Are we Entering an Era of Capital Shortage?
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We have, until recently, had such low-interest rates over the past decade partly because new capital formation has been plentiful. The Budapest Business Journal’s corporate finance columnist Les Nemethy explores the idea that capital will become much scarcer during the coming decade, contributing to a higher interest rate environment.
While this article, due to its brevity, may oversimplify the situation, I will deal with one preeminent reason why the supply of capital will suddenly diminish, and four reasons why the demand for money is likely to increase. This intersection of lower supply and higher demand could see asignificant market shift towards higher interest rates.
A large part of capital formation in any country comes from individual savings, which depend heavily on demographics. Youngsters usually borrow until their early 30s. Beyond that age, they save increasing amounts. In the years before retirement, they typically sock away as much money as possible. The savings rate accelerates from the early 30s as age progresses until approximately age 65.
Then it’s as if someone flicked a switch: upon retirement, a person stops saving and begins drawing down savings. This is true not only on the micro level but also on the macro level.
As I have written before, like the proverbial pig moving through the python, the demographic bulge of baby boomers has worked its way through to retirement to create a demographic cliff. There will be a record number of new retirees in the coming years who will suddenly begin drawing down savings.
Having dealt with one reason why the supply of capital will suddenly diminish, let me now outline four trends that are likely to increase the demand for money.
1) Automation: As the size of the working population decreases in relation to the total population, fewer people are available to fill open positions, leading to higher wages. This provides an increased incentive to substitute capital for labor, and so the economy shifts to being more capital-intensive.
2) Investment in Energy: Global warming has created enormous demands on capital and drives investment into new alternative energy sources (solar and wind farms, nuclear reactors, etc.) which are all capital intensive.
Electric vehicles demand vast amounts of battery minerals; copper, aluminum, nickel, cobalt, and lithium, to name a few. The supply of battery minerals is so inadequate that trillions of dollars will be required for new mines.
It is probable that increased drilling for oil and gas, investment in pipelines, etc., will also be required to compensate for geopolitical realignments and the fact that alternative energies don’t seem to be able to fill the gap from declining fossil fuels fast enough.
3) Near-shoring: Until recently, there was an exodus of manufacturing from the United States and Europe to places like Mexico, Asia, and especially to China. In the recent past, due to national security concerns and fears of disruption, much foreign investment that had been heading to China is relocating to places like Vietnam and India.
Improvements in automation, sensors, process automation, artificial intelligence, the internet of things, and so on mean that less labor and more capital is required to produce many goods, as well as a much more highly qualified workforce, creating a trend towards manufacturing in North America and Europe.
This reshoring and retooling of plants also require vast amounts of capital. For example, tens of billions of dollars are being spent to create chip capacity in America.
4) Increases in Military Spending: As can be seen from the chart below, global military spending as a percentage of GDP has declined dramatically over the past decades. Russia’s war in Ukraine, China’s threat to invade Taiwan, ongoing instability in the Middle East, and other geopolitical hotspots suggest this trend is likely to reverse.
Shifting the Curve
The cumulative effect of the above will likely shift curves for both supply and demand of capital to cause higher interest rates in the coming decade.
Since the Great Financial Crisis of 2008, there has been so much manipulation of interest rates by central banks through both quantitive easing and now quantitive tightening) that we seem to have forgotten that supply and demand for capital, ordinary market forces, help determine interest rates. The market manipulations ofcentral banks extol a price.
For example, QE has contributed toinflation and misallocation of capital spending, what the Austrian school of economics calls malinvestment. Hence, there may be a limit to manipulation: a significant shift in demand (caused, for example, by a loss of confidence in fiat currencies) may cause bond markets to override a central bank’s effort todetermine interest rates.
This article does not claim that supply and demand will inevitably push the cost of capital higher; however, underlying market forces seem to point in that direction. There are many other forces, central bank manipulation, tax policies, economic cycles, technological developments, and so on, that may create (at least temporary) surprises.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.
This article was first published in the Budapest Business Journal print issue of December 2, 2022.
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