Back in April I was in a conference where George-Marios Angeletos of MIT presented a business-cycle paper that really caught my eyes. Basically the paper is a theoretical model saying that if information about production fundamentals is dispersed and there are market transactions across the economy, then business cycle fluctuations are inevitable even if there is very little "real" fluctuation in underlining productivities. One noteworthy aspect of the theory is that the business cycles in the model are not generated from any sort of inefficiency or market failure. They are unavoidable equilibrium features of the economy as long as there are market trading activities. And no government interventions can prevent them from happening as long as production information is dispersed among individual producers.
To me this paper has some very interesting implications concerning trade activities-- trades in real market and financial market alike-- that go beyond the conventional arguments. The traditional market advocates, going back to Adam Smith, emphasize the welfare-improving aspects of market trade, through specialized labor distribution, comparative-advantage-driven production, increased diversity of available goods, etc.
On the other hand, the opponents of market trade, especially in the recent years of massive globalization of economic activities, argue that the increased scope of trade is to the disadvantage of developing countries and contribute to environmental problems and the worsening economic inequality around the world. Some people also attribute financial market crashes, such as the one in the past two years, to extensive trading activities in the financial market.
However, it seems to me that most of the existing complaints against extensive market trade/globalization are either moralistic or reactive. First, what is "fair" in the distribution of trade gains depend on individual judgments and differ from person to person. Besides, certain negative side effects or coordination problems are not intrinsic of trade activities themselves, but rather are the results of poor judgments or human imperfections of market participants. Although this is mostly not what's happening in reality, theoretically speaking most of these complaints can be addressed through corrective actions from governments or any semi- "social planner".
In contrast, according to Angeletos' paper there exist certain intrinsic characteristics of the market institution that can be undesirable, even when the market is functioning perfectly. If we believe that business cycle fluctuations generate negative social welfare, which I think many people do, then there will be a trade off between the welfare gain from market trade activities and the welfare loss from excessive economic fluctuations. If both are increasing in the scope of market, then there shall probably exist at least one optimal scale of exchange activities. In other words, whether trade or (related) economic globalization is "good" is not an all-or-nothing question, but rather depends on the extent of the market exchange. This seems to me a more balanced and reasonable assessment of the question than either side of the conventional battle. But of course, what is the "optimal" extent of trading is a tough question and depends on a lot of factors, which can perhaps make an interesting (but difficult) topic for empirical research.
(Disclaimer: The opinions expressed in this article are purely my own and do not represent the viewpoints of GM Angeletos' research.)
Tuesday, June 29, 2010
Sunday, June 20, 2010
SG&A and Management Quality
I kept thinking that I should mention this on my blog but kept forgetting. Now finally... Many people in my conference presentations have raised concerns about the validity of using SG&A (sales, general & administrative expenditure) as approximation of firms' intangible capital investment. I kept telling people that yes, the concerns are valid in that SG&A is not an exact measure of intangible investment. But the thing is that there exists no exact measure, given the current accounting practice, and SG&A is really not a bad one to get this job done.
Nick Bloom at Stanford sent me this. He did a regression of firms' management practice scores as in Bloom & Van Reenen (2007) on firms' intangible capital stock as approximated by the stock of SG&A using perpetual inventory. The regression coefficient turns out positive and highly significant. The following graph is a more visual presentation of the result.
The message is clear: management knowledge, which is an important and rising part of organizations' intangible assets, is positively associated with SG&A level. It is still a mystery to me how each penny of spending in SG&A is adding to firms' management finesse at micro level. It will be an interesting research project and can potentially inform the emerging practice of intangible capital accounting.
Nick Bloom at Stanford sent me this. He did a regression of firms' management practice scores as in Bloom & Van Reenen (2007) on firms' intangible capital stock as approximated by the stock of SG&A using perpetual inventory. The regression coefficient turns out positive and highly significant. The following graph is a more visual presentation of the result.
The message is clear: management knowledge, which is an important and rising part of organizations' intangible assets, is positively associated with SG&A level. It is still a mystery to me how each penny of spending in SG&A is adding to firms' management finesse at micro level. It will be an interesting research project and can potentially inform the emerging practice of intangible capital accounting.
Tuesday, March 23, 2010
Global Economic Inequality: Why It Exists and How to Change It
In the new book I’m reading (see the previous post), the author John Perkins chastised multinational corporations such as Nike and Wal-Mart for exploiting workers in developing countries with extremely low wages and terrible working conditions. He also ask his readers, most of them citizens in advanced economies I suppose, to take consumer responsibility, stop buying from companies that earn enormous profits from their “sweat shops”, and shift to companies that pay workers “fair-trade” wages. Although the prices of “fair-trade” products are often way higher than that of their “sweat shop” counterparts, the author argues that consumers should realize that the price premium is an investment in the collective future of the humanity – buying products from socially responsible companies will help to create a just and safe world for future generations.
This is a beautiful and passionate argument, which I can see will win the sympathy of many well-educated liberals. Reducing global inequality and increasing living standards of third-world countries are important courses, to be sure. However, whether asking people to buy the more expensive products is a solution to this goal is a totally different question. It is not difficult to see why the approach won’t be effective. Even if buying fair-trade products is a collectively worthy investment in the future, any individual purchase will be too small and uncertain a contribution to the end goal, while the sacrifice at present is very tangible to the individual decision maker. On the other hand, every such purchase creates positive externality to the society, i.e., the person who made the purchase will not receive the full return of his “investment”, which almost certainly will render fewer such purchases than socially desirable in a society dwelled by mostly rational individuals. It is difficult to rely on people’s spontaneous sense of justice and innate altruism – though those virtues do exist -- to make social changes sustainable. Especially true when the going gets tough, our survival instincts and rational calculation will triumph. The fact that despite its poor record in human rights and social responsibility, Wal-Mart’s profit even increases with the economic downturn is just one more example to remind us of this simple truth. Therefore, asking people to act noble as if they can internalize the welfare of the whole society is probably not the best way to change the world. Our species just hasn’t evolved to that level yet. I believe that accepting this fact will create a more solid ground for any attempt to change the world for the better.
