Knowing and Making

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 ...

The FSA is expected over the next few days to publish published yesterday its new rules on bank bonuses, broadly in line with the guidelines announced by CEBS, the pan-European committee of regulators. It's likely that, f From 1 January, banks will only be allowed to pay a third  40% of bonuses in cash, with the rest paid as deferred claims of one kind or another - debt, preference shares or equity - which can be drawn down over three to five years. This is meant to reduce the incentive for bankers to take risks: with a high proportion of their wealth tied up in the company they work for, they will want to ensure its survival. However, there are two questions it leaves open, as I just managed to squeeze in on Radio 5 this afternoon  before they decided the 6 o'clock news was more important. The first question is: do banks - and bankers - actually know whether their actions are risky? It certainly didn't seem that way in 2008. Investments in property that they thought...

From Mario Rizzo's comment on Coordination Problem (an Austrian blog): Keynes...does turn certain virtues (like saving) into vices -- from an economic or consequentialist perspective. What is particularly disturbing is that from a long-run perspective surely saving is a "virtue." But surely it's not. Investment  is a virtue; and saving, usually, is what enables investment. Saving in itself is a neutral act, because one person's savings are another person's debt. In the Keynesian model, attempts to increase saving while investment is falling simply lead to a spiral of shrinking income. It's investment that creates future wealth. According to the savings identity , total savings does equal investment, but that statement is misleading for two reasons: one, because this definition of investment includes inventory (which may be built up involuntarily, and is not especially "virtuous"); and two, because it hides the effects of savings in one peri...

Martin Wolf outlines what has to happen to get the UK's fiscal deficit under control while keeping the economy growing [note the similarity to Chris Dillow's argument a few days ago]: Policymakers must bear four points in mind: first, they must promote the essential strengthening of investment and net exports; second, they must realise that this big economic adjustment is a necessary condition for a durable fiscal improvement; third, they must also prevent the fiscal deficit from crowding out the needed rebalancing; and, finally, they cannot assume that today’s huge fiscal deficits can be comfortably financed indefinitely, should the rebalancing of the economy itself fail to occur. This is going to be a very tricky policy performance. I agree with the diagnosis. But it raises a different question which is not answered: why does not the market solve this problem? Some would argue that public sector borrowing itself causes the problem - if the government did not run a defici...

From a commenter on Chris Dillow's recent posting : I do wonder how good the data on investment is, and whether as the service sector grows it is systematically underestimating investment. How well is investment that essentially takes the form of hiring labour to work on intangible assets, or simply to constitute an accumulated hired factor production (human capital), accounted for in all this data that tells us investment has been falling? Posted by: Luis Enrique | March 11, 2010 at 05:24 PM This seems a pretty reasonable hypothesis. Any idea how it could be tested? The last thing that those service businesses want is for their intangible work to count as capital investment - they'll have to pay corporation tax on it until they can write it off in four years. So some firms may not want to report investment figures to the government. However, at least one form of non-tangible investment - scientific R&D - brings tax benefits in some countries, and companies do have an in...

Robert Peston has been working hard reporting on results from RBS and Lloyds the last couple of days. A couple of points. He claims that taxpayer's money has gone down the drain at RBS, because: we as taxpayers put in £25.5bn of new equity into this bank last autumn...but...the equity of this bank has increased by less than £16bn to £80bn. So almost £10bn of the £25.5bn we've only just put into RBS has already been wiped out by losses. Well, that's half true. £10 billion has indeed been wiped out by losses. But it's not £10 billion of our  money, it's £10 billion of the former shareholders'  money. Our £45.5 billion has bought 84% of that £80 billion in equity, a £67.2 billion asset. The reason we're not in profit yet is because the market is still applying a discount due to uncertainty over future losses. We don't know if those losses will happen yet - it depends mainly on economic recovery - but on the book value of the bank, we got a good a...

