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It’s the debt, stupid

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Submitted by Edward Harrison of Credit Writedowns.

Let’s say I run a company. For the sake of argument, we’ll call it a shoe store in New York City. I am making $100,000 net per year now. But, I look around me and see huge opportunity for growth. So I go to my bank and ask for a loan to expand my business.  I invest the money in expanding the store, and over the next five years I increase my earnings to $140,000.  Not bad!

Is this a well-run business?

GDP is not enough

Well, if your first instinct is to say, “you didn’t give me enough information,” I would have to agree. But, this is the way GDP statistics are used to measure the success of an economy.

Clearly then, GDP is an inadequate measure for understanding how healthy an economy is.  Nobel Prize-winning economist Joseph Stiglitz brought this issue into the public domain last week when he spoke in Paris, calling the focus on GDP a ‘fetish’ and favoring a broader measure of economic health.

Stiglitz was responding to reporters after a study on alternative measures of economic growth commissioned by French president Nicholas Sarkozy was released. At the time, Bloomberg reported Stiglitz saying:

GDP has increasingly become used as a measure of societal well-being and changes in the structure of the economy and our society have made it increasingly poor one…

So many things that are important to individuals are not included in GDP. There needs to be an array of numbers but we need to understand the role of each number. We may not be able to aggregate everything together.

Stiglitz is talking about the social costs of growth here.  Think about pollution, infant mortality rate, healthcare, life expectancy, or rates of obesity to name a few.  And his views are echoed in an article which prompted this tirade from me called “Emphasis on Growth Is Called Misguided“ by Peter Goodman in today’s New York Times.  Read it.

However, in this post, I want to focus on one narrow issue: debt.

The income statement vs. the balance sheet

In the shoe store example I gave, I borrowed money to fund growth.  In assessing how successful my growth strategy is, the obvious question is: how much did I borrow? It’s the debt, stupid.

What if I borrowed $1,000,000 at 7% interest? $40,000 is a return of 4% on that money, less than the cost of debt. In that case, the growth strategy is a loser.

We need to see the balance sheet as well as the income statement to know what is happening. GDP gives us no insight into the balance sheet of an economy, and is therefore incomplete as a measure of economic health. (I’ll leave the cash flow statement for another day!)

There is 4% growth sustained only through a rise in debt, growth that would have been 2% without an increase in relative indebtedness. And there is 4% growth fuelled by a positive return on that debt.

I am sure you have seen the graphs I published last October at the height of the panic in my post “Charts of the day: US macro disequilibria.” What should be clear from those charts is that the U.S. has been living in a period fuelled more by increases in debt and a concomitant increase in asset prices than in a world of sustainable growth.

The economics profession focus on the income sheet only

I suspect the GDP fetishism owes a lot to the models currently in use in the economics field, which focus exclusively on an economy’s income statement.

When I studied economics, in our introductory course, we used a book called “Economics – Principles and Policy” by two Princeton-affiliated professors William Baumol and Alan Blinder, a former vice chairman of the Federal Reserve (Yes, I still have the book from over twenty years ago).  The only mention of debt comes in Chapter 15 on “Budget Deficits and the National Debt” and it is basically a discussion of trade-offs between budget deficits and inflation.

Nowhere are aggregate debt levels in the private sector mentioned.  Now, I could be wrong because it is not in the index and I couldn’t find it in the book. I see this is reflective of the absence of debt as a topic in economic theory taught in universities.

In fact, the Chapter just before is called “Money and the National Economy: The Keynesian-Monetarist Debate.” I think the title says it all. Baumol and Blinder are Keynesians and they released a book to teach Economics in the Keynesian tradition.  To the degree they discuss any other economic models, it is only to weave the monetarist view into their own framework.  In the introduction of Chapter 14, the book states:

Then we turn to a very old and very simple macroeconomic model – the quantity theory of money, and its modern reincarnation, monetarism – for an alternative view of the effects of money on the economy. Although the monetarist and Keynesian theories seem to be two contradictory views of how monetary and fiscal policy work, we will see that the conflict is more apparent than real.