Inequality in wealth distribution around the globe is a structural problem that can hardly be solved by such local, band-aid solutions as asking consumers in the rich countries to pay more for the welfare of workers in the poor countries. It is easy to blame big corporations for not paying their workers enough. However, it is more useful to ask: if not plan A, what would be other options? Are plan Bs and Cs actually better? The fact that Nike’s “sweat shop” is able to establish itself in Mexico and hire enough workers despite the extreme low wages says a lot. If the Nike factory is not there, the country will probably suffer from a higher rate of unemployment. Though the workers have barely enough food to feed their families right now, the alternative scenario would mean that they have nothing to eat at all! This doesn’t mean that Nike and other multinational corporations are the saviors for the poor people in third world countries. They are not. In fact, in some circumstances free trade and the introduction of foreign competition to local markets contributed to income inequality and unemployment in those countries. For example, the import of mass-produced, cheaper corns from US crushed small farmers in Mexico and made their original occupation extinct. They had to look for other ways to support themselves and probably ended up in a low-paying factory run by US corporations. The story is not unlike what happened to English farmers at the beginning of the industrial revolution 300 years ago, which led to clashes between classes and Marxism (but that’s another story). Conservative economics teaches that free trade is welfare-enhancing for both exporting and importing countries. After all, Mexican consumers get to buy cheaper corns. What international trade theory neglects is that this gain from trade is very unevenly distributed among the population. The world today is certainly very different than 300 years ago. For example, many countries have implemented or attempt to implement minimum wage laws. However, setting aside the loss of economic efficiency accompanied with these regulations, their effects are in many cases marginal in terms of improving living standards of low income population.
Again, inequality over the world population is a structural problem. Consider a pair of Nike shoes that cost $70 in the US. The wage of the workers in some third-world country shoe factory is $2.75 per hour. The gap is astonishing, I know, but there is a structural reason for that. The labor cost, together with material and machinery cost to make the shoes, constitutes around 20% of the shoes’ price. Then where is the additional 80%? The answer is that it is shared basically among three types of work: design, marketing and distribution. All these work are mainly done in US and generally require high human capital – likely college-graduated workers. Such intangible-capital intensive industries as research & design, sales & marketing, whole sale & retail trade have seen tremendous increases in both their size and price in the past 50 years in most developed countries. Costs associated with these industries have become the biggest chunk of value in almost all goods and services sold in an advanced economy, from shoes to computers to financial services. There are supply-side and demand-side reasons for that. First, as mentioned before work in these industries is generally more complex. Their value-added is not just labor but knowledge, information, creativity, which in turn requires expensive education input. Second, consumers’ demand for product sophistication generally increases more than proportionally with income. As a country gets richer, people seek to satisfy higher needs beyond basic necessities. While it is always true that a generic pair of sneakers is not as attractive as a brand-name product that is scientifically-designed to be more comfortable and carries aesthetic value, it is truer in an advanced economy where people’s basic needs are satisfied. The result of these structural factors combined is that the shoe factory worker will only get a negligible portion of the Nike shoes’ cost.
A structural problem requires structural solutions instead of well-intentioned band-aids. Since the extreme gap between manufacture workers’ wage and the product value is caused by both supply-side and demand-side factors, we can tackle the problem from both sides, too. On the supply side, invest in education and human capital accumulation in low-income population of third-world countries. The industrial revolution in the 20th century is no different from that of the 19th century except that knowledge is so much more emphasized in production process of the 20th century. The fact that knowledge is accumulative and largely carried by the worker greatly shifted the balance of power between labor and capital. A most important way to elevate the manual worker out of poverty is to enable him to join the knowledge workforce, and that implies education investment. If as Perkins claims that buying products that pay workers higher wages is an investment in our future, I would argue that donating to education or training that applies the human capital already owned by the workers is a better investment, since it gives the workers more sustainable power. On the demand side, developing countries should expand local demand for locally-manufactured goods instead of solely relying on exports. Surely the manual workers in Mexico cannot afford a fair of Nike shoes. But as we discussed, the Nikes shoes that are sold at the high price in the US market contain a series of value-added that cater to the customers in developed economies. Enterprises should be encouraged to make products that cater to basic demands of local population. Products that do not involve extensive design and marketing are a lot more affordable to low income population and immediately serve local economy. (A side note: the enterprise Grameen Danone, a joint venture between Grameen Bank and Danone Group is a great example of enterprises catering to the local demand of low-income communities.) A diversified local market that has both volume and flexibility is the basis of economic independence for many third-world countries that heavily rely on labor-intensive exports and/or natural resource exploitation. It will also enable economic development to reach the vast majority of people instead of the privileged few.
Monday, March 22, 2010
Hoodwinked
I’m reading a new book called Hoodwinked by John Perkins. The book is on what Perkins called “predatory capitalism”, how the system has exploited the majority of global population to the benefit of a few, how it has caused the recent financial meltdown, how multinationals have seized control of worldwide resources and caused damages, and finally, how to change the world through enlightened activism. The book can be a very interesting read depending on who you are. The author is proficient in story-telling and weaving arguments and insights into stories. And the book is in no lack of passion and inspirations. However, the author has no interest in providing neutral and objective analyses of the topic with different sides of a controversy taken into consideration. Neither is he good at providing facts and numbers to support his arguments. So if you are the scholarly type who won’t buy into anything without sufficient hard-core proofs, or is easily annoyed by writers who call names or use emotion as a major tool of persuasion, you might be turned off by the book. My philosophy in reading any book is that I pick what I deem valuable and disregard the rest. Even if I dislike a particular style of the author or his opinions, I try not to let my judgment impact my ability to learn useful things from the book. It’s a waste of energy to indulge judgments on other people’s opinions. And they often blind us from receiving inspirations and valuable information. As for whether there is a better way to write the book, it is the author’s business. As a reader, my only task is to find if there is something useful in the book for me. If the answer is yes, then I consider the book a good one. In this sense, this is a good book and I recommend it to anybody that is interested in globalization, economics or social responsibility.
Saturday, February 13, 2010
Spiritual Capital
I was flipping through the Light of Consciousness magazine and came cross an article by Swami Amar Jyoti. I didn't know about this author. But I like the article. Here is a quote from it:
First, it is a production factor, that is, it can be used to produce other goods, except in this case, the "goods" produced are intangible, too. We can call them "blissful experiences", which certainly are valuable and consumable (for an extensive discussion of experience as commodity, see The Experience Economy, by Joseph Pine and James Gilmore). In Jyoti's words, spiritual capital helps produce certain experiences so that other things equal, "you could enjoy and have a more fulfilling life".
