Balance sheets are a vehicle for storing value, kind of like a massive economic freezer unit.
Other than commodities and perhaps some other obscure financial instruments, balance sheets are essentially the only way to store value for use in the future. Maybe it is on a bank’s balance sheet as a simple savings account. Maybe it is on a government’s balance sheet as public debt (a bond). Maybe it is on a corporate balance sheet as equity (stock).
I believe this concept of “storing” value for the future will be critical in navigating the next 20 years as the baby boomers retire. Why? They have been “storing” money for decades, and this phenomenon will reverse when they want the value back in retirement. As I wrote earlier, this is also one reason that governments have such large balance sheets right now.
One way this has changed my thinking
In general, we expect investments to have positive returns, but the “storage” concept shows how this is somewhat of a side effect to investing rather than the ultimate driver of what is going on when people save and invest.
For example, many years ago I would have told you that the risk free interest rate – the rate on very short term US treasury bonds – basically money you know you will get back – couldn’t be lower than the rate of inflation for an extended period of time. Why? The logic was that investors will at least demand the rate of inflation on their investments. Otherwise they would never invest.
Now I am not so sure. If an investor wants money for delivery in the future, they may need to accept a negative rate of return just to ensure that they have some money delivered in the future.
A simple example – think about the baby boomers
Imaging that the entire population of the world is 12 people. Let’s say 4 of those people are currently working and 8 of them are children in school. As the 4 that are working save and invest, they are buying shares in a future where there will be 8 people working (the children that are currently in school). In other words, they are buying slices of a future with twice as much output simply on a demographic basis. Their investment returns should be good.
But what if this is reversed? What if 8 people are currently working, but there are only 4 children in school. Those 8 people are all investing, socking away money for future delivery, but the future in which this money will be delivered only has 4 people working and producing. There is a lot less to be delivered in the future – unless there are some massive technological advances that allow those 4 workers to produce quite a bit more.
The 8 that are working still have to invest. They still have to store their money in the economic freezer for the future. They have no choice. But when the money is delivered, there will be a lot less because there is just a lot less production to go around with only 4 workers. Their investment returns will be poor, and perhaps negative. In fact, they may invest for the future even knowing full well that returns will be negative. They have no choice.