Economy

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The Divorce of Investment From Profits

One economic trend of recent years, more than any, begs the question of whether we as an economy have lost our edge.  As the FT reports:

Profits in the US are at an all-time high but, perversely, investment is stagnant.

According to GMO, the asset manager, profits and overall net investment in the US tracked each other closely until the late 1980s, with both about 9 per cent of gross domestic product. Then the relationship began to break down. After the recession, from 2009, it went haywire. Pre-tax corporate profits are now at record highs – more than 12 per cent of GDP – while net investment is barely 4 per cent of output. The pattern is similar, although less stark, when looking at corporate investment specifically.

This change is profoundly odd. Economic theory says investment is driven by profitable opportunities on one side and the cost of capital on the other. High profits suggest there are decent opportunities to make money; historic lows in interest rates and highs in the stock market mean that capital is dirt cheap. Yet investment does not follow.

“We have this strange thing that the return on capital really does seem to be high, the cost of equity capital is low, and yet we’re getting a lot of share buybacks and not much investment,” says Ben Inker, co-head of asset allocation at GMO. “It just feels a bit weird.”

Simply put, big corporations are no longer investing in innovation, despite having the money to do so.  The breakage of the link presents a new economic puzzle based on economic history and theory.

Two potential explanations for this are that 1) there are no innovative projects to invest in; and 2) there are such projects, but big companies do not have the incentive or access to invest in them.

For the purposes of this blog, we will assume the first is just not true:  Startup tech activity suggests that people are more entrepreneurial than ever.

We will explore the second explanation in several subsequent posts.

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Profits in the Intangible Economy

Not clear where Krugman is going in his blog today, and neither is he, but it looks to be somewhere interesting.

But there is at least one important respect in which the 21st-century economy is different in a way that ought to have a significant effect on macroeconomics: the much larger role of rents on intangible assets. This isn’t an original insight, but I haven’t been finding systematic analyses of the point.

What do I mean by the role of rents? Consider the changing identity of the most valuable company in America. For a long time, it was GM, then Exxon, then IBM. These were companies with huge visible production activities: GM had more than 400,000 employees, which was amazing when you consider that the overall national work force was much smaller than the one we have today, Exxon had oil refineries. IBM was an information technology company, but it still had many of the attributes of an old-style manufacturing giant, with many factories and a large, well-paid work force.

But now it’s Apple, which has hardly any employees and does hardly any manufacturing. The company tries, through fairly desperate PR efforts, to claim that it is indirectly responsible for lots of US jobs, but never mind. The reality is that the company is basically built around technology, design, and a brand identity.

There was an old Dilbert in which the pointy-haired boss explained that the company had discovered that despite its slogan, people weren’t its most important asset — money was, and people only came in at #8 or something. Actually, in Apple’s case market position is its most important asset.

There are a couple of obvious implications from this change in the nature of corporate success. One is that profits are no longer anything remotely resembling a “natural” aspect of the economy; they’re very much an artifact of antitrust policy or the lack thereof, intellectual property policy, etc. Another is that a lot of what we consider output is “produced” at low or zero marginal cost.

This jumps out at me.  When an economy moves toward where “intangible” assets are the economic driver, the level of reward is tied immensely to the regulatory rules of the reward which limit or allow competition.  So, for Apple, most would probably disagree that anyone could completely copy the iPhone from design to software to icon to Apple logo.  We might call that theft, and from an economic perspective, it would drive profits to zero and would reduce any incentive to come up with iPhone.

On the other end of the spectrum, many would probably disagree that by coming up with the iPhone, no one else was allowed to see a smartphone with a touchscreen, apps, etc.  From an economic perspective, this would make Apple’s profits even larger.

The current situation lies somewhere in between. The rules of the road that govern this are antitrust and intellectual property, as well as some other legal rules.  The push and pull determines where we end up in the wide spectrum between those poles.

One question that follows then from Krugman’s question and my analysis is whether it make sense for the same antitrust and IP rules that governed when tangible assets were the key driver to today’s world of intangible assets.

Maybe, maybe not.

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The Finance Tail Wagging the Dog

Interesting ratio re: finance for the sake of generating economic growth versus finance for the sake of finance:

Most of the finance the expanding banks provided, and the innovations they fostered, spurred economic growth, but a good chunk of it just inflated the size of the financial sector as banks created ever more securities to buy and sell from one another. McKinsey, a consultancy, reckons that about a third of the increase in the world’s debt-to-GDP ratio in the years before the crisis came from banks increasing the size of their balance-sheets; bond issuance by banks during this period was about five times larger than by companies. This trend accelerated after 1995, with only a quarter of the increase in debt to GDP coming from households and companies, an “astonishingly small share, given that this is the fundamental purpose of finance”, McKinsey says.

So, according to McKinsey, 25% of finance is funding the main street economy; the other 75% is arguably a casino.

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Career Shorts

This has been sitting in my draft folder for months now, having been forgotten. Appropriately, I found this today and am posting.

This is the economist, Tyler Cowen, on career choice as distortion by short-term signaling issues.

“I think about this a lot: you’re young, you come from a smart, wealthy family, you’re somehow supposed to show that you’re successful quite quickly. Banking, law, consultancy allow you to do this; engineering, science and entrepreneurship less so. Your friends expect it, your parents, your potential mates do … So we see so many talented people very quickly having to signal how smart they are but that may not be the longest-term social productivity.”