Second, spiritual capital is produced, not a pie from the sky. Spiritual traditions around the world teach people that spiritual capital can be produced in various ways -- meditation, yoga, prayer, selfless actions, for example. In other words, you have to "work" (read: spend time and energy) to get to a certain level of spiritual consciousness. Though the investment in spiritual capital has uncertain returns and different individuals achieve different levels of efficiency in its production, it certainly requires human inputs. And the time and resources spent in producing spiritual capital are very likely exclusive. For example, with the time one spends on meditation, one could have fixed himself a lunch sandwich (read: consumption goods production) or engaged in other productive activities.
Third, spiritual capital is a stock variable, i.e., it is not used up in a single period but instead, can be accumulated and benefit multiple future periods. One's spiritual capital may also depreciate over time due to neglect and lack of practice.
Now here is what's really interesting about the quote from Swami Amar Jyoti's article: it argues that spiritual capital is exchangeable with other goods. "The higher you go, the less dependent you are upon material needs". In economic terms, the level of human utility that can be generated by the consumption of 2 sports cars and 10 brand-name suits can be produced by x level of spiritual consciousness, too! This exchangeability, if true, brings spiritual capital one step closer to the mainstream market economy. Since if the value of what spiritual capital produces is comparable and exchangeable with the value of other goods, then spiritual capital can have a market price. And if this is true, I believe that it will eventually help to transform the market economy itself, along with other types of intangible goods.
There is another essential characteristic required for any goods to be integral part of a market system: interpersonal transferability, otherwise the good cannot be bought or sold. So is spiritual capital trade-able? I think the answer is to a large extend yes. Though the direct transfer of spiritual capital from one person to another is not possible (well, not until we invent technologies of brain data downloads), still individuals can buy and sell services (and also tangible goods in some cases) that facilitate spiritual capital production in the buyer. For example, we've seen in recent years rapid expansion of spirituality-oriented continuous education and health care industries, in the form of yoga education, life coaching, spiritual counseling businesses and non-profits, and in spirituality-related exhibition and publishing industries. They are all inputs to spiritual capital production. Though eventually it still depends on the seeker himself to produce and accumulate spiritual capital in himself, those inputs may increase the productivity tremendously. In this sense, spiritual capital can be a market product just like products of other education industries.
Imagine a time when the spiritual capital industry and other intangible goods industries become the major growth engines of our economy (like steel and automobile industries in the 20th century), and a large percentage of society members following the consumption pattern described in Jyoti's article. Imagine how different the world would be!
"The higher you go, the less dependent you are upon material needs. And because you depend less on these, the less you have to spend, which means you don't have to earn as much. And if you do not have to earn as much because you are now depending upon higher principles, the less you have to work for money, the finer your consciousness becomes and the more satisfaction you will have. I am not teaching poverty. On the contrary, I am trying to convey how to get rid of dependence on gross needs so that you could enjoy and have a more fulfilling life. It is only then that you can grasp and experience pure love."It is an interesting passage. Now this may sound crazy to you -- it appears to me that the author was actually describing the economic logic of a type of intangible wealth. I would call it -- excuse me for the lack of imagination -- "spiritual capital". You can think of it as the level of spiritual consciousness in a person, or the degree of awareness / enlightenment, or whatever term that makes spiritual sense to you. If you think about it, spiritual capital fits the common definition of "capital" very well:
First, it is a production factor, that is, it can be used to produce other goods, except in this case, the "goods" produced are intangible, too. We can call them "blissful experiences", which certainly are valuable and consumable (for an extensive discussion of experience as commodity, see The Experience Economy, by Joseph Pine and James Gilmore). In Jyoti's words, spiritual capital helps produce certain experiences so that other things equal, "you could enjoy and have a more fulfilling life".
Second, spiritual capital is produced, not a pie from the sky. Spiritual traditions around the world teach people that spiritual capital can be produced in various ways -- meditation, yoga, prayer, selfless actions, for example. In other words, you have to "work" (read: spend time and energy) to get to a certain level of spiritual consciousness. Though the investment in spiritual capital has uncertain returns and different individuals achieve different levels of efficiency in its production, it certainly requires human inputs. And the time and resources spent in producing spiritual capital are very likely exclusive. For example, with the time one spends on meditation, one could have fixed himself a lunch sandwich (read: consumption goods production) or engaged in other productive activities.
Third, spiritual capital is a stock variable, i.e., it is not used up in a single period but instead, can be accumulated and benefit multiple future periods. One's spiritual capital may also depreciate over time due to neglect and lack of practice.
Now here is what's really interesting about the quote from Swami Amar Jyoti's article: it argues that spiritual capital is exchangeable with other goods. "The higher you go, the less dependent you are upon material needs". In economic terms, the level of human utility that can be generated by the consumption of 2 sports cars and 10 brand-name suits can be produced by x level of spiritual consciousness, too! This exchangeability, if true, brings spiritual capital one step closer to the mainstream market economy. Since if the value of what spiritual capital produces is comparable and exchangeable with the value of other goods, then spiritual capital can have a market price. And if this is true, I believe that it will eventually help to transform the market economy itself, along with other types of intangible goods.
There is another essential characteristic required for any goods to be integral part of a market system: interpersonal transferability, otherwise the good cannot be bought or sold. So is spiritual capital trade-able? I think the answer is to a large extend yes. Though the direct transfer of spiritual capital from one person to another is not possible (well, not until we invent technologies of brain data downloads), still individuals can buy and sell services (and also tangible goods in some cases) that facilitate spiritual capital production in the buyer. For example, we've seen in recent years rapid expansion of spirituality-oriented continuous education and health care industries, in the form of yoga education, life coaching, spiritual counseling businesses and non-profits, and in spirituality-related exhibition and publishing industries. They are all inputs to spiritual capital production. Though eventually it still depends on the seeker himself to produce and accumulate spiritual capital in himself, those inputs may increase the productivity tremendously. In this sense, spiritual capital can be a market product just like products of other education industries.
Imagine a time when the spiritual capital industry and other intangible goods industries become the major growth engines of our economy (like steel and automobile industries in the 20th century), and a large percentage of society members following the consumption pattern described in Jyoti's article. Imagine how different the world would be!
Friday, February 5, 2010
The Price of Free Market
I'm standing in front of the blackboard looking at about 30 undergrad students in the classroom -- my first recitation class for this semester's Microeconomics Principles course. I'm supposed to go through some textbook examples about the concept of comparative advantage, opportunity cost, and how market exchanges or trade activities increase welfare for everybody involved.
