can not use them for anything until you realize them. But at that point they become dissavings. .

This is one of the complications. Enough retirees are using realized capital gains
that it increases the spending data without
increasing the income data. Consequently, the savings data is biased downward.

We usually thing of savings (investment) as
shifting resources from current consumption to capital spending. But when you bring capital gains into this it complicates the picture in ways that are not completely clear.
When you use capital gains you can have consumption without production. So what happens to Says law?

One thing that has happened this cyle is that gdp growth has been significantly stronger then income growth. But they are suppose to be two sides of the same coin and be equal. so why the divergence -- is it due to capital gains?

I think I see Arnold's point with respect to gains on equities. The value is the PV of future dividends. We're going to count those dividends as income when they are paid, so we can't also count them as income today. In other words, when I sell a stock, I am simply trading a future stream of cash for cash today. In that sense there is no gain, just a swap of assets.

Not sure all that's right, but it seems OK.

I don't understand why a nation can't have a net capital gain, especially in the presence of innovation.

Say I own a ytterbium mine valued at $100M. Then some genius at IBM discovers that doping silicon wafers with ytterbium lets chips run twice as fast as before, without changing the rest of the process.

Every chip manufacturer suddenly wants ytterbium, doubling the demand and doubling the price. Now my ytterbium mine is worth $200M, for a $100M capital gain.

Where's the offsetting capital loss in the nation? The chip makers aren't suffering: they're making a better product than ever. The consumers and companies buying the chips aren't suffering: they're paying the same for more speed, or benefitting from more speed than previously possible and happy to pay more for it. Maybe someone was short ytterbium-producer stocks, but that's matched by whoever was long in them.

Obviously, whoever was using ytterbium before now has to pay twice as much for it, but can they possbily lose as much as I, the other ytterbium producers, chip makers, and chip users have gained? If they're losing that much, why don't they just buy the mine?

George,

Your example is fine. There is surely income from your hypothetical discovery. The question I have, though, is when this income ought to be recognized.

What happens in your example? The stock in the mine goes up sharply, in expectation of increased profits, and the mine indeed starts making greater profits. But the capital gain and the extra profits are the same thing. I don't think you can count them twice, so when should you count them?

In the real economy the extra income - the increased power of the ytterbium-doped chips - is realized over time as the chips are produced and used. So shouldn't the financial income be treated the same way?

I have to agree with Bill and George. I don't understand how Arnold can believe that for a nation, capital gains are impossible. Surely the increase in a nation's capital stock (or any economy's capital stock) constitutes a capital gain? And surely capital stock can increase? Surely we have more productive resources available to us now than we did when we were agrarians or hunter-gatherers, both in absolute terms and per-capita?

Perhaps I'm misunderstanding Arnold's point. I think he is referring to increases in the price of capital assets without a corresponding increase in those assets' productive capabilities, i.e. shares in IBM rise 10% for no good reason. Presumably, Arnold thinks that in such cases, the shareholders have had a wealth gain that is offset by a loss... but whose loss? The corporation's?

Tyler's original question stipulated asset appreciation without bubbles. That implies that the asset's price has increased in line with some actual increase in the real value of the asset. That immediately raises the question: what caused the price to rise? The answer has to be that the future value stream that the asset will produce has gone up, such with Bill's fish trap or George's ytterbium mine. In which case, the asset is now a piece of capital that is suddenly more productive than it had been before. This represents a real increase in the economy's capital stock. The capital gain to the individual investor is also a capital gain to the economy; it's not offset by any corresponding loss to anyone.

Speculative bubbles are a completely different matter. Differentiating between asset appreciation from bubbles versus real increases in value is, I believe, still an unsolved problem. :)

Bernard: your questions about counting future revenues as income twice (once when the present value increases today, and again when the future values start paying off later) was discussed on Catallarchy; see the trackback below.

The short answer is that increases in present value today due to increases in future value do count as income, and so do the future payouts when they finally get here; odd as it seems, this is not double-counting. As time passes and the future payouts get closer, the present value rises. This is income. Each time the asset pays out, the owner gets the payout and the present value falls. The payout is income and the fall in PV is negative income.

Aren't all retailers making their income off of capital gains. Isn't Tyler saying in effect that Wal-Mart provides no net value to the economy.

Let me try to tie some threads of this discussion together.

One issue under discussion is whether capital gains are possible for the nation as a whole. Shivering Timers argue:

If a piece of property appreciates in value, there is only gain for the owner. There is nobody else (even in theory) who loses money because of that gain.

If those whose asset values increase benefit, and no one loses, then capital gains are possible for the country as a whole (contra Arnold).

I argue in response that when property appreciates, this is a form of inflation: the losers are everyone else, whose money buys less. But George has a good counter-example:

Say I own a ytterbium mine valued at $100M. Then some genius at IBM discovers that doping silicon wafers with ytterbium lets chips run twice as fast as before, without changing the rest of the process.

Every chip manufacturer suddenly wants ytterbium, doubling the demand and doubling the price. Now my ytterbium mine is worth $200M, for a $100M capital gain.

Where's the offsetting capital loss in the nation?

Is it plausible to treat the rise in housing prices as comparable to the appreciation of ytterbium as a result of technological discovery? eddie offers this cogent aside:

I think [Arnold] is referring to increases in the price of capital assets without a corresponding increase in those assets' productive capabilities

That's the point: is there a corresponding increase in assets' productive capacities? The mistake I made in my earlier comment was to ignore this possibility and assume that there was not.

