In January 1963, Warren Buffett included an impish observation in his letter to his investment partners: “I have it from unreliable sources that the cost of the voyage Isabella underwrote for Columbus was approximately $30,000.” he wrote.
Unreliable indeed: there was no dollar in 1492. But we get gist. Buffett goes on to observe that while the voyage could be seen as “at least a moderately successful utilization of venture capital”, If Queen Isabella has instead invested sum would have risen to $2tn by 1962. For her inheritor’s sake, perhaps Isabelle should have said no to Columbus and simply found the 15th century equivalent of a passive index fund instead.
Buffett’s thought experiment came back to me as I perused the latest list of billionaires from Forbes. None of the leading players has achieved their position by the simple accumulation of family wealth over generations. The top five – Bill Gates, Amancio Ortega, Buffett, Carlos Slim, Jeff Bezos – are all entrepreneurs. According to economist Caroline Freund and Sarah Oliver, the proportions of billionaires who inherited their fortunes has fallen from 55 per cent two decades ago to 30 per cent today.
Is this absence of old-money billionaires because Buffett’s 4 per cent compound interest was an available to the wealth and powerful of pre-industrial Europe? Hardly. If anything, 4 per cents is conservative. According to Thomas Pickett’s bestselling capital in the 12st century , the real rate of return on capital, after taxes and capital losses, was 4.5 per cent in the 16th and 17th centuries, then 5 per cent until 1913. Although, it fell sharply between the wars, the effective average rate of return was very nearly 4.3 percent across the five centuries. At that rate, $30,000in vested in 1492 would be worth $110tn today.
Not to get to technical, but 1.10tn is a lot of money. It’s more than 1,000 times the wealth of the world’s richest man, Bill Gates. It’s 17 times the total wealth of the 1,810 billionaires on the Forbes list – or nearly half the total household wealth of every citizen on the planet. (According to Credit Suisse’s Global Wealth Report, total global household wealth is $250tn. Queen Izabella’s investments adviser’s apparently let her down. Patient conservative investments would have left her heirs today with a fortune to tower over every modern plutocrat.
All this brought to mind Piketty’s r>g, a mathematical expression so celebrated that people started putting it on T-shirts. It describes a situation where “r” (the rate of return on capital) exceeds “g” (the growth rate of the economy as a whole.) That is the situation that described the most of the human history – but not, notably, the 20th century, when growth rates soared while the capital has a tendency to be nationalized, confiscated or reduced to rubble.
r>g is significant because if the capital is reinvested and grows faster than the economy, it will tend to loom larger in economic activity. And since capital is more unequally distributed than Labour income r>g may describe a society of increasingly entrenched privilege, where wealth and power steadily accrue in the hands of heirs.
This is fascinating (and worrying) possibility. But it is a poor description of the modern world. For one thing, when billionaires divide their inheritance, mere procreating can be social equalizer. Historically, the great houses of Europe intermarried and concentrated wealth in the hands of a single heir. (No wonder: One of Queen Isabella’s grandsons Ferdinand I, had 15 children. But these days, disinheriting daughters and second son is out of fashion. (That said, “assortative mating”, the tendency of educated people to marry each other, is back and may explain more about rising income inequality than we realize.)
Another thing: The rich do not simply wallow money vaults like Disney’s Scrooge McDuck. They spend. According to Harvard economist Greg Mankiw, “a plausible estimate of the “Wealthy do not simply wallow in bank vaults like Scrooge McDuck – they spend” marginal propensity to consume out of wealth, based on both theory and empirical evidence, is about 3per cent.” Instead of 4.3 per cent then, wealth compounds at 1.3 per cent after allowing for this spending. Five centuries of compound interest at 1.3 per cent turns $30,000 into about $2.5m – not the kind of money that will get you near the Forbes list.
Of course, inherited privilege shapes our societies, not only the plutocracy but also down in the rolling foothills of English middle-class wealth. There, economic destiny is increasingly governed by weather your parents bought a house in the right place – and by the UK government’s astonishing abolition on inheritance tax on family homes.
But whether mega-wealth in the 21st century will be driven by the patient accumulation of rent in capital, rather than disruptive entrepreneurship of the late 20th century remains to be seen. Long-term real interest rates in advance economies have fallen steadily from 4-5 per cent three decades ago to nothing at all today. You don’t need to be Buffett to figure out that if you want to get rich by accumulating compound interest of zero, you’ll be awaiting a long time.
Quoting Warren Buffett in the 1960’s, shows that the general concept of his story hasn’t changed over time, even today.
There is a lot of value in steady, long term compound growth and you don’t need ridiculous returns to get rich: referring to a conservative passive index fund……(SP500?)
There is also a good point at the end of the article too:
“Long term real interest rates in advanced economies have fallen steadily from 4-5 percent three decades ago, to nothing at all today.
You don’t need to be Buffett to figure out that if you want to get rich by accumulating compound interest of zero, you’ll be waiting a long time”
I have a low risk Fixed Income Portfolio available as an alternative to keeping money in the bank yielding zero… “they’ll be waiting a long time to get rich off that money in the bank!”