Here is one of the examples, simple but illustrating. Suppose that in an economy there are only two goods produced, bread and milk. In the scenario without market trade, every household has to produce both goods. Naturally, their capabilities for the two tasks vary. Now suppose you and I start trading. Then each of us can just produce the good we are relatively better at and exchange a portion of our products with each other. The labor distribution improves the efficiency of our time allocation. There will be more bread and milk produced in the economy and both of us better off. In addition, by focusing on making milk and not getting distracted with other activities, my milk-making skill is likely to improve faster, so is my trade partner's bread-making skill. The conclusion is that trade, no matter whether it is between individuals or between countries, makes everybody happier.
This argument for free market exchange is one of the crown jewels of modern economic thinking. It is powerful and elegant, and economists have been using it to advocate for free trade and globalization since the time of Adam Smith. Many years ago, when I first learned about it in my undergrad Econ class, I was immediately hooked and felt so excited as if I had been given new eyes to see the world. From then on, anybody who questioned the expansion of free market would look either crazy or downright stupid in my point of view.
But today when I was supposed to teach the same brilliant theory to my students, I suddenly found it a very frustrating task: the real world is so much more complex than described in those elegant textbook examples, and I'm not sure that I'm offering those young minds a "better" way to see the world by simply presenting them some over-simplified cases.
When the scope of market is small, everyone in the economy needs to basically be self-sufficient. One juggles across different activities throughout the day, his goal to allocate time spent on each kind of work to maximize the total value of his production, according to the implicit prices he assigns to different products. He won't spend all his time doing a single kind of work -- he won't be able to meet his various needs in life that way. In Economists' Language, the marginal value of one activity goes down quickly with more time spent on it. Though probably not the most "efficient" arrangement, the keyword for such a lifestyle is "balance", something that the citizens of modern society long for but find hard to achieve, for reasons I will specify below. But surely the aggregate goods produced in this society would be less than in the scenario with active and large-scale market trades.
In contrast, when the market is sufficiently developed, most people are specialized in only one kind of work -- we are doctors, farmers, or barbers, but not all of those. Our production goal is very different from that in the previous case. Now as an individual one needs to rely on other members of the society to give him everything his needs in life except the one thing he himself produces. And the way he can convince them to do so is to exchange his own product with theirs through a monetized market system. But his can be a very vulnerable position. As an individual producer he is not likely to have a perceivable impact on the market price of his product, and whether he will prosper or starve tomorrow completely depends on the whim of market conditions. If absolute specialization of production is imposed, then what an individual can do to ensure survival is straightforward -- to produce more of his product. With the market system, one's consumption maximization problem across different goods is completely separated from one's production decision. The production decision is now much simpler and much more "single-minded", to work as much as he can, to produce as much as he can, so that he will have more to trade with other people. Here comes also the dichotomy of "work" and "life": the ONE thing we do for market exchanges and the rest of who we are. The kind of dichotomy that didn't exist before the emergence of modern market economy.
Ever wonder why the advancement in technology and production efficiency has not significantly reduced working hours? Why is the life pace in New York City, where commerce and trade is highly developed, so much faster than that in, say, some remote village in China? Why is there so much stress and competition pressure in modern society? Our very specific maximization goal developed through the extended market exchange system largely contributes to these phenomena.
The institution of economic exchange came into existence with many blessings. It improved the diversity and efficiency of goods and services production in an economy. But it has its own trade-offs. For one thing, the nature of human physical and mental system favors balance. Our well-beings benefit from variation in activities, freely-expressed creativity and diversified pursuits. But these are the direct opposite to what a highly specialized labor distribution system can bring us. It is true that if I produce only milk and let my neighbor produce bread, both of us will probably have more milk and bread to consume. But can the increase in goods consumption more than compensate for the boredom I endure in working on the same task day after day, for the competition pressure I feel in having to compete against other milk makers for my neighbors' favor, for the constant worry about not making enough milk to exchange for the necessary amount of bread? Those are the intangible welfare losses that are hardly quantifiable and never entered economic models.
Economics see human beings as single-dimensional creatures, whose only purpose on earth is to maximize consumption and that is the only source of values. But it doesn't mean that other values and purposes do not exist in reality. Just to the opposite, the deprivation of "intangible" values and purposes has been a major cause of many psychological and social problems in modern life. Free market institution is really not free. It comes with a price. The issues faced by countries in a globalized economic system are analogues to the issues faced by specialized individuals, especially for small developing countries who are not diversified in the global allocation of production tasks.
When the idea of labor distribution and market exchange was first invented, its consequences, both positive and negative, were probably mostly unforeseen. Over the course of market development at both local and global levels, the human society has more and more come to realize that the increased economic efficiency through market exchange does not come freely. And people are making choices to limit the degree of specialization and the scope of market. That's why "localization" is becoming a new economic trend of this century, alongside the seemingly unstoppable force of globalization. At first sight, the localization trend might seem to go against the economic logic of rational decision maker and utility maximization. But the choice of more self-sufficiency and limited market can actually be a very "rational" choice, if we are willing to see humans as multi-dimensional beings, capable of appreciating and making trade-off among a sophisticated set of values, instead of some sort of consumption-maximizing machines.
Here is one of the examples, simple but illustrating. Suppose that in an economy there are only two goods produced, bread and milk. In the scenario without market trade, every household has to produce both goods. Naturally, their capabilities for the two tasks vary. Now suppose you and I start trading. Then each of us can just produce the good we are relatively better at and exchange a portion of our products with each other. The labor distribution improves the efficiency of our time allocation. There will be more bread and milk produced in the economy and both of us better off. In addition, by focusing on making milk and not getting distracted with other activities, my milk-making skill is likely to improve faster, so is my trade partner's bread-making skill. The conclusion is that trade, no matter whether it is between individuals or between countries, makes everybody happier.
This argument for free market exchange is one of the crown jewels of modern economic thinking. It is powerful and elegant, and economists have been using it to advocate for free trade and globalization since the time of Adam Smith. Many years ago, when I first learned about it in my undergrad Econ class, I was immediately hooked and felt so excited as if I had been given new eyes to see the world. From then on, anybody who questioned the expansion of free market would look either crazy or downright stupid in my point of view.
But today when I was supposed to teach the same brilliant theory to my students, I suddenly found it a very frustrating task: the real world is so much more complex than described in those elegant textbook examples, and I'm not sure that I'm offering those young minds a "better" way to see the world by simply presenting them some over-simplified cases.
