Sunday, 31 August 2014

The natural way to become rich in 21st century is to born rich?

French Economist Thomas Piketty's Capital in 21st Century, a best-seller book about economic inequality, has brought storm into the realm of Economics. My cousin recommended me this book in Feb. But until now I have merely gone through the book(it has over 600 pages). Many chapters are very academic and read like a textbook. One can jolly well use it as a sleeping pill. :)

Well, what is this book about? 


Piketty started to explore the economic inequality issue since Industrial Revolution. In 18th and 19th centuries in Europe, the society was highly unequal: wealth was concentrated in the few hands of rich families sitting on top of a rigid class structure. This system persisted, even as workers' wages increased over the centuries, and reached its peak in the beginning of 20th century right before WW I. After then, the two World Wars and Great Depression disrupted the pattern. The following decades after WWII saw a period of more egalitarian society, as Wars destroyed accumulated wealth, and welfare states helped with wealth redistribution. But Piketty argues that this extraordinary period (1950s-1980s) is unique and abnormal in economic history. He called it a shock. But the shock have faded since 1980s and wealth , especially accumulated wealth,  is reasserting its historical role in wealth distribution as it did in 18th and 19th century. Piketty went on and boldly predicted that the dynamic of economic inequality in 21st century will be nothing like 20th, but more close to 18th or 19th century. i.e. wealth will be concentrated to the top and wealth, especially accumulated from past ( as opposed to labor or employment) will play a bigger role in income distribution.


In his book, Piketty derived a general rule: wealth grows faster than economic output, or r>g (where r is the rate of return of capital(or wealth), and g is the economic growth rate). During the abnormal period of rapid economic growth where g>r, income from labor/employment (represented by g) plays more important role than income from capital ( represented by r). However, in ordinary time, r is greater than g (refer to his book for thorough derivation), and it has an important implication: the top rich percentile' income are derived mainly from their capital income, and the bottom depends on their labor/employment income. As a result, the poor can only get poorer relatively to the rich. ( as r>g, or labor income growth can not catch up with capital income growth). Of course, in absolute terms, both the poor and the rich can improve, except that the rich improve at faster pace. 


Think of the case in Singapore: how fast does your salary grow annually on average (use your own case as proxy)? How much does the capital grow on average ( use major stock index CAGR, or your house value's CAGR as proxy)? I bet different generation will give different answers, which is totally to the point.  Because in the most recent half century, the world has underwent dramatic economic changes. In Singapore, the fast growth period is gone, or g>r is gone. We are now in the era of r>g. So folks, it means in future, on average, the income from one's capital will grow faster and faster than the income from one's employment. Hence, if one means to move up the wealth ladder, he should not consider depending on employment income, but strives to accumulate more capital (business, stocks, property, land, etc) and tries to increase his income from the capital . Besides, one must also realize the fact that if your peers start with an advantage (e.g. inheritance or sudden wind-fall), the wealth gap between you and your peers can grow much bigger with time. (just remember, in our time, r>g! )


It sounds very theoretical. Let's looks at Singapore as an example.


According to the report from Department of Statistics, in 2013, the average monthly income from work per household member for resident household is SGD 2902. (The amount includes employer's CPF contribution.) For simplicity, let's use 16% as employers' CPF contribution rate and 20% as employees' contribution rate, then the "take-home" pay per household member ( employed or not) is 2902/1.16*0.8=2001. For a typical family with double-income parents and two children, their combined take-home pay is 2k*4=8k, which means the parents' combined salary before CPF should be 8k/(1-0.2)=10k, or 5k per parent. 

Ok. Let's do some math now. In his book, Piketty derived that the capital/income(annual) ratio for major Western societies is 6-7 on historical average. Let's use 6. This means, on average, one's capital should be six times of his annual income. So if we apply to Singapore case, on average, a resident should posses 6*(2K*12)=144K. For a typical household with 2 adults and 2 children living in HDB, the capital should be 144K x4 = 576K, which is incidentally more or less the value of  a typical 4 or 5 room HDB. Does that mean average Singaporean family has met the standard of major Western societies? No! 


One must differentiate capital and investable capital. Your own house for your family living generally can not be considered as an investable capital, as self-living flats does not generate any income. Instead, you may have to pay mortgage, i.e. outward cash flow. (in fact, mortgaged self-living house is not an asset, but a liability.) Never mind how the government preaches that HDB flats are your valuable assets just like your CPF. Besides, HDB is not free-hold property that can be passed on for generations. So if excluding the self-living house, how much is your investable capital? Bear in mind, Cars and luxury items are NOT capital in any measurement, albeit in some cases, one can sell at a profit. Well, excluding all above, do your family have 576K investable capital now?  Or in another way, do you possess investable assets of 576K? Investable assets can include your financial investments, non-self-living property(minus outstanding loans), business, etc. On average, Singapore families probably do not reach the western standard. ( this is mainly due to Singaporeans have less wealth inheritance on average than residents in western societies which have been developing for much more generations)


But that is just the average case. To the lucky lots who are above or well above the average, Singapore is indeed their oyster. The rich do not live in HDB, they have free hold properties, probably more than one. Think of the r the rich can get. The rich do not ride MRT, COE is just pocket money. The point is that the one who can earn a monthly salary of many times the average (5k) can not just call themselves as the rich, unless they have accumulated or inherited sizable capital. (r>g!). 