Now that crisis has hit, there is no inter-weaving of theories. Those two worlds, the monetarists (freshwater economists as Krugman calls them) and the Keynesians (saltwater economists in Krugman’s parlance), are at war over economic theory’s contribution to the global economic meltdown.  The Economist laments:

Economic writers will continue to try and describe the arguments wracking the field for an audience which wants to know about them, but economists need to figure out how to resolve some of these questions on their terms. If the best the dismal science can do in establishing the merit of one position versus another is make a play for the hearts and minds of lay-people, then economics is in more trouble than we all thought.

More noteworthy for me is how the salt- and freshwater types completely disregard debt, an issue central to the Austrian and Minskyian schools of thought. Paul Krugman wrote 6,000 words focused only on the income statement. There was no mention of the huge rise in debt in the U.S. and other economies like the U.K., Spain, Ireland, Iceland or Latvia (I take up the issue of Latvia, Iceland and Hungary in the post that followed this at Credit Writedowns).

All of these countries have one common feature: asset price booms underpinned by rising debt levels. Let’s hope we start seeing more discussion about the balance sheet in future.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward

26 comments

  1. fresno dan

    Very, very good point. But what is more interesting is that it is such an obvious point, yet economists give little attention to financing and debt. Money just appears and debts just get retired.
    One hears talk nowadays as if the only trade off is between unemployment (under use of all resources) and inflation. Gee, am I the only dinosaur here? We had this thingy called stagflation in the 70′s. Theoretically impossible. I imagine in a year or two the misery index will reappear.

  2. WH

    Ummm… Let me know if I am misreading this or am thinking about this wrong, but I think you are mistaken. This growth strategy is a winner.

    Do you mean “net income” or EBITDA, here?
    If it is net income, then, then interest is deducted.

    That means that the return on the $1 million is 11% =
    ($70k interest + $40k net income)/$1 million.

    The return is greater than the cost of capital. This investment has a positive NPV and a good ROI. It is a very good growth strategy.

    This can also be looked at as a annual increase in expenses of $70k produced an additional annual revenue of $110k. That is a 57% return.

    1. Edward Harrison Post author

      This isn’t an exercise in measuring return on capital of a fictitious shoe store WH. That is irrelevant and is merely for illustrative purposes.

      But, if you must go there, you will notice I said “$100,000 net per year now.” That’s net, not gross. Assume that is EBITDA.

  3. Jeff Ellerbee

    Dude, do you even have an advanced economics degree? Saltwater/freshwater isn’t about monetarist/keynesian (even in Krugman’s parlance). Please stop posting about topics you haven’t researched thoroughly–especially academic macroeconomic theory. For your kind information, Minsky is a neo-Marxist (qua Marx as critique of Capitalism; shorter version, “Capital tends to Crisis”). And Austrian is just both dead wrong (with respect to what actions should be taken in this environment) and a political non-starter for a number of reasons. Honestly, Keynesian is about counter-cyclical fiscal policy and maintaining stability in long-run aggregate supply. Please, please get a clue outside of some Economics 101 textbook.

    1. Edward Harrison Post author

      I would also suggest you read a 1988 NY Times article by Peter Kilborn:

      http://www.nytimes.com/1988/07/23/business/fresh-water-economists-gain.html

      The difference between the schools is as you indicate, Keynesians see counter-cyclical fiscal stimulus as key to fighting recessions, while the freshwater types are more libertarian. Friedman believed money supply was the key to control over the economy and best represents the freshwater types along with Lucas.

      Your label of Minsky as a neo-Marxist is just that, a label. The key difference between the neoclassicals and the Keynesians on one side and the Austrians and Minskyians on the other is the focus on debt.

  4. steve from virginia

    When I studied economics, in our introductory course, we used a book called “Economics – Principles and Policy” by two Princeton-affiliated professors William Baumol and Alan Blinder, a former vice chairman of the Federal Reserve (Yes, I still have the book from over twenty years ago). The only mention of debt comes in Chapter 15 on “Budget Deficits and the National Debt” and it is basically a discussion of trade-offs between budget deficits and inflation.

    Don’t got no debt … don’t got no energy, either!