When the scope of market is small, everyone in the economy needs to basically be self-sufficient. One juggles across different activities throughout the day, his goal to allocate time spent on each kind of work to maximize the total value of his production, according to the implicit prices he assigns to different products. He won't spend all his time doing a single kind of work -- he won't be able to meet his various needs in life that way. In Economists' Language, the marginal value of one activity goes down quickly with more time spent on it. Though probably not the most "efficient" arrangement, the keyword for such a lifestyle is "balance", something that the citizens of modern society long for but find hard to achieve, for reasons I will specify below. But surely the aggregate goods produced in this society would be less than in the scenario with active and large-scale market trades.
In contrast, when the market is sufficiently developed, most people are specialized in only one kind of work -- we are doctors, farmers, or barbers, but not all of those. Our production goal is very different from that in the previous case. Now as an individual one needs to rely on other members of the society to give him everything his needs in life except the one thing he himself produces. And the way he can convince them to do so is to exchange his own product with theirs through a monetized market system. But his can be a very vulnerable position. As an individual producer he is not likely to have a perceivable impact on the market price of his product, and whether he will prosper or starve tomorrow completely depends on the whim of market conditions. If absolute specialization of production is imposed, then what an individual can do to ensure survival is straightforward -- to produce more of his product. With the market system, one's consumption maximization problem across different goods is completely separated from one's production decision. The production decision is now much simpler and much more "single-minded", to work as much as he can, to produce as much as he can, so that he will have more to trade with other people. Here comes also the dichotomy of "work" and "life": the ONE thing we do for market exchanges and the rest of who we are. The kind of dichotomy that didn't exist before the emergence of modern market economy.
Ever wonder why the advancement in technology and production efficiency has not significantly reduced working hours? Why is the life pace in New York City, where commerce and trade is highly developed, so much faster than that in, say, some remote village in China? Why is there so much stress and competition pressure in modern society? Our very specific maximization goal developed through the extended market exchange system largely contributes to these phenomena.
The institution of economic exchange came into existence with many blessings. It improved the diversity and efficiency of goods and services production in an economy. But it has its own trade-offs. For one thing, the nature of human physical and mental system favors balance. Our well-beings benefit from variation in activities, freely-expressed creativity and diversified pursuits. But these are the direct opposite to what a highly specialized labor distribution system can bring us. It is true that if I produce only milk and let my neighbor produce bread, both of us will probably have more milk and bread to consume. But can the increase in goods consumption more than compensate for the boredom I endure in working on the same task day after day, for the competition pressure I feel in having to compete against other milk makers for my neighbors' favor, for the constant worry about not making enough milk to exchange for the necessary amount of bread? Those are the intangible welfare losses that are hardly quantifiable and never entered economic models.
Economics see human beings as single-dimensional creatures, whose only purpose on earth is to maximize consumption and that is the only source of values. But it doesn't mean that other values and purposes do not exist in reality. Just to the opposite, the deprivation of "intangible" values and purposes has been a major cause of many psychological and social problems in modern life. Free market institution is really not free. It comes with a price. The issues faced by countries in a globalized economic system are analogues to the issues faced by specialized individuals, especially for small developing countries who are not diversified in the global allocation of production tasks.
When the idea of labor distribution and market exchange was first invented, its consequences, both positive and negative, were probably mostly unforeseen. Over the course of market development at both local and global levels, the human society has more and more come to realize that the increased economic efficiency through market exchange does not come freely. And people are making choices to limit the degree of specialization and the scope of market. That's why "localization" is becoming a new economic trend of this century, alongside the seemingly unstoppable force of globalization. At first sight, the localization trend might seem to go against the economic logic of rational decision maker and utility maximization. But the choice of more self-sufficiency and limited market can actually be a very "rational" choice, if we are willing to see humans as multi-dimensional beings, capable of appreciating and making trade-off among a sophisticated set of values, instead of some sort of consumption-maximizing machines.
Sunday, January 24, 2010
Is a New Growth Model Possible?
I just came back from a trip to Shanghai. The city is changing fast by any standard. I could hardly recognize many of the places I had been to only two years ago. What is changing even faster than roads, buildings and shops is the city’s mentality. It seems that the accumulation of material wealth has bypassed any other concern and is becoming more and more the central focus of life in this city. The media is filled with money-making tips and newest consumer products information. The conversations with friends and family frequently involve cars, houses and memberships of department stores. The modern American culture has often been seen as a culture of mass consumption and materialism. But now I feel that China has already bypassed the US in its fascination about material wealth, at least for some part of China.
This change in social mentality shouldn’t be a surprise. It is simply an eastern rendition of Max Weber’s “Spirit of Capitalism”, probably an inevitable aspect of any society’s transition into market economy. The focus on wealth, production and consumption serves as a fertilizer to economic growth, which ideally leads to the prosperity of society and better life for everybody.
However, what I experienced in Shanghai was not just the merry spirit of economic growth. My Washington DC – trained respiratory system had a hard time working in the polluted air of Shanghai. I felt almost difficult to breathe no matter where I went. I could sense that my hair and nose were filled with dust and particles even after only 2 hours’ walk in the downtown streets. (I once lived in this lovely city for ten years. Talking about change!) Private ownership of cars has soared in recent years. The roads of Shanghai boast the newest models of every famous international car makers. But another increase that is equally obvious is the level of traffic congestion and sound pollution. By some calculation, China’s carbon emission level had already bypassed the United States in 2006. And we are talking about an economy whose per capita GDP is still only about one tenth of that of US. Imagine the day when every Chinese would own a car!
The government is well aware of the problem, to be sure. And China, like many developed countries, has made positive efforts to reduce carbon emission and to resolve other sustainability-related issues. However, most of those policies are only short-term solutions and feeble compromises. The fundamental reality that most of us has been refusing to see is that the prevailing model of "economic development" is not a feasible one anymore. Our planet simply does not have enough resources to sustain every country on the earth as a "developed" or "industrialized" society in those words' commonly conceptualized forms.
Luckily, it may not be necessary for every country to go through a heavy industrial phase when the production and consumption of such goods as steel, autos and machinery are emphasized, to become a well-off society. After all, it has only been in the past two hundred years that these industries become the major embodiment of national wealth. The Auto shipment index was seen as an important indicator of business cycles only after cars became a major household consumption in most advanced economies, which, if you think about it, is only a pretty recent phenomenon in the world economic history. It is temping to think, as macroeconomists often do, that the economic growth for less-developed countries is always a "catching-up" process, and those countries have to follow step by step the road traveled by countries with higher GDPs. However, what embody value and wealth have always been changing, with the shifts in technology, culture, preferences and living environment of the communities.