If the productive capabilities of our homes are not increasing, but their prices are rising, that's inflation. If it's not recorded in the inflation numbers, that's the numbers' problem. If inflation is higher than we believed, then real interest rates are lower. And that, in turn, explains why savings is so low.

But what if the productive capabilities of homes are increasing? This is possible because the value of a home does not depend only on the physical structure of the home; it depends on the community where the home is located. If the schools improve; if the crime rate falls; if the city renovates a nearby park and begins to hold concerts and plays there; if a strip of charming cafes and specialty shops opens nearby; if a company opens a large office a few miles away and creates hundreds of jobs; then not only the price, but the value of the house rises, in the form of the attractive things that the house allows you to live near.

So this is the real-estate-market analogue to George's suddenly-appreciating ytterbium mine: improvements in the quality of life of the community increase the value of assets. This might even answer Tyler's description and constitute a form of "saving." Instead of investing by putting more money in the bank and having it lent to entrepreneurs, we're investing by making better communities for ourselves, by strengthening the moral fabric of our society so that there's less crime, by patronizing the arts, or whatever.

Needless to say, it's very hard to measure this kind of "investment," and thus to say whether rising home values represent investment or inflation. I'd rather see us assume the latter and try to push the savings rate up.

Aren't all retailers making their income off of capital gains. Isn't Tyler saying in effect that Wal-Mart provides no net value to the economy.

Shadow Hunter,

Retailers' profits are not capital gains.

Retailers provide a number of services. They select goods that their customers are interested in buying, they display them for examination, bring them from manufacturers or warehouses to more convenient locations for consumers, bear the costs of keeping them in stock so they are instantly available, sometimes provide advice, simplify the process of dealing with defective goods, etc. These sorts of things are what they get paid for.

eddie,

I disagree. What we are trying to do is get a handle on what is going on in the real economy. A capital gain, like that in the ytterbium mine stock, reflects no current change in real economic activity. It is the change in the value of a claim to future income. As such I don't think it belongs in the national income accounts.

The ex-dividend example seems irrelevant to me, since, as you point out, the changes in the stock value cancel each other, leaving the dividend as the only actual income.

Bernard,

The change in the value of the claim to future income is part of the real economy in the present. The recognition of increased future value is a real increase in present value. It is increased capital that can be put to productive use in the present; you can borrow against it (or sell it) and immediately use the loan (or sales proceeds) to fund additional capital investment or consumption in the present. Without the increase in future value and thus present value, you could not get as large a loan or sales proceeds.

The vast bulk of real economic activity concerns the present value of claims to future revenue.

Eddie,

It's not clear to me how you are using the word "real." I am using it in the economic sense of actual physical activity as opposed to the trading and valuing of financial claims. The "real" economy is the production and sale of goods and services. What I am saying is that the capital gain reflects no current increase in this activity.

Bernard,

A capital gain doesn't look like a good or a service, i.e. physical activity, but it serves just as well. Every summer I have to grow food so I can eat during the winter. If in springtime I learn that manna will fall from the sky sometime in October, then I can play baseball all summer instead of working. My increased expectations for the future have given me extra goods or services in the present, long before the future arrives. In this case what I got was leisure, but I could have just as easily used the time to make pottery or tacky knick-knacks to sell to the tourists.

Eddie,

If you play baseball instead of working there is no increase in income. Sure, it's more fun, but leisure doesn't count in the income statistics. The manna counts. The baseball doesn't, unless Steinbrenner comes around.

If you make pottery and sell it that is income. But the value is the value of the pottery, not the PV of the manna. In fact, that is likely to be less than the PV ofthe manna, else why were you not making pottery and buying food all along, instead of growing food.

Bernard,

If there's no manna coming, I won't play baseball because not starving in winter has a high utility for me. Once I know the manna is coming, I could still grow food all summer and have twice as much come the winter. But the utility of having twice as much food as I need come wintertime is less than the utility of having just enough food and getting to play baseball all summer.

If the manna were a surprise, I'd have more food than I need and I'd have missed out on some serious fun. The knowledge of the future allows me to allocate my productive resources more efficiently, producing a result with greater total utility. The value of capital isn't just that it will eventually produce value, it's that you have a present expectation of what that future value will be. If you don't count the PV as income but only count it if and when it arrives, then you miss counting the benefit you gain today from being able to devote production to things with less marginal utility but which provide a greater total utility after including the future products from the capital.

To bring this back around to Arnold's original post: you're right, leisure doesn't count in the income statistics. But it should. It has utility and it has value; people are willing to give up time on the margin that could be spent earning income in order to gain leisure time. National income is not an ideal econometric tool, it's just the only thing we've got. If Arnold can postulate "clever national accounting" that can distinguish between education's consumption value (entertainment) and investment value (career enhancement), then I can postulate something even more clever that measures not just goods and services but in fact everything of value, including leisure time.

I'm starting to think that one way to do that is to measure changes in the capital stock rather than sales of goods and services. But I'm still working on that.

Bernard, thanks for the discussion. It's been thoughtful and thought-provoking. If you'd like, you can have the final word, but then I think we've hijacked Arnold's blog enough for one topic. :)

I have to correct myself for posterity. I said:

If you don't count the PV as income but only count it if and when it arrives, then you miss counting the benefit you gain today [..]

I should make clear that gains in PV aren't "income" per se. They are gains in wealth. However, wealth and income are substitutible for each other. Income funds consumption and savings; savings are an increase in wealth. If capital gains cause an increase in wealth, the effect is the same as an increase in income.

This underscores my main point: capital gains that reflect an increase in the expected future value of capital are just as productive in the present as increases in income in the present.