The Law of Diminishing Returns

You can never get enough of what you don’t need to make you happy.

~ Eric Hoffer

Remember when you were a kid and you begged, pleaded with, and nagged your parents to buy you something for months on end? You wanted it so badly. It would solve all of your problems and provide you with endless happiness.

When your birthday came along and you finally received the desired treasure, it probably did give you the boost you predicted. But how long was it before that treasure ended up collecting dust somewhere and you moved on to the next desperately needed gadget, trinket, or toy?

For many of us, this cycle repeated over the course of our youth. For some of us, it continued well into our adult years. Indeed, the decades following World War II saw society as a whole adopt much the same pattern. Our homes gradually “needed” to be larger, even as the average family size decreased. One car, television, or garage was not enough. The age of consumerism was born. The line between wants and needs blurred until it all but disappeared. Did this increasing consumption lead to increasing satisfaction?

The Law of Diminishing Returns

In economics, the Law of Diminishing Returns states that if one factor of production is increased while other factors are held constant, the amount of resulting output increase will level off over time, and eventually start to decline. In layman’s terms, it basically means getting less bang for your buck over time, much like the child who is continually indulged but somehow less satisfied on each occasion. I’m going to refer to the Law of Diminishing Returns in the latter sense, so I’ll ask for some latitude from the economists out there.

The post war era has seen a dramatic increase in many factors. The returns on these have steadily increased as well – until recently. Let’s take a look at a few different types of factors, the relative returns they provide, and what some of the future trends might look like.

Corporate Factors

Corporations contributed to the economic success (and excess?) of the post war era in a couple of ways:

Mergers & Acquisitions

Many companies, particularly in the financial sector, grew by merging with or acquiring other businesses. This type of activity is stimulative to the economy and the stock market as it provides a lot of revenue for the bankers, lawyers and accountants necessary to facilitate these transactions. M&A activity took a break during the recent credit crisis, but has recently seen a resurgence with several large deals recently announced.

It seems, however, that investors are not viewing this activity quite so positively as they have in the past. The stock market was generally flat to down when these moves were announced. Some have speculated that the lack of enthusiasm might be due to the fact that corporate consolidation often leads to layoffs and hiring reductions. In a market craving jobs more than anything else, this is not a good thing. So M&A doesn’t seem to be providing as much bang for your buck as it did a few years ago because of reduced activity as well as reduced economic benefits.

Stock Buybacks

In the equity heyday, all it took was a rumour that some company was going to buy back its stock and you could count on a sizeable boost in its share price. Like M&A activity, stock buybacks have slowed and so has the enthusiasm with which they are greeted. Investors are generally less confident in equity price increases due to economic and financial market instability and flat to lower returns over the past decade. And in the end, wouldn’t you rather see the company you’re invested in putting cash into R&D or organic growth strategies rather than incestuous stock buybacks?

Government and Central Banking Factors

Global governments and central banks have done everything they can to incite consumers to spend and corporations to grow. The resulting outputs have been accelerated economic growth, an increased perception of prosperity, and a mountain of debt. Here are a few of the ways in which governments and central banks have contributed to economic growth:

Low Interest Rates & QE

Once Paul Volcker conquered inflation by raising interest rates in the early 1980s, a period of steadily declining rates began. The Greenspan era saw the Federal Reserve dramatically lower rates whenever the economy looked like it was ready to take a breather. Lower rates led to asset price increases and higher growth rates as consumers, corporations, and governments took advantage of the cheap borrowing costs to spend, spend, spend.

The result, as we know, was a series of financial bubbles and trillions of dollars of debt on household and sovereign balance sheets. With rates at or near zero, there’s no more bang to be had for your buck in this area – unless you believe further quantitative easing will be effective. Even if it does provide some temporary confidence boost, it seems apparent with each new round that the Law of Diminishing Returns is at work here as well.

Government Stimulus Programs

In the wake of the recent spending and debt-induced financial crisis, governments around the globe came to our rescue with more spending and debt. Cash for clunkers, various incentives and programs for underwater homeowners, and lots of borrowed taxpayer cash for stimulus programs were heralded as the reason for the economic and stock market bounce of 2009.

As recently as August 2nd of this year, U.S. Treasury Secretary Tim Geithner penned an Op-Ed in the New York Times entitled Welcome to the Recovery. Once again, the Law of Diminishing Returns was evident. The market saw a bit of a bump up following Secretary Geithner’s article, and then proceeded to sell off for the remainder of the month of August. The actual economic data painted a picture of sparse to declining activity compared to the lovely pastoral the Treasury Secretary tried to sell.

Consumer Factors

Consumers contributed to the post war boom by buying what the government and advertisers were selling – usually with no money down and easy monthly payments.

Spending on Stuff & Self

In an earlier article entitled How Did We Get Here? I wrote about the post war transition from austerity and selflessness to prosperity and mindfulness to temerity and selfishness. Gradually, we came to believe that we needed – no, deserved - more gadgets, bling and stuff in order to be happy. Did all of this stuff fill a void, distract us from that void, or create a new one?

We’re finally starting to see some signs that these socioeconomic bubbles may be ready to pop, or at least deflate a little. Somehow that Hummer isn’t bringing us the joy we thought it might. Neither is the 3-car garage, the coolest gadget, or the hottest fashion. In fact, dealing with the debt we incurred to buy all this stuff is starting to get downright stressful. Retail therapy just isn’t providing the same bang for your buck it did a few years ago.

Are you noticing any signs of the law of diminishing returns out there? Do you think that’s a good thing?