    Dozens if not hundreds of pieces of economic analysis are presented every day in academia, in the media and over the Internet. Energy is either not mentioned at all as an input factor … or is given backhand mention, only.

    Consider two economies … separate but equal. The sexy, attractive finance economy gets all the attention. The productive economy upon which the sexpot entirely depends is falling apart due to mis- investment. Mainly, it is currently constrained by oil depletion against a backdrop of expanding – finance driven – demand.

    When a big highway bridge falls, due notice is taken. Consider Cantarell oil field in Mexico: 2 million barrels per day at the peak of production with 1m bbls. exported to the US in 2003. Net exports will reach zero in two years, cutting revenue to the Mexican government and oil availability here.

    The 500% increase in oil price since 1998 has had a destructive effect on the productive economy, masked/hedged against by the finance bubbles. Theoretically, the Fed can monetize all the US public and private debt. It cannot control or monetize oil prices. $70 oil is an economy destroyer which is working its evil right this minute.

    Not just debt. Oil.

    1. mikkel

      As I mentioned in another thread, Stiglitz is the only major economist I know of that has talked about resource utilization and how easy it is to spike the GDP in the short term by destroying the environment with over consumption, but leads to lower growth rates over the long term.

      There’s a reason he’s marginalized.

  5. Ishmael

    Mr. Harrison – I believe your point about debt and GDP is an extremely important one but the story is even worse than you portray. I have not worked through the computations but it appears to me that GDP is basically handled on a cash basis of accounting versus the accrual method and when money is borrowed it is added to the GDP and when it is paid back is a subtraction from GDP. Go out borrow money and the money is spent then GDP increases. Save money (or more accurately negatively borrow) and the money is removed from the system so we have a decrease in GDP.

    For instance in your shoe store example, the individual borrows money to expand his store and spends it. This does not generate any additional income to the store right then but the general economy will get a lift from his additional spending. The next year, since there is no borrowing by the shoe store there will be a decrease in the economy.

    The extra $40,000 of earnings impact is questionable for the store since we do not know as you pointed out what the debt service is for the expanded store. However, for the complete economy is it not really a zero impact because the positive for store was a negative elsewhere in the economy.

    It seems to me that GDP should be shown net of the change of borrowing. Then the naturally sustainable level of GDP would be shown.

    In truth, for each country sustainable GDP would only be driven by exporting (assuming currency stays constant ie gold standard) or technology changes which would include the use of resources that would incorporate the oil reference above. Overall improvement of GDP for the complete world on a per capita basis would only be driven by technology changes.

    In the US if we subracted incremental increases in debt each year from GDP we would have had a declining GDP.

    The funds flow statement bridges the balance sheet and the income statement. The current GDP number seems to be fixing funds from operation with funds from financing. This would be very misleading statement for a company and seems to also be true for a country.

  6. JKH

    The balance sheet is more than debt. While you’re at it, have a look at equity as well – i.e. household net worth (ref. fed flow of funds report). That’s the balance sheet position that matters most to the economy.

  7. craazyman

    My college economics experience is a couple years farther back in time than Ed’s — and my beer and reefer drenched brain didn’t absorb much of it anyway — ha ha ha ha — but I do recall the dismal science took great pains to distinguish “normative” judgements from “positive” ones.

    “Normative” referred to subjective judgements that were matters of opinion, such as whether transactions promoted happiness or misery. “Positive” referred to hard facts, quantifiable in numbers, such as prices, quantities and GDP. The profession did not claim that GDP itself was good or bad, simply that it was.

    It left the notion of what is good or bad to the political and social philosophers, the poets, the essayists, priests and ministers and, now, bloggers — the arbiters of society’s values.

    And so I’m a little sympathetic to the brittle old farts of the field who scratch their heads at the notion that there’s something wrong with GDP. “It is what is is, a number,” I can hear them say. “It’s our job to measure it, and it’s your job — as voters, politicians, humans — to interpret it in the light of your own values and pursuits of happiness.”

    Still, I also believe that response is sort of lame. And ultimately it’s an evasion, made acute in political society’s “fetish” that more GDP = more happiness.

