The source of economic greatness – the efficient use of capital

US President Donald Trump’s “Liberation Day” tariffs have shaken the world’s markets. Whether this leading tool in his toolbox achieves his goal to “Make America Great Again” or turns out to be disastrous is the topic for an upcoming discussion. In this article, we look at what made the US the world’s foremost economy and what lessons there are for countries like South Africa.

America has not always been great. In the 1960s and early 1970s, it engaged in a lengthy and ultimately fruitless war in Vietnam. Conscripting its young men for this costly war and the long overdue attempts to address racism divided the nation in a most ugly way. Also in the 1970s, inflation took off and rose to over 13% by December 1979.

And then came an impressive comeback. Inflation came under control in the 1980s after a short, sharp recession and the US won the Cold War under the leadership of Ronald Reagan.  And something else, very important for the economy, was also underway. The revolution in corporate finance, in theory and practice, came to transform how US business would direct itself and improve its performance. Increasingly managers acted in the interest of the providers of their all-important capital, their shareholders. Return on capital became the focus of management's attention. This was a discipline that was forced on managers by increasingly active investors, backed by access to credit made available to them on an unprecedented scale.

Shareholders did not need business managers to diversify on their behalf. Conglomeration became a dirty word. The share market could do it for them and big business became more specialised, efficient and profitable in the true economic sense – earning more than the opportunity cost of the capital they employed.  The bar was being raised for US businesses and their CEOs and they responded accordingly, by improving the efficiency of their operations, to the benefit of workers, savers and investors.

The US equity markets tell the story of improved efficiency and enormous amounts of additional wealth creation. Donald Chew, editor of the Journal of Applied Finance, provides an incisive overview in his book The Making of Modern Corporate Finance (Columbia University Press, 2025). The improvement in the value of US equities and the strength of household balance sheets after 1985 has been nothing less than extraordinary.  The value of US households’ investments in equities, adjusted for inflation, was stagnant between 1960 and 1985. Put another way, the share market was not a source of real wealth creation for about a quarter of a century. Thereafter the market value of US equities held by households took off and is now worth about 18 times more in real terms than it was in 1985. Buoyed increasingly by the gains in the market value of these equities, the ratio of household wealth after debts to household incomes has increased from 4.8 times in 1987 to the current over seven times, even as disposable incomes have risen.

Personal disposable incomes grew from $3.65 trillion in 1988 to 21.89 trillion by the end of 2024, an average compound growth rate of 4.8% a year over the 37 years. The net wealth of US households grew from $18.52 trillion in 1988 to $163.5 trillion by 2024, at a higher average compound growth rate of 5.9% a year over the same period, helped largely by the increased value of US businesses.

These wealth gains have been especially large after the Covid-19 pandemic. Between 2020 and 2024, personal incomes after taxes, assisted by Covid-19 relief, grew from $14 trillion to $22 trillion, or by 57%. The net worth of US households grew much faster and extraordinarily over the same period, from $42.2 trillion in 2020 to $163.5 trillion, or by 287%. These wealth effects have dominated the income effects on spending.
 

Charting the explosion of wealth in US equities

The charts below show the trends and how gains in the equity market came to dominate household balance sheets.

Figure 1: Ratio of household wealth to personal disposable incomes, 1987 to 2024
 

Source: Federal Reserve Bank of St. Louis (Fred), Investec Wealth & Investment International, 3 April 2025

Figure 2: US holdings of equities, adjusted for inflation (1960 = 100)
 

Source: Federal Reserve Bank of St. Louis (Fred), Investec Wealth & Investment International, 3 April 2025

The value of equities in household portfolios has come to dominate household balance sheets. A fuller illustration of the trends in household balance sheets after 1990 is also shown below.

Figure 3: US household holdings of equities and financial assets, and GDP (1960 = 100)  
 

Source: Federal Reserve Bank of St. Louis (Fred), Investec Wealth & Investment International, 3 April 2025

Figure 4: US household balance sheet by category (1987 = 100)
 

Source: Federal Reserve Bank of St. Louis (Fred), Investec Wealth & Investment International, 3 April 2025

Figure 5: Value of equities held by US households and the S&P 500 index (1960 = 100)  
 

Source: Federal Reserve Bank of St. Louis (Fred), Investec Wealth & Investment International, 3 April 2025

Figure 6: Annual increases in household wealth and incomes in US dollars (2020 to 2025)  
 

Source: Federal Reserve Bank of St. Louis (Fred), Investec Wealth & Investment International, 3 April 2025 
 

South Africa – a case of capital wasted

Closer to home, South African business is also under pressure from shareholders to generate economic profits for their shareholders, though the SA economy has offered fewer opportunities for growing businesses than the US economy. An important reason for this failure to grow can be found in the operating performance of the state-owned enterprises (SOEs) and the terrible waste of the capital that taxpayers have been forced to supply them with. Eskom, the state-owned electricity utility, employs as much as R700bn of capital in its operations. The return on this capital is at best about 1% a year. If Eskom were to cover its cost of debt capital (about 11% a year) it would need to generate and additional R70bn each year from its operations. Or, to put it another way, Eskom has been wasting about R70bn of taxpayers’ potential income every year. Transnet, the state-owned transport company, employing about R312bn worth of capital, at an 11% a year charge is similarly wasteful. It would need about R31bn of extra profit annually to cover its costs of capital. These numbers show the sacrifice taxpayers have made in the form of potential income, had capital been used efficiently.

South Africa needs a revolution in its use of capital. It needs a focus on the return on capital, and on the interests of its shareholders in the SOEs.  Among the most abused shareholders anywhere are South African taxpayers. The solution is obvious: taxpayers should not be throwing potentially valuable capital after bad. They should demand that the inefficient operations of the SOEs be transferred to private operators, who need to cover their costs of capital to survive. The state can exchange assets or additional capital for a stake in more efficient businesses. A good example of the success of this approach is Temasek, the multinational investment business owned by the Singapore government. If we get it right, then the South African government can look forward to taxing their profits rather than covering their further losses.

*Co-written by David Holland, co-founder of Fractal Value Advisors and previously a senior adviser at Credit Suisse. He has long advised Investec Wealth & Investment on applying return on capital metrics using the Holt System.