The consumption of industrial goods from plastic bags to electronic appliances to automobiles, has become the standard way to live in a modern society. These goods surely contain values and generate utility for the consumers. And the mass-produced manufacturing products have also been the major carriers of the state-of-art technologies since the 19th century. That's why we count the new goods produced as a major part of GDP, the national wealth generated every period. However, the manufacturing, consumption and disposal of these goods also generate negative values -- depleted natural resources, polluted air and water, for instance. Yet unfortunately, these dis-values are never subtracted from GDP in the national wealth accounting. This is of course due to a lot of reasons. The dis-values may be intangible, too hard to count; their effects may be long-term, too hard to foresee; the dis-utilities are mainly in the form of negative externality, difficult to be revealed in the pricing of products. But despite all these barriers in calculation, it is still undeniable that the increased production of industrial goods is NOT equal to the generation of more national wealth. In some cases it is simply the opposite.
The good news is that the industrial structure is already changing, for most developed countries and many developing countries as well. Partly because of the IT revolution in the latter half of the 20th century, the cutting-edge technologies are no longer only embodied by tangible products, but more and more carried by softwares, designs and human resources. The structures of both consumption and investment in a modern society are shifting towards "intangible" products. Intangible capital investment -- R&D, design, marketing, management, training -- in the US is already larger than physical investment, according Corrado, Hulten & Sichiel (2005)'s calculation. On the consumption side, almost every goods or service in today's economy contains an intangible, conceptual part that constitutes a considerable part of, if not most of the product's value. This change in the structure of economy is also apparent in the rising share of high-intangible service industries in the total national outputs (Che, 2009).
Imagine an economy where most of "wealth" and economic values of society are embodied in intangible or conceptual goods, and the major household consumptions are intangible products instead of automobiles and electronics. In such an economic model, there will be no conflict between economic growth/increase of consumption and the sustainability of development, since the creation and consumption of wealth does not depend on natural resources or impose negative effects on the environment. Is such a consumption model too much of a fantasy? I don't think so. Just think about how much a typical American household has already spent on such goods as education and health care, which are basically intangible goods. And the advancement of technology is often way beyond our imagination and takes the value system of society on unexpected adventures. (Even the most brilliant minds in the 19th century couldn't have foreseen the major industrial inventions of the 20th century and how they would transform people's lives.) Maybe by the 2nd half of this century, we would be able to consume most of the consumer products we enjoy now in their virtual forms. Who knows?
But this new path of economic growth won't unfold by accident. It requires a shift in the concept of economic growth and development for all of us, from government to academia to business sector, so that we will work to explore this new vision through policy-making, scholarly research and entrepreneurial endeavors. And given the enormous changes we've already experienced since the beginning of this century, I don't think this shift would be too drastic in comparison.
This change in social mentality shouldn’t be a surprise. It is simply an eastern rendition of Max Weber’s “Spirit of Capitalism”, probably an inevitable aspect of any society’s transition into market economy. The focus on wealth, production and consumption serves as a fertilizer to economic growth, which ideally leads to the prosperity of society and better life for everybody.
However, what I experienced in Shanghai was not just the merry spirit of economic growth. My Washington DC – trained respiratory system had a hard time working in the polluted air of Shanghai. I felt almost difficult to breathe no matter where I went. I could sense that my hair and nose were filled with dust and particles even after only 2 hours’ walk in the downtown streets. (I once lived in this lovely city for ten years. Talking about change!) Private ownership of cars has soared in recent years. The roads of Shanghai boast the newest models of every famous international car makers. But another increase that is equally obvious is the level of traffic congestion and sound pollution. By some calculation, China’s carbon emission level had already bypassed the United States in 2006. And we are talking about an economy whose per capita GDP is still only about one tenth of that of US. Imagine the day when every Chinese would own a car!
The government is well aware of the problem, to be sure. And China, like many developed countries, has made positive efforts to reduce carbon emission and to resolve other sustainability-related issues. However, most of those policies are only short-term solutions and feeble compromises. The fundamental reality that most of us has been refusing to see is that the prevailing model of "economic development" is not a feasible one anymore. Our planet simply does not have enough resources to sustain every country on the earth as a "developed" or "industrialized" society in those words' commonly conceptualized forms.
Luckily, it may not be necessary for every country to go through a heavy industrial phase when the production and consumption of such goods as steel, autos and machinery are emphasized, to become a well-off society. After all, it has only been in the past two hundred years that these industries become the major embodiment of national wealth. The Auto shipment index was seen as an important indicator of business cycles only after cars became a major household consumption in most advanced economies, which, if you think about it, is only a pretty recent phenomenon in the world economic history. It is temping to think, as macroeconomists often do, that the economic growth for less-developed countries is always a "catching-up" process, and those countries have to follow step by step the road traveled by countries with higher GDPs. However, what embody value and wealth have always been changing, with the shifts in technology, culture, preferences and living environment of the communities.
The consumption of industrial goods from plastic bags to electronic appliances to automobiles, has become the standard way to live in a modern society. These goods surely contain values and generate utility for the consumers. And the mass-produced manufacturing products have also been the major carriers of the state-of-art technologies since the 19th century. That's why we count the new goods produced as a major part of GDP, the national wealth generated every period. However, the manufacturing, consumption and disposal of these goods also generate negative values -- depleted natural resources, polluted air and water, for instance. Yet unfortunately, these dis-values are never subtracted from GDP in the national wealth accounting. This is of course due to a lot of reasons. The dis-values may be intangible, too hard to count; their effects may be long-term, too hard to foresee; the dis-utilities are mainly in the form of negative externality, difficult to be revealed in the pricing of products. But despite all these barriers in calculation, it is still undeniable that the increased production of industrial goods is NOT equal to the generation of more national wealth. In some cases it is simply the opposite.
The good news is that the industrial structure is already changing, for most developed countries and many developing countries as well. Partly because of the IT revolution in the latter half of the 20th century, the cutting-edge technologies are no longer only embodied by tangible products, but more and more carried by softwares, designs and human resources. The structures of both consumption and investment in a modern society are shifting towards "intangible" products. Intangible capital investment -- R&D, design, marketing, management, training -- in the US is already larger than physical investment, according Corrado, Hulten & Sichiel (2005)'s calculation. On the consumption side, almost every goods or service in today's economy contains an intangible, conceptual part that constitutes a considerable part of, if not most of the product's value. This change in the structure of economy is also apparent in the rising share of high-intangible service industries in the total national outputs (Che, 2009).