    In another thought experiment, consider a town where (it’s an old-fashioned place) all the men work good jobs that support their families and the women stay home and tend to the kids. Then something happens and the town loses strength in its employment base. Unemployment rises among the men, incomes fall, and the women go to work. So now babysitters (let’s say low paid illegal immigrants) watch the kids and the families are stressed. Probably GDP has gone up because family incomes and consumption may be marginally higher with two working parents, plus babysitter income, plus extra consumption to make up for what used to be done “do it yourself”. Also, therapists are thriving helping the men deal with reduced status lifestyles and drug companies are making money off anti-depressant and anti-anxiety medication too. Liquor sales are up to help deal with the stresses and security costs have gone up to deal with the inevitable increase in crime. Overall, GDP is up because more money is being spent, but happiness is way down. And it may also be that the new businesses serving the towns “new needs” — such as private prisons, security guards, rehab centers, mental health clinics, liquor stores, et. al. — financed themselves largely through debt, supplied by securitizations organized by, you guessed it, Goldman Sachs. Ha ha ha haha.

    A snake biting it’s tail, thinking it’s found a meal. ha ha ha ha hahahahaha!!!! It will keep swallowing, until it feels its teeth on the back of its head. And then it will think it’s got a delicacy to savor for its next bite.

    I wish Mr. Sarkozy and Mr. Stiglitz good luck on their endeavor to redefine GDP. It’s a worthy effort.

    1. DownSouth

      I agree with reason in his assessment that your’s was a good comment.

      I also agree with reason’s observation that “They define their subject so that GDP is indeed the measurement that counts.”

  8. reason

    Crazyman,
    good post. But I would put it subtly differently. The problem is not in GDP as such, but in the much subtler bias introduced by economists definition of the scope of their subject. They define their subject so that GDP is indeed the measurement that counts. But that narrow view of economics is next to useless.

  9. Ramanan

    Hey Ed,

    Yes you are thinking in the right direction. Such an approach is already in place. You can try to find the work of Wynne Godley and Marc Lavoie and many others at the Levy Institute. There is also a book on this by Godley and Lavoie http://www.amazon.com/Monetary-Economics-Integrated-Approach-Production/dp/0230500552 – Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth

    Wynne Godley’s approach is stock-flow consistent as well. Its so surprisingly rediculous that the work of a genius has been neglected by Economists.

  10. Siggy

    A very long time ago I had a business associate who was quite erudite and a serious patron of the arts. He was the firm’s in house general counsel. He was in session with members of the operating committe and the issue at hand related to a lease contract that had some arcane language and curious negative covenants. Within the committee we had a fellow (Charlie) who one might otherwise consider very bright but had this proclivity to want to reduce all considerations to the fewest points possible. We were uncertain as to whether we wanted to do the deal and the impediment in our considerations was Charlie. He took the view that the contract was initially for a large space at modest cost and on that basis we should execute the contract. Our counsel, a man mild manner, who opposed the contract on the grounds that the contingency clauses were unaffordable, finally exploded: “Charlie, you’ve got read all the ******* words!”

    Taken by itself, GDP tells you something and yet it tells you nothing. It is one hand clapping in an empty forest. If you asked me to evaluate a company I would begin by looking first at the Operating Statement, then The Balance Sheet, then the Statement of Cash Flows and finally the Statement of Equity Position. For each of these, I’d like to see three to five years of history. After that I would want to know about the company’s product/service and its competitive position in the market, etc . . .

    The lack of attention to debt in the economic dialogue is, indeed curious. I recall in one the courses there was the idea put forward that the level of debt that a corporation carries has limited to no impact on the price of it’s shares. This was view posited by one of the M&Ms, I forget which. The paragraph was three or four medium sized sentences long. I read it, considered it and rejected it. All debt is a claim against all assets. That which is owed must be prepaid. The servcing of debt is a charge against earnings. When debt is applied to production, that production must produce a rate of return greater than the cost of the debt. It’s a question of context. A number taken by itself is number, a number considered in context may mean something. My view is that debt matters and that it matters greatly.

