Wednesday, 31 August 2011

Has the nature of investment in the economy changed?

I may have more to say about this in the next few weeks, but this New York Times article about industrial policy reminds me of a question I asked on twitter the other day:
...hedge funds and venture capitalists are geared toward investing in financial instruments and software companies. In such endeavors, even modest investments can yield extraordinarily quick and large returns. Financing brick-and-mortar factories, by contrast, is expensive and painstaking and offers far less potential for speedy returns.
This might not just be a change in investors' preferences. (Although if they have decided they prefer fast returns over slow ones, I don't know that I'd criticise them for that.)

What if something deeper has happened. In the late 1940s and early 50s, macroeconomic trends were fairly clear: Europe was on the verge of a major recovery, and American growth was likely to continue. In conjunction with this, we could predict with some confidence what people would want to spend the proceeds of that growth on. Most people would want cars, houses, refrigerators and TVs.

Therefore it was fairly clear that you could make decent money by investing in factories to build cars, refrigerators, TVs - or on land in Western Europe where houses would be built. Which is fortunate, because those are long-term investments. It takes several years to build a car factory and longer to build all the related distribution infrastructure - but that investment would keep paying back into the 1970s and even 80s - thirty years out.

Today, the macroeconomic trends are still fairly clear - China and India will get much richer over the next twenty years, while the Western economies and Japan will grow more slowly, though there will still be plenty of consumer demand there.

But it looks like consumer preferences are changing much faster than fifty years ago. The thirty-year predictions we could make in the fifties would be crazy to make now. I have no clue what consumer goods or services people will want to buy in 2041.

Of course there will still be cars and fridges on sale. But those will earn lower margins than in the 1970s, and if you don't already run Toyota or LG, it's almost impossible to invest profitably in that market. Anything that takes ten years to build, when we have no idea what consumers will want in ten years, is a losing investment.

So is it any surprise that investors turn to software - which, although it is also kind of unpredictable, at least turns around quickly. You will know in 18 months whether your bet has paid off. And if it pays off, it pays off big - the returns are quick, high, and disappear in a few years.

Presumably there are some long-term physical investments that look sensible - the car battery plants in the NYT article seem to be one example - but will the current investors be able to capture the returns, or will they be competed away as employees move around and patents expire?

Maybe this is what investment looks like now - short-term, individually risky but diversified via venture capital portfolios - instead of long-term and (relatively) low-risk via stockmarket holdings. You can make a long-term investment out of lots of short-term VC stakes, rolling them over when they mature; but that's a model that most investors are probably not willing to get involved in, except via shareholdings in the occasional company like Google which can afford to operate that kind of product development model in-house. Perhaps those who want to invest for the long term have no real choice but to buy government bonds.

Sunday, 14 August 2011

Why Obama should propose a Balanced Budget Amendment

It's the one simplest thing President Obama could do to seize control of the economic agenda. It's counterintuitive - but done right, it could be the tonic both for the economy and for a divided political scene. Don't click on your back button yet - I haven't gone crazy.

Obama should propose a Balanced Budget Amendment with the following key features:
  • The balance must be achieved over ten years, not one
  • It should include automatic (not discretionary) investment programmes when unemployment is high, which are scaled down when the economy is doing well
  • It should commit to share the proceeds of future growth between deficit reduction/debt repayment, tax cuts and investment
This policy would provide countercyclical intervention - exactly as a responsible government should. Right now, the US economy could use five to ten million more jobs (that's about $500 billion a year, by the way). Five years ago it didn't need anything like that - there was plenty of private investment going on, so the government wasn't needed so much. We hope that in five years time the same will be true again. Responsible Keynesians promote smaller government in boom times, just as they argue for larger government during recessions.

The stability provided by such an amendment would allow "shovel-ready" plans to be prepared in advance. Any needed stimulus could be spent well, on public goods which genuinely provide physical infrastructure or education that the private sector cannot. Individual states might sometimes decide to execute these plans on their own, if the federal government is in a low-spending year; that is up to them - after all, they're closer to the ground and know the needs of their own people and businesses better.

And by precommitting some of the proceeds of growth - which will increase government revenue - to repay debt, the plan would show responsibility towards the future without hurting current income. It would allow government to grow in absolute terms - something that is probably inevitable - but to grow more slowly than the economy, meaning that government spending as a percentage of GDP would fall in the long run.