[Fairly long post: scroll to the bottom for a one-paragraph summary] I've been interested in this debate for many years. It takes several different forms, but the simplest statement is: stockmarket investors are too focused on short-term returns at the expense of the long-term investment that builds real economic capital. I first heard this argument deployed against "asset strippers" such as Hanson, a UK conglomerate prominent in the 1980s. Since then it's been used to describe stockmarket traders, company shareholders in general , financial institutions of all kinds, and US and UK companies who supposedly focus greedily on quarterly earnings, unlike the more virtuous French, German and Japanese firms who are willing to take the long view. The first problem with the argument is this: long-term returns are just a string of several short-term returns in a row. For example, £1,000 invested over 20 years to return £5,000 is equivalent to an annual return of 8.3%. B...

A perceptive article by Tony Jackson in the FT illustrates two theoretical points I'll be developing in more detail over the next few weeks. First, he equivocates about the efficient markets hypothesis (EMH): When we make a killing in a rising market, we dwell on our own smartness rather than the irrationality of prices having been too low. This is a key point to understand in markets - especially illiquid ones such as property. Some commodities tend to exhibit long-term bear and bull markets. Residential property in the UK showed a consistent rising trend from the early 1990s until 2007. It's hard to argue, even having seen subsequent falls, that this obeyed the "random walk" theory of the pure EMH. Instead, it's more convincing to posit that there was a "correct" efficient value - perhaps the 2004 or 2005 price? - and that most people from the mid-90s onwards could see that the correct value was higher than the current price. However, natural caution,...

Any of these links could have made a blog posting of its own, but instead why not help yourself to a high-density nutritious snack selection of random commentary? During the first lecture of Paul Krugman's London visit last month he commented that the economy might be "stabilising". The stockmarket leapt a hundred points (giving rise to much hilarity on the second and third evenings). This perceptive writer points out a similar occasion in 1929 when someone "of no great note" called Roger Babson made a comment that the market was due to crash. At which point it duly crashed - for the next twenty-five years. Now a little later in the Robbins lectures Paul Krugman reviewed a history of not the 1929 but the 1873 depression - and how the economy recovered from that, in the absence of the modern era's gifts of Keynesian stimulus and World War II. Nothing to do with the earlier comments...except for one little thing... An interesting behavioural marketing tactic ...

The relative economic strength of the last eight years has for me contained one abiding mystery: why isn't there more business investment? Paul Krugman's current lecture series emphasises the contribution of a housing boom (exacerbated by cheap secured home loans); there's a consensus that debt-financed consumer spending has been the other driver of growth. Worldwide saving has fallen and, with it, investment. And yet, as Martin Wolf points out today , returns on physical capital have been excellent - above 13% for several years. So why aren't more people investing? A shallow answer is that consumers are focused on the short term and prefer the instant gratification of consumption to the long-term returns of investment. But this isn't really a question for consumers. The mystery is why savers have accepted miserable returns on consumer, mortgage and government debt instead of earning more that twice as much money by investing. You might think that there are few vali...

missmarketcrash kindly alerted me today to Paul B. Farrell's hilarious screed on Marketwatch: " Five reasons neuroeconomics is a big, fat hoax ". I thought this was laughable all the way through. Let me just show the highlights: Page 1: " all their books are based on junk science, anecdotes, broad conclusions from small samples ". Page 2: " Remember, 88% of our behavior is driven by the subconscious ". This spuriously precise assertion is even worse than the "Only 7% of communication takes place through words" mantra beloved of marketing consultants everywhere. Do some research, folks! Understand the scientific method! Page 1: neuroeconomics doesn't work. Page 2: Wall Street is using neuroeconomics to con us out of hundreds of billions of dollars a year. Which is it, Paul? Equilibrium economists are mostly Republicans. Behavioural economists are mostly Democrats. Therefore both of them must be wrong. Huh? " Neuroeconomics: call it w...

