His thesis is that the economy has structurally changed. This change is basically that capital and labor are no longer complementary.
In the past, to produce goods you needed people, and people needed machines to produce goods. If you were running an automobile factory in the 1950's, you needed assembly line workers plus the machines or capital that were used by the people.
What Larry Summers is proposing is that, starting in the late 90's, capital began to be not a complement but a substitute for labor. Essentially, the automobile factory no longer needs the same ratio of people to machines. Effectively, the people making the cars can be replaced with technology.
This is causing the aggregate share of labor income to decline and the share of capital to rise. From a common sense perspective, if capital is a substitute for labor the economic pie is going to go more and more to those that own the capital and less to those that own the labor. This is the explanation for the growing amount of income inequality in the world. People are being replaced by technology and the capitalists are taking greater and greater gains from economic growth.
This disruption is extremely positive for publicly traded corporations. We would expect to see higher profit margins in aggregate as a result of low wage growth and this is exactly what we are witnessing.
If this shift from capital being a complement to labor to becoming a replacement for labor is truly here, the effect will be twofold:
- First and foremost, interest rates will remain much lower for a longer time than anyone is currently anticipating. With capital replacing labor, wages remain under pressure. As I have said many times, there has never been a period of price inflation that has not been accompanied by a period of wage inflation.
- Second, and most important to investors, the stock market should go much higher than what people, including me are anticipating. If technological advances are causing capital to get a greater percentage of the economic pie than it used to, the best course of action is to own the capital. In other words, invest in the stock market.
What Do I Think of This?
Well, an old saw of wisdom is that when people start saying that "This time it is different," they are usually mistaken. The theory that capital and technology are becoming substitutes for labor is a well thought out, if not brilliant argument. It explains why interest rates are globally low, profit margins are high, wages are stagnant, inflation is benign, inequality is rising, and yet the market keeps heading higher and the P/E multiple keeps expanding. The theory explains the data, but brilliant theories usually do.
However, I tend to feel that the more things change the more they stay the same especially with regard to the equity market. This time around nothing is different.
Wages will eventually go up, inflation will return, interest rates will rise and the market will appreciate not at an accelerated rate but at its historical rate of 6% above the risk-free interest rates.
Summers' argument is very powerful, but it is simply a brilliant way of saying "This time things are different."
-- Mitch Zacks, ZIM Weekly Update