There are a number of options which might help strengthen the plan:
  • The debt ceiling rules should change to include an allowance for the government's assets as well as its debts. Voters understand that it's OK to take out a mortgage as long as the value of your house keeps up with it. The figures would look at lot better if the government could put all those roads, schools and aircraft carriers on its balance sheet.
  • A clarification of the Fed's mandate - ideally towards a target for total nominal spending, but almost any change would be an improvement - would reduce uncertainty. In any case, being able to predict the fiscal balance of the economy would make the Fed's job a lot easier.
  • A serious look at the education system would be a worthwhile investment in the future. American education and educators are sometimes unfairly criticised - it really isn't that bad - but the system does fail to give a lot of people the skills they really need to innovate and compete in new industries.
  • The countercyclical argument can be framed like this: Today, we are asking wealthier Americans to lend a little to help their fellow citizens through this time. In five years, they will be repaid with a faster growing economy and lower taxes. The same argument applies across states with low and high unemployment, and across generations.
  • In the long run, it may be more effective to structure the balanced requirement as a rule stabilising the long-term ratio of debt to GDP. However, politically it is probably necessary to reduce this ratio before it can be frozen (at perhaps 60%).
A package like this could surely achieve significant political support across much of the population. It is fiscally responsible; it recognises the need for reform of government (and education) to help the private sector compete better; it includes a hard-to-break commitment to future tax cuts; and it also provides jobs, investment in public goods, and makes available a new future stream for spending when growth allows for it.

I wouldn't pretend that Republicans in Congress are going to jump on board with this - they have a strong political interest in not doing so - but it would reflect the desires of many Republican and independent voters. If Obama wants to bring the country together and transcend partisanship, recognising the validity of some Republican arguments, without caving in directly to Republican politicians, is a good way to do it.

This proposal is hardly a panacea. There are economic problems and budget issues that it doesn't handle; and there are political groups whose anger or alienation won't be assuaged by this kind of coalition-building. But it would be a start. Politically it would spike one of the right's rhetorical weapons, the call for a balanced-budget amendment, and it would make progress towards satisfying the genuinely held economic beliefs of both sides. It might therefore allow that particular left-right battle to fade into the background for a while, allowing space for society to deal with some other issues.

Update: I had missed a recent discussion by Reihan Salam of a similar proposal from Alex Tabarrok, a related (but stricter) offering from Ed Glaeser and the policies of the governments of Sweden and Chile (via Ed Dolan). Thanks to @KhalMojo on twitter for alerting me. I could also mention Gordon Brown's fairly successful policy from around 1997-2006 of a structurally balanced budget (excluding net investment) over the business cycle - which, however, was never enshrined in legislation and was weakened by the lack of an objective definition of "the business cycle".

Those articles focus on the economics of the proposal; I would emphasise that the politics are equally important. This could be a rare opportunity to unite some widely separated constituencies in America.

Update 2: Could this help the US to regain its AAA rating from S&P? Recall that S&P cited politics more than economics as its reason for the rating. Ratings alone aren't a good reason to make economic policy. But it wouldn't do any harm.

Update 3: Mark Thoma has written an article about this proposal today as well. It must be in the air.

Monday, 1 August 2011

The cost of making a hit single

I've been listening to NPR's Planet Money podcast, and one of the recent episodes [mp3 link] is about how much it costs to make - and promote - a hit single. Or more accurately: to attempt to make a hit single.

A friend in the music industry asked me to write down their figures with so he doesn't have to listen to the whole podcast. So here they are. The record in question is Rihanna's "Man Down", which her record company Def Jam was hoping would be one of the anthems of the summer. The costs break down like this:

  • Initial demos made at a "writing camp": $18,000 (it costs around $200,000 to hire 10 studios for a couple of weeks and make 50-100 demos for Rihanna to choose between; this cost is apportioned over the 11 tracks on the album)
  • Fee to lyricist: $15,000
  • Fee to producer/composer: $20,000
  • Fee to vocal coach/producer: $10-15,000
  • Cost of other studios and recording costs: $10,000
Total production cost: around $78,000

And then the marketing - advertising, (allegedly, and indirectly) paying DJs, other promotional costs. They don't break this down - there's an interesting debate about why payola is illegal and to what extent it still happens anyway - but they put an estimate on it of $1 million.

And the video: $200,000.

So the total cost of creating this single was about $1.25 million. And it wasn't even a hit!

There were three other hit singles on the album, it has sold 1.3 million copies - so they may have made their money back in the end. But this case certainly suggests, if no more, that the business model of the record industry is rather precarious.

The blame might be put on illegal downloads, or on a general change in how people consume entertainment, or on changes in how artists and the recording industry are perceived; or maybe you have your own theory.

Some people respond by suggesting artists cut out the record companies - and, by implication, all those marketing costs. That would presumably free up a higher proportion of the money to go to the artist (if they can still monetise their work). But on the other hand, maybe the marketing costs are necessary to get an audience, in which case there might be no way for most bands to make the free-plus-premium-box-set model work.

Maybe the marketing money is an implicit cross-subsidy to the radio stations (at least in the US) and keeps them afloat; or maybe most of the marketing money is burned in a status game, where the money spent on one song just cancels out the money spent on another. If we want to know what kind of business models will work for music, these are some of the questions that have to be answered.