I visited a networking group yesterday which brings entrepreneurs and investors together to try and matchmake them. At the end we had a conversation about how to make the group work best. One of the persistent concerns about investment networking events is that each investor just stands there while a hundred entrepreneurs swarm over them, trying to get their money. This is unmanageable for the investor and doesn't serve the entrepreneurs very well either. Most of them get nothing and it is so competitive that those who might get an offer, get screwed down on terms. What's more, the facades that people (particularly entrepreneurs) erect make the search for worthwhile matches difficult. Even though investors will nearly always get to the truth before providing and money, the results of search theory  mean that they will have to spend more time, and will find worse matches, than if the entrepreneurs were honest (although there may be behavioural phenomena that counter this - back ...

There are a few things I want to comment on today, but I'll start with a quick analysis of the latest Krugman-Mankiw debate. The Obama administration projects that when the recession ends, growth will be faster than the long-term average, as the economy catches up with its permanent trend. This is called the trend-stationary assumption -  Paul Krugman supports it  and  Greg Mankiw disagrees , citing an alternative hypothesis called unit-root . Though I often disagree with Mankiw, this time I fear he is right. Both parties are citing different analyses of historical data. In economics, data is always easy to argue about, especially macroeconomic time series data of which there are rarely enough to make unambiguous inferences. Neither are going into detail about their answer in terms of an underlying theoretical model. Of course, models are also easy to argue about, but in this case it seems relatively easy to at least expose the implicit assumptions, if not to know which are right...

Another article (this time by Niall Ferguson, of whom more later) on the too-much-debt theory. The subtitle is: "Governments cling to the delusion that a crisis of excess debt can be solved by creating more debt". Well, this isn't a crisis of excess debt. To the extent that credit problems are responsible for the recession, it is a reduction  in the availability of credit that has triggered it. Ferguson may think that companies and individuals owe too much. But who do they owe it to? Er, other companies and individuals! He doesn't present much evidence for the "too much" theory, except an assertion: The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities...

Warren Meyer at Coyote makes a familiar argument against the stimulus : At the end of the day, businesses and individuals have a felt need to deleverage.  That is going to cause a recession, end of story.  The Congress’s and Obama Administration’s obsession with short-circuiting this sensible desire to reduce debt is not only counter-productive, it is offensive.  Banks are sensibly trying to strengthen their balance sheets, but the government wants to stop them. Individuals are trying to cut back on spending, reduce debt, and save more.  Again, the government wants to stop them, by going to debt and spending for them if consumers won’t do it on their own. This sounds intuitively sensible, but is it correct? As often is the case, a simple model sheds some light on the argument (retrospective note: the model is simple, but the analysis turned out longer than expected. I still think it's worth reading). Imagine a very small economy with just two people in it. A is a baker and B is a b...

An update on my proposal (and Roger Farmer's) from the beginning of this month: The Japanese government  has proposed  buying equity stakes in small to medium sized companies. Not via the central bank, but the (state-owned) Development Bank of Japan. The plan will be considered by the cabinet next month.

While the amount of net debt across the world is always zero , the amount of gross debt is not. And gross debt has reduced substantially in the last year as firms and consumers are deleveraging. An interesting post from Steve Waldman at Interfluidity praises this trend. I'm not convinced by his conclusion but he does contribute something rarely visible in economics commentary - a good philosophical understanding of what debt is. "Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources." I would put it slightly more generally: Debt is a promise to give resources to another party in the future . On this view, the gross amount of debt in the world is a representation of the number of promises we have made to each other. A promise is a restrict...

On this blog, as well as on several others, there's a strand of opinion supporting fiscal stimulus aimed at investment rather than consumption. Of course investment, depending on the multiplier, leads to a certain amount of consumption anyway. But the argument is that direct government spending should be weighted towards investment, either because there is a deficiency of investment in this phase of most recessions; because there has been underinvestment in the last few years which needs to be made up; or because it's a more "responsible" way to spend public money. A typical goal in designing an investment program is to create demand for things that can be provided by currently-unemployed people. This encourages unused resources (people) to be brought into use, so the stimulus gets an economic free lunch instead of diverting resources that are already economically productive. The challenge is that people are unemployed typically because their skills are less useful in...