Imagine an economy where most of "wealth" and economic values of society are embodied in intangible or conceptual goods, and the major household consumptions are intangible products instead of automobiles and electronics. In such an economic model, there will be no conflict between economic growth/increase of consumption and the sustainability of development, since the creation and consumption of wealth does not depend on natural resources or impose negative effects on the environment. Is such a consumption model too much of a fantasy? I don't think so. Just think about how much a typical American household has already spent on such goods as education and health care, which are basically intangible goods. And the advancement of technology is often way beyond our imagination and takes the value system of society on unexpected adventures. (Even the most brilliant minds in the 19th century couldn't have foreseen the major industrial inventions of the 20th century and how they would transform people's lives.) Maybe by the 2nd half of this century, we would be able to consume most of the consumer products we enjoy now in their virtual forms. Who knows?
But this new path of economic growth won't unfold by accident. It requires a shift in the concept of economic growth and development for all of us, from government to academia to business sector, so that we will work to explore this new vision through policy-making, scholarly research and entrepreneurial endeavors. And given the enormous changes we've already experienced since the beginning of this century, I don't think this shift would be too drastic in comparison.
Tuesday, January 5, 2010
A Peaceful Revolution: How Knowledge Capital Can Solve the Growth-and-Sustainability Dilemma
I just got back from American Economics Association's annual meeting in Atlanta. Had a really good time there. Well, presenting my own paper is always fun. But not only that. It seems that being immersed in an ocean of economic papers for an intensive period does something peculiar to the brain. I guess my subconsciousness still needs more time to digest it.
But despite all the exciting intellectual stimulation, the whole time I was bothered by a strong sense of segregation between different fields of thoughts. Compared with previous years, there were a lot more papers this year on climate change, peak oil, alternative energy and other sustainability-related topics. To me this is a good sign. In the past two hundred years, we as a species have been endangering ourselves with way too many ignorant damages to the earth and its eco-system, all in the name of economic development and growth. It is encouraging to see that the economics profession, despite its over-simplified assumptions about human welfare and the nature of "values", is turning its attention towards what may well be among the biggest challenges ever faced by the human race.
However, the maximization of consumption, no matter how many caveats and twists you add to it, is still the fundamental goal in almost every economic model. In the meeting, one of the most crowded sessions I went to featured five leading macroeconomists in US, and the topic is growth prospects after the recession. Though the panelists differ in the degree of optimism, it was never questioned that a higher GDP growth is what we economists hope for and is what every country on the earth strives to achieve.
The dicussion would almost sound absurd if you, like me, just came from a session on the environmental impact of economic development. (If you need a refreshment on this topic, a beautifully-written report from the International Forum on Globalization can be found here.) In the standard neo-classical growth model, the output and consumption of the economy can grow forever. But this is achieved by simply assuming an exogenous growth rate of "technology", which is outside the realm of economists' expertise. In reality, it is hard to imagine that increased consumption of material goods can continue infinitely, given the limited resources our planet can offer. Textbooks of growth economics often emphisize the fact that the growth of material wealth in the past two hundred years was so much faster than any previous period in human history. What they conveniently neglected is that the speed we deplete natural resources is even more unpresedented. Moreover, most of the solutions that we have come up with to solve the resource constraint problem, such as renewable energy or so-called eco-friendly consumption, are either too mild or just short-term band-aids. We are entering an age that the survival of human race on this planet is running head to head with our desire to increase material consumption and economic "growth".
From this perspective, it is really not that meaningful for macroeconomists to argue among ourselves whether the GDP growth next year will be 2% or 2.5%, or what the government can do to stimulate consumption and physical capital investment. Imagine an extreme senario: suppose that we find a way to dig up all the oil and coal energy reserves on the earth in one year and turn them into consumable products-- food, clothes, cars, houses, etc. How splendid would the GDP statistics be? But is it truly "development"? Not only is the answer no, but probably nobody would disagree that a year like that would be the most disastrous year in human history!
Some environmentalists and visionary liberals argue that the only way to accommondate the daunting challenge of preserving the eco-system and saving us from the self-made extinction is to reduce material consumption and completely stop the industrialization process. Now this may sound too radical to you, certainly heretical to most of people in my profession. But compared with macroeconomists' naive assumption about what is true "wealth" and our single-minded pursuit of "economic growth", I'm not sure which one is more insane.
But no matter which side you are on theoretically, the preservation of the earth and its eco-system calls for a drastic change of the meaning of economic development, which, given how deep-rooted this concept is in modern society, seems unrealistic. "Less is more" is a very un-instinctive idea. It is only next to impossible to convince any developing or developed country to give up extra percentage of GDP growth for the sake of sustainability, the benefit of which is shared by all human beings and will never be fully internalized by any country or any generation. (If you don't believe how hard it is for any of us to change our disposition about growth, read some news reports of the Copenhagen Climate Change Conference.)
The good news is that perhaps no extreme change in the goal of economic growth is necessary, if we are willing to expand our view of national wealth. The energy and material used in producing every dollar of GDP has been on decline since the beginning of last century. This is largely due to the contribution of knowledge in the production process, and the shift in the sectoral composition of the economy towards intangible-capital intensive service industries. Industries such as IT service and financial management, which have been the growth engine of US economy in the 1990s, basically use knowledge capital to produce knowledge products. The damage to the environment and the resources consumed in the production process are very small compared with industrialized manufacturing. Near-market industries such as education and health care, which use a high percentage of intangible capital inputs, have seen tremendous growth in recent decades. They can also be categorized as ego-friendly industries when properly managed. Even in manufacturing industries, we see the additional value created through the "knowledge transformation" everywhere. For example, products with better design features and more reputable brands sell at a premium relative to their generic counterparts, without creating much extra burden to the environment.
Imagine an economy where wealth and value are mainly created by intangible capital and a large proportion of consumed outputs are knowledge products. If national wealth is mainly created this way, it is possible to reconcile the tension between economic growth and material resource constraint on the earth, not to mention that the innovative nature of knowledge work makes it so much more fulfilling than monotonic work on an assembly line. The welfare generated simply through the shift in work characteristics is already beyond calculation.
A mostly "intangible" economic system is probably less unrealistic than you might think. With the advancement in IT technology, internet and increased average years in education, the industrial structures of most developed countries are all heading towards this direction, though perhaps in a slower speed than ideal.
A necessary step to speed up the transformation is to recognize knowledge capital and its value added in the national accounts, that is, to make up for the "missing" part in GDP. A change in the official formula of "wealth" calculation will help facilitate a change in our subjective value system about what constitutes growth and development. And this is a preliminary step of a "peaceful revolution" that will fulfill the goals of both economic growth and sustainability.