  11. RueTheDay

    “More noteworthy for me is how the salt- and freshwater types completely disregard debt, an issue central to the Austrian and Minskyian schools of thought.”

    What is with the incessant need to insert “the Austrians” into all of these discussions?

    The Austrians are just as ignorant of the role of debt financing and money as the neoclassicals/monetarists. Perhaps the Austrians are slightly more sophisticated in that they allow for a simple version of short-term non-neutrality (by saying that those who get the new money first are impacted differently than those who get it later) but for the most part the Austrians adhere to the old quantity theory. They are locked into a gold standard (essentially barter) view of the world. They are locked into a savings = investment mindset where capital investment is always financed out of current savings rather than the issuance of new debt. They are locked into the view of an economy always operating on the PPF where there is always a direct tradeoff between consumption spending and investment spending (which implicitly ASSUMES full employment in its premise). Their business cycle theory depends upon a set of arbitrary and illogical constructs like the “average period of production” and a singular “natural rate of interest” which were throroughly debunked decades ago.

    The Austrians have little or nothing to contribute to the current debate. Minsky, on the other hand, couldn’t be more relevant.

    1. CS

      RueTheDay, as others have mentioned, the fresh/saltwater schools of thought have barely have a passing mention of debt/credit. (Ignorant = not knowing/unaware)

      The primary theory of the Austrian school, the Austrian Business Cycle (ABC), states “that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.” By this very definition they clearly recognize the importance of debt by public and private entities, and hence you can’t even BEGIN to lump them in with the salt/fresh schools.

      “They are locked into a savings = investment mindset where capital investment is always financed out of current savings rather than the issuance of new debt.”

      Perhaps you wrote the sentence a little too quickly, but you need to put “genuine investment” in there. The ABC’s premise is that new debt w/o current savings DOES occur, but when it does, inaccurate interest rates will form malinvestment and the next business cycle.

  12. RueTheDay

    ” The primary theory of the Austrian school, the Austrian Business Cycle (ABC), states “that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.” ”
    ————————

    Now you need to objectively define “low” interest rates. What is “low”? The Austrians define “low” as when the “money rate of interest” is less than the “natural rate of interest”. Ok, so what is the natural rate of interest? The Austrians define this as the ratio between the amount of goods that someone will be willing to forgo in the present in exchange for some larger quantity of goods in the future – time preference. There are two problems with this – first, like utility, aether, and phlogiston, it can’t be measured; second, and perhaps more important, as Sraffa showed decades ago, the idea of a single natural rate of interest is literal nonsense, using the Austrian’s own tools he demonstrated that logically there would be as many “natural rates” as there were commodities, they would all likely differ, and some could even be negative. The edifice of Austrian Business Cycle theory was destroyed.

    “Perhaps you wrote the sentence a little too quickly, but you need to put “genuine investment” in there. The ABC’s premise is that new debt w/o current savings DOES occur, but when it does, inaccurate interest rates will form malinvestment and the next business cycle.”
    ————————

    The very notion of “genuine investment” vs “malinvestment” is sheer silliness. The only POSSIBLE objective standard for differentiating between the two is whether the discounted present value of the future cash flows derived from the investment is positive with respect to the cost of capital. (This is actually Minsky’s point). It is IMPOSSIBLE to know whether an investment will be profitable or not at the time the investment is made. This is because the future is uncertain, in a Knightian sence. There are MANY factors that can make an investment profitable or not, including the macro level of investment itself. It has nothing to do with the big bad government (the Austrian’s nemesis) holding short term interest rates below some imaginary natural rate, like the Austrians mistakenly believe.

    1. CS

      “What is “low”?”

      Would you agree that if the Fed wasn’t there pegging the FFR to 0% and bailing everyone out that the free market would float all rates, such as deposits, mortgages, etc., higher than zero? (Mentioning them all since you hinted at Sraffa)

      “There are two problems with this – first, like utility, aether, and phlogiston, it can’t be measured”

      Then how do we know the Fed has the time preference right?

