Individual Prosperity: The Role of Leverage vs. Liquidation
Economists think that individuals become wealthy by accumulating savings and spending those savings to acquire things that make the individual more productive. Therefore, wealthy nations are wealthy because their citizens saved, acquired “capital goods,” and increased their productivity. I argue that this is only the first step in a more sophisticated process that is responsible for economic growth, that you can learn this process, and that you can implement it in your own life.
Thanks to Kaye Lynn Peterson for help with editing and conceptual development.
Why Saving Matters
Economists argue that economic growth — improvements in material prosperity — originates with saving. Saving is just the opposite of consumption. If you earn $10 dollars and spend $8, you’ve saved $2. If you do this on a regular basis — that is, if you continue to spend less than you earn — then you accumulate savings. Eventually you’ll have enough money saved to the point where you can spend it to acquire something that makes you more productive.
Productivity is an economic concept that refers to your ability to generate income in a given unit of time. Though it is natural to think of productivity as it relates to wages, it’ll be better to keep things high level. A more productive person can accomplish more in the same unit of time, and vice-versa. Productivity relates to savings in this manner: if you can spend your savings to acquire something that makes you more productive, then you can produce more wealth in a given unit of time compared to working unaided.
Take an example of a secretary with a typewriter compared to a secretary with a modern computer. The secretary equipped with the typewriter will theoretically be less productive, since she will have to restart her typing if she makes an error. However, equipped with a modern laptop or desktop computer, the secretary can accomplish her typing task much more efficiently, since she need only press a key to fix typing errors.
The typewriter and the laptop are both examples of what are called capital goods. The idea is that if individuals save sufficiently, they can spend their savings to acquire capital goods that make them more productive. Highly productive capital goods-equipped individuals produce material prosperity faster.
This is the generally accepted reasoning used to explain why some individuals become materially wealthier and others don’t. Of course, I’m speaking broadly, since there are all sorts of different “capital goods,” different natural human talents, different political environments, and so on.
But the crux of the argument is that people who become wealthy get that way because they save and they spend those savings to acquire productivity-enhancing capital goods.
Oh, but There’s More
I’m going to propose to you that this is only part of the story. Savings is important and so are capital goods, but spending savings is a relatively inefficient method to achieving material prosperity (economic growth). In fact, I have a hunch that the dramatic rise in global GDP around the year 1800 (illustrated below) is due in part to what I’ll explain below.
What I think happened over the course of history is the development of the financial concepts of capital and leverage.
To understand the dynamics involved between capital and leverage, we need to back up to the idea of savings.
There are different ways to save. I’ve argued before that there are three things you can do with income: you can consume, save, or invest. In the explanation above, saving money in the form of holding cash either in your physical possession or in a bank account is a (pretty inefficient) method of building capital.
In the rough schematic above, economists have argued that the path to prosperity is from Value Creation to Saving to Capital Liquidation. I’m not arguing that this is false. In fact, it’s fully theoretically sound insofar as the individual acquires a capital good that make him more productive per unit of time.
What I am arguing is that the pathway from Value Creation to Saving to Capital Accumulation is more financially profitable — be it in the case of a nation or an individual.
It may help to review the concept of leverage to see why this may be the case. When you use credit to purchase an asset, you develop a situation in which you can build equity. Equity is the financial value of the difference between what your asset would sell for (its market price) and what you owe on the debt you used to purchase the assert. Mathematically, you can say: Equity = Market Price — Debt. You build equity by making payments to your lender, thereby reducing the amount you owe. Over time, your equity, this financial value, gets bigger.
This equity, if used to acquire wealth, is conceptually indistinguishable from the idea of financial capital.
What makes leveraging capital more efficient than liquidating capital? The explanation is challenging to communicate in words, and a numerical example becomes messy. The main conceptual reason that leveraging is more profitable in terms of long-term financial growth is as follows…
The individual who leverages capital (equity) to purchase a given asset will benefit from ownership of the new asset and continued growth in value of his leveraged asset. The individual who liquidates capital (equity) only receives the benefits of owning the newly purchased asset.
Things get even more exciting if the value of the leveraged asset grows consistently year-to-year. This is type of consistently positive growth is called compounding.
A curious feature of compounding growth over time is that it if you graph it, you get a non-linear, exponential curve. Could the development of sophisticated financial contracts that allowed for the leveraging of capital be responsible, in part, for the compounding nature of global economic growth? Answering this question would require intense research of the history of finance. Fortunately, we need not settle the question in order to understand that intentional capital accumulation at the individual level will generate growth processes that leave the individual materially more prosperous than he would otherwise be.
In Part III of R. Nelson Nash’s Becoming Your Own Banker, Nash proves numerically the truth of the above analysis by comparing the various methods of purchasing an automobile.
In fact, you could say that Nelson Nash updated our economic understanding of the power of financial capital by applying it directly to the individual and demonstrating once and for all that accumulating capital and leveraging it to acquire wealth is a financially superior to spending savings. Comprehending this analysis is the first step to super-charging an individual’s own financial performance.
