Wednesday, August 26, 2015

What the Chinese stock bust and US productivity decline have in common

Though it was recently announced that productivity in the US rose 1.3% from the previous quarter, Alan Greenspan is worried about the collapse in productivity: “I think it’s the most serious problem that confronts not only the United States but the world at large and more exactly the developed world especially. American productivity is not significantly different from zero growth in the last 6 or 8 quarters. And the cause of that … is that capital investment has been inadequate to fund the amount of assets that you need.”

Others say that the problem is not that investments are too low; but repeat a statement attributed to Charles Duell, commissioner of the United States Patent Office in 1899, that: “Everything that can be invented – has already been invented; Still others suggest that “productivity” is not well measured.  Many make recommendations how to measure better, how companies and government should change their spending patterns to increase productivity and so forth.

These recommendations and analyses miss the main issue:  Where there is no accountability, or it is weakened, measures of “productivity” lose their meaning, whether they show great improvements or are dismal. Better measurement or spending more on R&D or any other recommendations are useless, unless accountability is dealt with first.  Weakened – or, to start with, weak — accountability is the common cause between the China stock market bust and the productivity declines around the world.

The facts are sharp and clear, and measures covering the financial sector illustrate this point with no need for modeling or statistical sophistication.

Andrew Haldane and his co-authors from Bank of England found that growth in financial sector value added has been more than double that of the economy as a whole since 1850 and until 2008, “Measured real value added of the financial intermediation sector more than trebled between 1980 and 2008 while whole economy output doubled over the same period …  Total returns to holders of major banks’ equity in the UK, US and euro area rose a cumulative 150% between 2002 and 2007.”  All this changed after 2008, showing that a good part of the financial sector’s explosive “productivity” for about a decade before 2007 was a mirage.  How could that be?

Societies becomes more “productive” when capital and talent are matched in more accountable manner – meaning, mismatches between capital and the variety of talents are corrected faster, innovations coming to life faster, and others, perceived unsuccessful, being discarded faster.  There are four terms in this observation: “capital,” “talent,” “matchmakers” – and “accountability.”   The recent crisis illustrates sharply how “productivity” measures mislead when accountability gets lost – at times inadvertently with even good – not “greedy” — intentions.

The main matchmakers in every society at all times have been governments and the financial sector.  “Criminal” sectors have been doing their matchmaking too, and in corrupt countries the distinction between them and governments is thin.  Measuring performance in the latter type countries is a political masquerade – as the Chinese Communist party has been publicly acknowledging the last two years – emphasizing corruption in land and construction deals. Such acknowledgment though made the weak accountability transparent, and raised question about financing the companies traded on its stock market.

Governments tax and borrow money, and spend it according to various criteria.  They are held accountable to differing degrees across countries, the present mythology being that separation of powers and Western-style “democracy” are the way to achieve this, recent evidence to the contrary – Greece included — notwithstanding.   As it turns out the ancient problem about who would “guard the guardians” did not yet find a very good solution – except perhaps in Switzerland with their accidental “direct democracy.” In one-party transitioning China, the layers of accountability are not even transparent, yet the party has been the main financial matchmaker.

Elsewhere the financial sector consists mainly of banks and capital markets – with banks the dominant matchmakers around the world, except in the US, where capital markets dominate, the US exception having started in the 1970s.  Bankers and investors  lend money at a certain price – matching capital and “talents,” the latter either individuals or companies, and they expect to collect the money owed.   What are their chances to collect?  That depends on how good the bankers were in doing due diligence, how well they priced the credit, how good was the collateral.

In the US, badly designed government policies, perhaps with good intentions, started with significantly changing capital gain taxes in 1997 (only for homes, not stocks), which turned homes more into a “liquid asset” than before.  Freddie and Fanny, the two not quite fully accountable major players in the mortgage business, but which had a vague neither quite private, nor quite public status, expanded significantly.  These changes as well as other policies encouraging home “ownership” led to vast expansion of construction related industries, and with the leveraged home equities of many others as well.  Banks, insurance companies, investors, rating agencies compounded on these mistakes and did not carry out due diligence.

As a result, the  financial sector displayed unprecedented “productivity” gains for a while, as banks and capital markets advanced unprecedented amount of loans; investors assumed them to be properly priced and being backed by good collateral – even though there was neither income nor asset to hold such expectations.   This led to mismatches not only by directing top talents to financial markets, but also in many other sectors, such as “real estate” – which in 2008 proved to be anything but “real.” And productivity in the financial sector collapsed, followed by others.

The conclusion appears straightforward: When institutions to hold matchmakers accountable are weak or non-existent measuring “productivity” is a foolish academic, bureaucratic endeavor.   As mistakes compound, and the slower they are corrected, the more mismatches persist in the country – and the lower is “productivity” – if it was properly measured to start with.  And once accountability is revealed to have been weakened – whether in the US or China – stocks will drop, especially those that represent companies financed my government induced misallocated credit.

Mismatches are a cost – even though it may take time to realize that matchmakers made mistakes.  The difference between government and “private” mismatching is not that politicians and bureaucracies are necessarily making them more frequently than bankers, insurance companies, VCs, “angel investors,” or others.   The difference is that the latter must correct mistakes faster or go bankrupt — unless they can count on governments (or in this last crisis the Fed too), to rescue them with taxpayer’s money.

Thus, before speculating how to measure productivity these days, or suggesting that because of Google, Skype, YouTube, Facebook, constant chats on mobile devices and the like, we may underestimate productivity (though perhaps 50% of the time using them prevent people from concentrating and they may even pollute their minds) – we should first take a closer look at institutions and incentives to held talent, capital and the matchmakers between them more accountable, be it in the US or China.  Only then do productivity measures and stock prices get meaning.

Reuven Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management. The article draws on his Force of Finance (2001).


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