      “The only POSSIBLE objective standard for differentiating between the two is whether the discounted present value of the future cash flows derived from the investment is positive with respect to the cost of capital… It is IMPOSSIBLE to know whether an investment will be profitable or not at the time the investment is made. ”

      But this objective standard is still heavily dependent on the interest rate. If I plug an interest rate that is 100bps lower than the market rate, I can come to a conclusion that the project has a positive NPV when in reality it doesn’t.

      I agree that it is impossible to know for sure whether an investment will be profitable or not. However, if I calculate the project CoC too low, I can guarantee that failure (unprofitability) will be much more probable.

      1. RueTheDay

        Yes, obviously rates would be much higher if the Fed wasn’t doing everything in its power to hold them down. And we’d likely be in a full-blown depression right now if that were the case.

        “Then how do we know the Fed has the time preference right?”
        —————-

        That would only be a (somewhat) relevant question if I were arguing in favor of fine-tuning monetary policy, which I’m not. I’m arguing in favor of not allowing the entire financial system to collapse and not allowing asset deflation to turn into goods deflation.

        “But this objective standard is still heavily dependent on the interest rate. If I plug an interest rate that is 100bps lower than the market rate”
        ———————-

        That is correct in general, but if you look at empirical data on past bubbles – e.g., housing in CA/NV/FL, dotcoms, etc., you will see asset valuations completely detached from reality – you could set the discount rate at 0.01% and still no rational level of future earnings expectations can justify the prices of the capital assets.

        1. john c. halasz

          The “time preference” theory of interest, its implicit bogus moralism aside, is a result of a subjective/psychologistic neo-classical conception of “utility”, whereby individual “perceptions” of time are abstracted out, then re-aggregated. It is prolonged into a “time theory of production”, which supposedly is “round-about”. But both production and interest rates are ongoing, continuous processes: temporal and varying, yes, as are all processes, but tied to the objective requirements and constraints of the system, not to subjective perceptions of it. Austrians share in the basic neo-classical fallacy that the entire economy can be usefully and realistically reduced to the terms of market transactions, and that the production system and realized returns from it don’t have their own constraints and dynamics. Once one recognizes the constraints of a re-production schema, then even if production decisions are market mediated, it’s the production system that imposes its constraints on market transactions and not vice versa.

          1. RueTheDay

            Yes, and that was largely my point – the Austrians aren’t that much different than the neoclassicals on the really important points. Trying to piggyback Austrianism on the current discontent with mainstream economics is just silly.

  13. n

    Economists: The stupidest smart people I have ever seen.
    Wonderful,elegant formulas and charst, smart! But a clue guys. Study and do real science first, then go to the tea-leaf-reading stuff. That’s why you’re stupid.

  14. reason

    Rue the day,
    in general a good criticism of the ABC but you left CS unnecessarily too much wiggle room. First you forgot to point out that there is no such thing as “the interest rate” which is relevant to investment, nor did you point out that the nominal interest set by authorities is known by entrepeneurs not to apply to whole time period relevant for the investment.

    Secondly, you failed to point out monetary policy is all about expectations including inflationary and general economic conditions expectations and these in turn will effect the investment decision. The ABC sells entrepeuners short, they aren’t so dumb as they make them out to be. Or that given there is a monetary authority and fiat currency that control has to be excercised somewhere and historical manipulation of short term interest rates has proven to be the best way of producing stable results. Monetary authorities learn and are getting ever better at what they do (ignoring for a moment – the real and quite different issue of excessive debt and asset price bubbles).

    Thirdly of course is the fact that the ABC in general is based on an unrealistic view of the consumer. Many consumers are quite happy to accumulate claims, without having specific plans about what to do with them. Interest rates just are not that fine tuned. I would hope that the economy is more robust than the Austrian’s make it out to be.

    But in general they are looking in the wrong place. The real problem is in the parallel world of paper assets, a barter view of the world no matter how sophisticated, is just looking in the wrong place.

  15. reason

    It just occurs to me to ask CS, why he thinks the discount rate used to evaluate investment decisions is the same as the short term rate of interest as controlled by monetary authorities? I would have thought a generalised risk adjusted return on capital would have appropriate (and this surely is dependent on actual investment results).

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