In the intangible economy, wealth is still mostly tangible and rising equity and real estate values are drivers of increased global wealth – not savings and investment.
Late last year McKinsey Global Institute (MGI) put out a report on The rise and rise of the global balance sheet: How productively are we using our wealth? which revealed an interesting feature of the intangible economy: while investment is increasingly in intangibles, wealth is overwhelmingly tangible. Intangible account for only 4% of real global assets as of 2020. Real estate (land and structures) account for 68%. The remainder is made up of other tangible assets such as infrastructure, machinery & equipment, and inventory.
Looking more broadly at the global balance sheet, the value of these real (aka non-financial) assets account for roughly a third of total global assets. The other two-thirds of wealth are financial assets held by financial corporations (the financial sector) and financial assets held by households, governments, and nonfinancial corporations (the financial system). Analysis of the growth in these global assets reveals a worrisome fact. Over the past two decades asset growth has been largely due to rising prices (valuation) for equities and real estate. Increased savings and investment account for just over a quarter in wealth creation.
I have two take-ways from this report. My main take-away is about the difficulty of measuring the value of intangible assets as assets. The report uses data from existing System of National Accounts framework. In the US data, the only intangibles included are intellectual property products which include only software, research & development, and entertainment, literary & artistic originals.
It should be noted that the authors of the report are well aware of the importance of intangibles as a factor in production (see MGI report Getting tangible about intangibles: The future of growth and productivity?. For comparability’s sake they used the globally accepted framework.
However, as part of their sensitivity analysis, they modified the treatment of intangibles. They first expanded the list to include additional intangibles from the INTAN-Invest project database such as organizational capital, training, and brand investments. Adding these doubles the value of intangibles. Next, they removing the standard accounting practice of depreciating IP on a 5-year schedule. This quadruples the value of intangibles.
Admittedly, these modifications result in only minor changes in the relative size of intangible assets compared with total. But they do illustrate the difficulty in using intangibles as a store of value.
[Note there are other frameworks as well. For example, World Bank’s Changing Wealth of Nations series https://www.worldbank.org/en/publication/changing-wealth-of-nations includes human and natural capital in its analysis. It should be pointed out however that measuring human capital and natural capital is a work in progress.]
My second take-away is more of a macroeconomic concern about the relatively small contribution of saving and investment to overall wealth creation. To the extent that additional wealth created by rising asset prices is channeled back into the economy in the form of savings and investment, this can be a positive spur to economic growth. However, this is not necessarily what happens. As the report states, the process could “encourage investors to seek asset price increases rather than more traditional benefits from operating assets.” In other words, create an asset bubble.
The report discusses to role of low real interest rates, among other factors, in fostering this situation. If we are moving to an era of higher interest rates (as it appears that we are), the future growth of the economy may be more fragile than we thought.
For this, and other, reasons, the report concludes that we need to find “alternative long-term stores of value.” However, it also lays out the case as to why it is difficult for intangibles to play that role:
“Although intangibles have attracted plenty of investment, they have not served as a long-term store of value at scale. Measured using current assumptions for their value rather than the broader societal value they might bring, they constitute only a tiny part of total net worth. But these assumptions and the amount of private value intangibles can hold depend on the economic and competitive context. Most intangibles can be scaled at near zero marginal cost and are not “used up” in production. That means the returns on intangibles investments can flow to a variety of stakeholders. At one extreme, if competition is strong and IP protection light, all value of intangibles investment will quickly pass to consumers as customer surplus, increasing real income and standards of living for all but not serving as a long-term store of value for those making the investment. At the other extreme, the policy and competitive environment could allow companies investing in intangibles to protect—and scale—the value of those investments ad infinitum, through IP protection, protection of trade secrets, sustained advantages of scale, barriers to entry, or not containing monopoly power. In such a setting, intangibles investments could become long-term stores of value for savers and increase the value of their investments over time, but at the expense of competition and consumers. What policy mix is needed to extract more value and return from intangibles investment and yet also preserve customer surplus and strong competition? And what might then be the right way to measure intangibles at a company and societal level?”
For all these reasons, I am beginning to believe that we need to modify our view intangibles. We need view intangibles as an “asset” in the sense of something useful (using the Merriam-Webster’s definition of an asset as an advantage or a resource) – not an asset as in a store of value. In other words, focus on intangibles as input to the production process. As such, we need to focus measurement on investment metrics, rather than valuations.
More on this to come.