So what value of the Capital/Annual Income ratio can make one declare oneself as rich? We must make some assumption. Firstly, how much income can be considered enough to support rich life style? Let's recall that together the couple of an average household earn 10k a month. So how about assuming a rich couple who earns 10 times of national average(100k a month)? ( just think in this way, in the rich couple's eyes, every price tag in the mall looks 90% cheaper than an average couple). Well, the rich couple can have an annual income of 10k x10x12=1200k. Let's assume the value of r is 6% ( this is modest). Assume again the rich couple do not work, or donate all of their employment income to charity. Hence, to derive an annual income of 2400k with 6% return rate, their capital must be 20 mil. That's quite a lot of money! If we adjust the annual income level to define rich, we can get following results.


Annual income (x of average)    Capital Size

1                                                      2mil
2                                                      4mil
3                                                      6mil
4                                                      8mil
5                                                      10mil
6                                                      12mil
7                                                      14mil
8                                                      16mil
9                                                      18mil
10                                                    20mil

It is interesting to note that if a couple can possess 2mil investable capital, and can manage to get 6% annual return, their capital income is already 120k per year, or 10k per month, which means their capital income alone beats average employees' labor income. All you need is 2mil per couple or 1mil per person. Therefore, if your peer starts with 1mil capital in hand, and you starts with 0, save the extreme cases, it will not be easy for you to catch up with your peer, not in the period when r>g! No need rocket science here, empirical knowledge can make one see that the economic growth rate nowadays is lower than capital growth rate. So the natural way to become rich in 21st century is to born rich!


The above is only from one chapter of the book. The simplest one, I might say. Piketty continued with the "2nd fundamental law of capitalism":  beta=s/g. where beta is the capital/income ratio, s is the saving rate and g is the growth rate. 


Recall that in Singapore, one only need 2mil capital to beat average employees. That is not the end, as beta itself is decided by saving rate and growth rate. A country that saves a lot and grow slowly( such as Japan now, and Singapore in future) will, over the long run, accumulate an enormous stock of capital(relative to its income). In a quasi-stagnant society (Singapore in future will be, or already is now), wealth accumulated in the past will inevitably acquire disproportionate importance over employment income. Hence, If the rich are willing to save more to form more capital, they can grow their income and capital even faster! (They need not to save a big proportion though, just a small proportion means a sizable amount. "You need Money to make Money"). 


What's more, if the economy is slowing down, that works for the rich and against the poor! ( see that beta is inversely proportionate to g). As demonstrated by the recent GFC, the rich comes out of the storm even richer as the capital market has soared after GFC, while many poor who lost their jobs are still trying to make ends meet. 


Bingo again to Rich class! Win the 2nd fundamental Law!


...



While reading the book, I am watching the British TV drama Downton Abbey. This well-produced drama is a splendid display of what Piketty's book tries to describe. If you have watched the drama, you may remember that when Matthew, a lawyer ( an admirable profession then (now also), but is only a middle class to the REAL rich), first stepped into Downton Abbey, he said to his rich relatives: " ...I normally have more free time in weekends..." The Dowager Lady(the REAL rich) was totally lost and asked " What is a weekend?". The service men laughed secretly: " A real gentleman should never work, just like our Lord." 

This episode was set at the time right before WWI, when the economic inequality in the Western societies reached its peak. I did a little study. In 1910s in England, there are more domestic service men/women (wearing uniforms, staying at rich class's houses) than mine workers. 


Now as 21st centuries started to unfold, are we coming back to 19th century's Downton Abbey as precited by Piketty in his book? 


Put in this way, In Downton Abbey in 1910s, the service men considered helping master to pick up the most suitable cuff link as proud skills (serious, no sarcastic here) and they fight their way to climb up the ranks designed for service men, just as in 2010s, collage graduates are proud that he can do programming/accounting/marketing...and tries their best to climb up the corporate ladder designed (by whom?) for employees. 


In Downton Abbey, even if you climb up to the top as Butler, you are still a servant, a servant to the Masters! I guess in today, even if you climb up as CEO of a company, you are still an agent, an agent to the Owner! But of course to many in 1910s or in 2010s, the success is defined by the service rank, and climbing up are the rewards. 


Warren Buffet once said: " There is class warfare, all right, but it's my class, the rich that's making the war, and we are winning!"

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