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The Curious Life of A Turkey

Another of what is becoming periodic posts with wisdom from Taleb’s Antifragile:

This one involves seeing opportunity: being a turkey in reverse:

“A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So with the butcher surprising it, the turkey will have a revision of belief — right when its confidence in the statement that the butcher loves turkeys is maximal and “it is very quiet” and soothingly predictable in the life of the turkey. This example builds on an adaptation of a metaphor by Bertrand Russell. The key here is that such a surprise will be a Black Swan event; but just for the turkey, not for the butcher.

“We can also see from the turkey story the mother of all harmful mistakes: mistaking absence of evidence (of harm) for evidence of absence, a mistake that we will see tends to prevail in intellectual circles and one that is grounded in the social sciences.

“So our mission in life becomes simply “how not to be a turkey,” or, if possible, how to be a turkey in reverse — antifragile, that is. “Not being a turkey” starts with figuring out the difference between true and manufactured stability.”

Being a turkey in reverse is about seeing beyond stability in life and markets, stability that is usually manufactured, but that has terror and disorder lurking right under the surface.  That’s where the opportunity might be.

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PC Tectonics

The launch of Windows 8 — after a half-decade or so of tablets and smartphone — failed to arrest and, indeed, accelerated the major drift that was happening away from a WinTel world.  The FT reports the biggest ever drop (14%) in PC sales in the first quarter, noting in a quote by Bob O’Donnell, an IDC analyst:

“At this point, unfortunately, it seems clear that the Windows 8 launch not only failed to provide a positive boost to the PC market, but appears to have slowed it. The radical changes to the [user interface], removal of the familiar Start button, and the costs associated with touch have made PCs a less attractive alternative to dedicated tablets and other competitive devices.”

In essence, Windows is playing too far off its own turf now to catch up.

Like the effect of continental breakup and the resultant effect on evolutionary diversity of birds and mammals, I think Levie gets its right today when he tweeted:

The effect of a drop in PC sales is far-reaching: less PCs -> less MS dominance -> more heterogeneity -> more startup opportunity

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A Fragile Workforce

On cue, a FT front page headline of the dire consequences of fragility when things go bad:

The US has gained 387,000 managers and lost almost 2m clerical jobs since 2007, as new technologies replace office workers and plunge the American middle class deeper into crisis…The number of clerical workers such as book-keepers, tellers, data entry keyers, file clerks and typists has been falling, pointing to a structural decline. The number of retail cashiers has also dropped – indicating that internet shopping and self-checkout systems may be eroding another occupation.

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Transfer Pricing

 

Just informational – when you hear discussion about corporate tax avoidance, transfer pricing is a lot of what they are referring to, a structure based on a Libor-like, non-arms length, incestuous self-reported fake transactions.

It treats multinationals as if they were loose collections of separate entities operating in different jurisdictions, giving companies huge scope to move income around the world to minimise their tax liabilities.

One of the main vehicles of corporate tax avoidance is a practice known as transfer pricing. Under international rules, transactions between company subsidiaries are supposed to be priced as if they were conducted “at arm’s length” between unrelated parties. In practice, though, the price can be adjusted to move profits to the lower-tax jurisdiction and expenses to the higher-tax one. The more complex the transaction, the easier this becomes. Many tax-haven subsidiaries are essentially shell companies that exist only to hold intellectual-property (IP) rights and charge other parts of the group for their use or provide other “services” at above-market rates. Transfer pricing (really mispricing) is sometimes also used to load costs onto countries that offer generous subsidies, especially in extractive industries. It has become a key plank of multinational tax strategies.

Technology companies, with oodles of IP to shift around, are avid practitioners of the art. Google, for instance, avoided a tax bill of around $2 billion in 2011 by moving almost $10 billion into a unit in Bermuda, a jurisdiction that levies no corporate income tax. Bermuda is the legal residence for tax purposes of an Irish subsidiary which collects royalties from another Irish division which in turn had collected revenues from ads sold across Europe (a structure known as the “Double Irish”). To avoid an Irish withholding tax, the company added a “Dutch Sandwich” to its tax-planning menu, routing the payments to Bermuda through a shell in the Netherlands. The end result is that there is little connection between where the economic activity takes place and where the profits are booked.

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The Big Apple Trades Down

With some hiccups, a New York City resident over the last 15 years opens his renewal lease annually to find a rent increase.

Now the WSJ reports that the process has started to reverse itself, correlating with the drop in finance jobs:

Back in 2006, nearly 60% of new renters worked in the financial sector; now about 40% do. Workers in creative fields and technology have nearly doubled, now making up nearly three out of 10 renters, the report found.

As a result:

An influx of artists, designers, young people in the city’s burgeoning technology sector and other industries is helping to drive rent prices down because they typically make less money than those in financial services, which has seen weaker job growth, according to the report by real-estate marketing consultant Nancy Packes, released with SteetEasy.com and On-Site.com, a national leasing and tenant screening company.

“Lower wages are contributing to lower rental growth,” Ms. Packes wrote. “The highly compensated finance sector is losing market share to the technology and creative industries.”