Thursday, October 30, 2014

If returns to capital aren't high, then why is compensation share low? (Hint: It really is monopolistic profits!)

There are only so many places for income to go.  If returns to capital aren't high, then why is compensation low and declining?

Short answer.....Housing

Here is a graph of compensation share of GDI along with net rental income share of GDI.

First, this is a little tricky, because 60% of American households own their homes.  So, in effect, this is a measure of rent we are paying ourselves.  Or, put differently, this is a measure of the income share we capture because home ownership tends to provide excess returns.

The trend in Compensation has dropped from about 57% in 1970 to about 53% - a 4% drop.  But, the trend in Rent + Compensation has dropped from about 59% to 57%.  Rental income explains about half the drop in Compensation Share, and in fact, accounts for more than all of the drop in Compensation Share since the previous low point in 2006.

To the extent that Rental Income supplements Compensation, this income is probably distributed mostly to middle and upper-middle class households.  So, both the level and the distribution of household Compensation Share are probably helped by reducing excess returns to Rental Income.

Returns = Income from Asset / Price of Asset

Rent is generally going to move proportionately to incomes.  A mistake I see committed widely is to model home prices as a proportion of incomes.  Home prices should come from rent and from expected returns.  If rent is stable proportionately to incomes, then home prices should respond to changes in expected returns.  Real estate is usually a relatively low risk investment.  Low-risk rates of return are currently very low, even on very long term investments.  This raises the value of homes.  The only non-disruptive way to reduce this excess net Rental Income is to allow the price of homes to rise.

Estimated Excess Return to Home Ownership
I recently estimated the relative return to home ownership by using mortgage rates, CPI rent inflation, and FHFA home prices, and I found a similar trend to the trend we see in the BEA net Rental Income share - excess returns rise in the 1990's, dip in the late 2000's and rise even higher after the financial crisis.

This is a very difficult concept to accept, but rising home prices would be a positive development for Compensation share and equitable income distribution.  (Please see my Housing label for more extensive discussion of this issue.)

Take another look at the top graph.  In the 2000's, during the presumed housing bubble, net Rental Income was higher than it had been since the early 1970's.  The reason the housing market was hot in the 2000's was because it provided high returns relative to other investment opportunities.  Speculation in the housing market was not pushing home prices into the unsustainable stratosphere, it was simply capturing gains from sticky prices in the housing market that created a delay in home prices moving up to their intrinsic values.  Rent levels were not unusual.  To justify the housing bubble narrative, one would need to explain why net rent income remained so strong.

Risk Trading

UERP = Unlevered Equity Risk Premium
This leaves a decline of about 2% in Compensation Share from the peak period of 1950s to 1970s.  I have discussed the fluctuations of labor share in a risk trading context.  Just as an increase in risk aversion causes both leverage and the rates paid to creditors to decline, an increase in risk aversion could also cause some decline in the rate paid to and quantity demanded of labor.  This is easily imagined in the form of workers on the margin between labor and owner, and how the costs and benefits of a change would be affected by their attitudes toward risk.

Please read the links if you're interested in this idea, for a slightly more detailed description.

The table below outlines the general trends shown in this graph as they comport with the risk trading framework. (RFR = Risk Free Rate, ERP = Equity Risk Premium)

RFR ERP Compensation Debt Level Equity Value Enterprise Value
1960s Low Med. Med. Low High Med.
1970s High High Med. Med. Low Low
1980s High Low Very High High Med. High
1990s Low Low Med. Med. Very High Very High
2000s Very Low High Very Low Very Low Med. Med.


But, I want the main focus of this post to be the housing element.  A mixture of bank health, bank behavior, regulatory influence, and monetary policy have created an economic context where there are tremendous non-price barriers to entry into home ownership.  The monopolist profits are going to home owners!  Krugman is right.  He's just looking in the wrong place.  And DeLong is right, too.  Investment is low because expected growth is low.  If the housing market were made liquid again, either through inflation-produced deleveraging or through regulatory accommodations, growth and investment would both increase, as we begin to build homes again to reflect demand that isn't dampened by regulatory and monetary policies.  And, lower income shares going to housing would lead to higher income shares going to compenstion - not to mention all the construction jobs that would come along with this development.  (DeLong is looking in the wrong place too.  Clearly the missing investment is in residential fixed investment.)

When QE was adding cash to the economy, all-cash institutional home buyers were flooding into the home market, because excess profits are available for the economic elite who have the means to purchase real estate.  If compensation is going to recover, these barriers to entry need to be removed.  But, for this to happen, many people will need to be disabused of the notion that high home prices must be irrational.  For those not disabused, I think you need to explain why net rental income is higher than it's been since the 1940s.

Follow up:  Housing shortage is causing real income stagnation.


  1. TravisV here.

    One of the most brilliant minds on the planet (David Glasner):

    "Why Are Corporations Hoarding all that Cash?"

    1. Thanks Travis. He is great. If anything, sometimes his posts are too challenging for me to follow.

    2. TravisV here.

      Just finished reading Glasner's new post. Nothing new. Sorry for linking.

    3. No apology necessary. I left a comment at his post relaying some of the stuff I've been positing, but it's stuck in moderation. I'm curious to see how he responds.