The wealth of nations

Let’s start with a thought experiment. Imagine a restless entrepreneur in bronze-age Mesopotamia with an eye for the main chance. When he spots a peasant making wonderful progress carrying his grain to market in a box propelled by a round thing, he immediately calls it a ‘wheel’ and dashes to Mesopotamia’s patents office in down-town Babylon where he registers ‘his’ invention – tough on the peasant – in the name of his company, Nineveh Investments.

As a result of this and the 4,000-year stream of income from licensing the rights to use the wheel, today Nineveh Investments is the world’s most valuable company and Iraq is its wealthiest country.

Okay, we might have several objections to the logic underlying this tale, not least of which is that Mesopotamia’s patent laws must have been so restrictive as to stifle all innovation (and, yeh, okay, Mesopotamia didn’t have any patent laws). But let’s not sweat the detail. The point is to illustrate the income-generating power – and therefore the value – of intellectual property (IP) and its accounting equivalent, intangible assets.

Yet this presents us with a problem: if intangible assets are so important, why is their value so unimportant compared with tangible assets, the stuff of business that you can see and feel, in accounting assessments? True, the question isn’t new, but it still awaits a satisfactory answer. Meanwhile, the anomaly between the power of IP and its rather feeble accountancy valuation is discussed in a heavyweight piece of research by McKinsey Global Institute, the research arm of management consultant McKinsey & Co*.

With the aim of grasping a better understanding of the dynamics that power the 21st century global economy, McKinsey compiles a global balance sheet of the assets and liabilities – public sector as well as private – of 10 countries that produce about 60 per cent of global output (GDP).

As Table 1 shows, this global balance sheet has expanded hugely in the first 20 years of the century. Without making adjustments for inflation, gross assets have risen 3.4 times to $1,540 trillion while gross liabilities, much of which is debt, have risen slightly faster (3.5 times). That leaves net worth – or just plain wealth – 3.2 times higher at $510 trillion.

Sure, the figures are too big to grasp, which is one reason why it is sensible to compare global assets and liabilities with global GDP. In accountancy terms, think of this as a rough-and-ready way of comparing ‘book value’ (or net assets) with gross profits, since GDP is effectively a measure of added value. Thus the world has become a lot more valuable in the past 20 years. In 2000, global net worth was 4.0 times global GDP. By 2020, that ratio had risen to 6.1 times, or – as McKinsey puts it – “the historical link between the growth of wealth and the value of economic flows, such as GDP, no longer holds”.

Perhaps that judgement is premature and McKinsey would not be a management consultant if it failed to suggest that we may be in the midst of a paradigm shift. Be that as it may, interesting things seem to be happening. Wealth is being created but its source is obscured from view. There are two possible explanations. The first is that, actually, the wealth is illusory and will evaporate. More on that in a moment. The second is that there is a failure in accountancy. The wealth is real enough, but the language of accountancy can’t define it so it remains hidden.

The clue is in Table 2, which shows a percentage breakdown of the $520 trillion-worth of global real-economy assets in 2020 identified in Table 1. These are dominated by archetypal ‘old world’ assets – land, buildings, plant and equipment – the things that weigh so heavily in the balance sheets of manufacturers or miners. Arguably, however, the most important row of data also has the equal-lowest percentage – intellectual property comprises just 4 per cent of the total.

The reason for this, McKinsey says, is “that for their mostly corporate owners, the value of intangible assets is assumed to decline rapidly due to obsolescence and competition even if their value to society may have a much longer shelf life”. Indeed, “intangibles, like know-how, live nearly forever”, it adds. At which point we are back with our Babylonian entrepreneur and the foresight of his decision to patent the wheel. After all, the wheel remains important today and, in our parallel world, even Elon Musk must pay a tribute to Nineveh Investments if he wants to put wheels – literally and metaphorically – on Tesla (US:TSLA).

More prosaically, McKinsey’s research finds that writing back all depreciation or amortisation of intangibles over the past 20 years would quadruple their value in Table 2’s schedule. Other things being equal, it would also mean a further 11 per cent increase in global net worth.

This prompts two thoughts. First, that if more value were held within the book value of intangible assets then there would be less need to chase the value of physical assets, such as property. Second, as McKinsey suggests, if more of the hidden value of intangibles were put onto the face of balance sheets then that would help explain the divergence between the book value of listed equities and their market value. That, for instance, would make more reasonable the superior performance of US equities since, according to McKinsey, “companies and markets in the US and Canada may seem to value intangibles more favourably than those in other countries”.

There may be other explanations. McKinsey also acknowledges that the performance of US equities may owe much to the ‘super-star’ effects of just a few companies. Arguably, however, that is the same explanation just put another way since the super stars – the likes of Amazon (US:AMZN), Apple (US:AAPL) and the rest – rely heavily on IP and the scalability that so often results from putting IP into practice. In other words, they are the corporate embodiment of the power of IP.

Then again, we may be altogether barking up the wrong tree. It may be no coincidence that the divergence between global net worth and global output began as interest rates started to fall at the start of the century, fell much more then stayed ultra low. This had a predictable effect – reliable and steady streams of income became more valuable and few are more steadier than property rentals. Thus property values rose to reflect the rising value of sticky rents in a world of falling interest rates.

Oddly, perhaps, the US was least affected by this trend (see Table 3). More of its rise in house values from 2000 to 2020 was due to rising rentals than any other of the 10 economies that McKinsey surveyed. In the UK, the house-price rise was split fairly evenly between higher rents and lower rental yields. The global average – heavily influenced by China’s property boom – was for house prices to rise 250 per cent, powered by a 69 per cent rise in rentals and a 43 per cent drop in yields (where, say, a 5 per cent yield fell to 2.9 per cent).

The overall effect is that the value of residential property accounted for almost half of global net worth in 2020, with company and state-owned property adding another 20 per cent. The proportion is big enough for McKinsey to say “this raises questions about the way societies allocate and build capital and wealth”. Meanwhile, enthusiasm for intellectual property is all very well, but McKinsey is doubtful it yet provides “a 21st century store of value that could be as durable as bricks and mortar”.

But how durable is the latest rise in global wealth anyway? McKinsey is also unsure about this (aren’t we all?) and suggests alternative paths – the paradigm shift or the reversion to mean.

The paradigm shift is the optimistic scenario. It requires more value to be attributed to intangible assets but demands companies demonstrate that the value of their IP is more enduring than conventional wisdom currently assumes. It might also demand a continuation of large-scale saving by the affluent classes of the developed world in order to keep interest rates ultra low.

Trouble is, that might be expecting too much. A nation’s demographics only change by the generation and the West’s – much like Japan’s already – are remorselessly moving to that age of man where savings pots get emptied. Which prompts the idea of mean reversion, a return to the longstanding relation between wealth and output. This requires wealth to fall or, at least, in relative terms. The fall may be dramatic or it may be gradual. Whichever, the most likely trigger would be a factor that causes interest rates to rise, thus undermining property values. McKinsey reckons that net worth to GDP might drop a third if the ratio between the two returned to its average for the period 1970-2000.

In some ways that might not even be a bad thing since rising wealth already depends too much on further increasing the value of existing and largely non-productive assets. In a way, that’s just a Ponzi scheme on a global scale. Not a happy thought to carry into the new year.

bearbull@ft.com

*The rise and rise of the global balance sheet; McKinsey Global Institute