The return on capital and its determinants in recent times

Prepared by John Hutchinson and Arthur Saint Guilhem

Published as part of the ECB Economic Bulletin, Issue 5/2024.

Since the peak of real interest rates in the 1980s, the divergence between the returns on capital for production and on safe assets has increased. Understanding this trend is of interest, given the potential implications for investment. The return on capital for productive purposes is an important investment metric. Given that the risk-free rate serves as an opportunity cost for investing in productive capital, a persistent wedge may suggest that investors are hesitant to allocate resources to projects perceived as riskier, thereby leading to inefficient capital allocation and underinvestment. Such a situation poses risks to the substantial investment needed to advance the green transition. This box examines what might account for this wedge, finding that a higher risk premium is the main factor, but rising economic rents also play a role.

Estimating the return on capital involves various assumptions, particularly concerning financial assets and the role of the housing sector in the capital stock. Additional considerations relate to calculating capital income and whether the total economy should be included or just the productive sectors. As a result, different approaches can be taken.

This box uses a comprehensive measure: the pre-tax real return on capital for the whole economy.^[1] This measure is computed as net domestic income less total compensation divided by the net capital stock. Since the 1990s the measure has fluctuated within a relatively narrow range in both the euro area and the United States, with a slight upward trend observed in the United States.^[2] The return on capital has also consistently been higher in the United States than in the euro area. The wedge is computed as the difference between the return on capital and the real risk-free rate, which for the purpose of this box is defined as the three-month EURIBOR (for the euro area) or the Treasury bills rate (for the United States) minus one-year-ahead inflation expectations.

The growing wedge between the return on capital and the risk-free rate peaked during the pandemic in both the euro area the United States, before narrowing during the recent rate tightening cycle. The relatively stable return on capital contrasts sharply with the long-term decline in the real return on safe assets. The wedge further increased significantly and reached its maximum during the recent inflation surge (Chart A). The subsequent monetary policy response and decline in inflation expectations have led to an increase in the real risk-free rate, thereby narrowing the wedge between it and the return on capital.

To analyse the factors underlying this wedge in the euro area, we employ an accounting framework proposed by Caballero, Farhi and Gourinchas which links the evolution of the wedge to developments in four key economic variables: the labour share; the risk premium; the expected capital loss; and mark-ups.^[3] The labour share can be observed and is taken as the adjusted wage share from the European Commission’s AMECO database.^[4] From the wage share and the output elasticity to capital, we can infer a measure of the average goods mark-up – a proxy for economic rents in this framework, which is inversely proportional to the labour share. The real average return on capital is defined as the ratio of real capital income to the stock of capital, net of depreciation. The capital risk premium is then estimated as the return on capital exceeding the risk-free interest rate, accounting for depreciation, rents and expected capital losses due to the price of investment declining over time. In this exercise we adopt a Cobb-Douglas production function instead of a constant elasticity of substitution (CES) production function. This approach implies that changes in the labour share are attributed to changes in mark-ups and that capital-augmenting technology does not play a role.^[5]

Using data for the euro area and the United States, this framework is calibrated to match the observed wedge between the pre-tax return on capital and the risk-free rate between 1990 and 2023 (Chart B). Since around the mid-2000s, the wedge has increased in both jurisdictions. In the euro area, this increase can be attributed predominantly to the risk premium, especially since the pandemic, while the contribution from mark-ups, though significant throughout the various periods, has somewhat declined. The shift in the latter may reflect the impact of labour and product market reforms implemented in the euro area following the global financial crisis and the euro area sovereign debt crisis. In the United States, the rise was primarily due to the increase in the risk premium and, to a lesser extent, increased mark-ups. The wedge and the factors accounting for it using this framework are largely unchanged in the United States since the start of the pandemic. The observation that a considerable proportion of the wedge in the United States is due to mark-ups aligns with empirical studies indicating a rise in mark-ups over the last 30 years in the United States.^[6]

The rise in the risk premium in the euro area since the pandemic can be attributed to heightened uncertainty arising from the pandemic and geopolitical developments as well as to a longer-term trend of increased demand for safe assets and reduced supply, which has lowered the risk-free rate while leaving returns on risky assets unaffected. Taking a longer-term perspective, the significant rise in the risk premium from around 2000 may reflect increased demand for safe assets, exacerbated by post-crisis regulatory changes and a general decline in the supply of safe assets. These factors have progressively reduced the net supply of safe assets, thereby pushing down the risk-free rate while leaving the return on risky assets unaffected.^[7],[8] Other factors, such as demographics and low productivity, have been identified as drivers of the secular decline in risk-free rates, but their effect on the wedge is somewhat unclear.

This persistent wedge can be viewed as an indicator of inefficiencies in capital allocation. Elevated returns on capital may deter firms from undertaking investment projects, particularly those that are younger and exhibit higher productivity, thereby impeding economic growth. Facilitating improved access to capital financing could mitigate this wedge, thereby fostering investment and advancing the green transition.

For the euro area, further financial integration, such as the completion of the capital markets union could help reduce the risk premium by reducing financial fragmentation, increasing portfolio diversification and enhancing market efficiency, thereby boosting lacklustre investment and supporting the green transition in the euro area. The investment needed for the euro area to meet its “Fit for 55” commitments are substantial. While some of these investment needs could be met through carbon taxes, significantly more investment will be required to achieve the necessary levels.^[9]