But despite all the exciting intellectual stimulation, the whole time I was bothered by a strong sense of segregation between different fields of thoughts. Compared with previous years, there were a lot more papers this year on climate change, peak oil, alternative energy and other sustainability-related topics. To me this is a good sign. In the past two hundred years, we as a species have been endangering ourselves with way too many ignorant damages to the earth and its eco-system, all in the name of economic development and growth. It is encouraging to see that the economics profession, despite its over-simplified assumptions about human welfare and the nature of "values", is turning its attention towards what may well be among the biggest challenges ever faced by the human race.
However, the maximization of consumption, no matter how many caveats and twists you add to it, is still the fundamental goal in almost every economic model. In the meeting, one of the most crowded sessions I went to featured five leading macroeconomists in US, and the topic is growth prospects after the recession. Though the panelists differ in the degree of optimism, it was never questioned that a higher GDP growth is what we economists hope for and is what every country on the earth strives to achieve.
The dicussion would almost sound absurd if you, like me, just came from a session on the environmental impact of economic development. (If you need a refreshment on this topic, a beautifully-written report from the International Forum on Globalization can be found here.) In the standard neo-classical growth model, the output and consumption of the economy can grow forever. But this is achieved by simply assuming an exogenous growth rate of "technology", which is outside the realm of economists' expertise. In reality, it is hard to imagine that increased consumption of material goods can continue infinitely, given the limited resources our planet can offer. Textbooks of growth economics often emphisize the fact that the growth of material wealth in the past two hundred years was so much faster than any previous period in human history. What they conveniently neglected is that the speed we deplete natural resources is even more unpresedented. Moreover, most of the solutions that we have come up with to solve the resource constraint problem, such as renewable energy or so-called eco-friendly consumption, are either too mild or just short-term band-aids. We are entering an age that the survival of human race on this planet is running head to head with our desire to increase material consumption and economic "growth".
From this perspective, it is really not that meaningful for macroeconomists to argue among ourselves whether the GDP growth next year will be 2% or 2.5%, or what the government can do to stimulate consumption and physical capital investment. Imagine an extreme senario: suppose that we find a way to dig up all the oil and coal energy reserves on the earth in one year and turn them into consumable products-- food, clothes, cars, houses, etc. How splendid would the GDP statistics be? But is it truly "development"? Not only is the answer no, but probably nobody would disagree that a year like that would be the most disastrous year in human history!
Some environmentalists and visionary liberals argue that the only way to accommondate the daunting challenge of preserving the eco-system and saving us from the self-made extinction is to reduce material consumption and completely stop the industrialization process. Now this may sound too radical to you, certainly heretical to most of people in my profession. But compared with macroeconomists' naive assumption about what is true "wealth" and our single-minded pursuit of "economic growth", I'm not sure which one is more insane.
But no matter which side you are on theoretically, the preservation of the earth and its eco-system calls for a drastic change of the meaning of economic development, which, given how deep-rooted this concept is in modern society, seems unrealistic. "Less is more" is a very un-instinctive idea. It is only next to impossible to convince any developing or developed country to give up extra percentage of GDP growth for the sake of sustainability, the benefit of which is shared by all human beings and will never be fully internalized by any country or any generation. (If you don't believe how hard it is for any of us to change our disposition about growth, read some news reports of the Copenhagen Climate Change Conference.)
The good news is that perhaps no extreme change in the goal of economic growth is necessary, if we are willing to expand our view of national wealth. The energy and material used in producing every dollar of GDP has been on decline since the beginning of last century. This is largely due to the contribution of knowledge in the production process, and the shift in the sectoral composition of the economy towards intangible-capital intensive service industries. Industries such as IT service and financial management, which have been the growth engine of US economy in the 1990s, basically use knowledge capital to produce knowledge products. The damage to the environment and the resources consumed in the production process are very small compared with industrialized manufacturing. Near-market industries such as education and health care, which use a high percentage of intangible capital inputs, have seen tremendous growth in recent decades. They can also be categorized as ego-friendly industries when properly managed. Even in manufacturing industries, we see the additional value created through the "knowledge transformation" everywhere. For example, products with better design features and more reputable brands sell at a premium relative to their generic counterparts, without creating much extra burden to the environment.
Imagine an economy where wealth and value are mainly created by intangible capital and a large proportion of consumed outputs are knowledge products. If national wealth is mainly created this way, it is possible to reconcile the tension between economic growth and material resource constraint on the earth, not to mention that the innovative nature of knowledge work makes it so much more fulfilling than monotonic work on an assembly line. The welfare generated simply through the shift in work characteristics is already beyond calculation.
A mostly "intangible" economic system is probably less unrealistic than you might think. With the advancement in IT technology, internet and increased average years in education, the industrial structures of most developed countries are all heading towards this direction, though perhaps in a slower speed than ideal.
A necessary step to speed up the transformation is to recognize knowledge capital and its value added in the national accounts, that is, to make up for the "missing" part in GDP. A change in the official formula of "wealth" calculation will help facilitate a change in our subjective value system about what constitutes growth and development. And this is a preliminary step of a "peaceful revolution" that will fulfill the goals of both economic growth and sustainability.
Monday, September 7, 2009
Is SG&A Expenditure "Missing" in GDP?
A lot have been said about adjustments that need to be made to the national income and product accounts if intangible capital (IC) investment is to be treated properly. Basically, since intangible investment is currently treated as intermediate inputs in the national accounts, GDP number is understated by the amount of IC investment.
The issue is easy to understand at a theoretical level. But when it comes to really specifying a linkage between micro and macro adjustments, i.e., between firms' financial statement and aggregate GDP accounting, it takes more than a one-liner to explain.
For example, in the firm-level empirical studies of my recent two papers, I used sales, general & administrative (SG&A) expenditure to approximate firms' IC investment. SG&A generally includes most of IC investment cost items-- R&D, management fees, software, marketing expenditure, etc. The usage of SG&A as IC investment approximation was adopted from accounting research literature. In the presentations of my papers, a recurring question from the audience is: "If as you claimed, IC investment is largely missing from GDP, then is SG&A-represented IC investment currently counted in GDP or not, if the income approach of GDP accounting is used?"
Good question. After thinking about it, my answer to the question is: "sometimes no, sometimes seemingly yes, but still no."
To see how SG&A should be treated to allow full recognition of intangible investment. Let's compare the current accounting rules for physical and intangible capital investments and their different effects on national income. Suppose Company A buys a machine from Company B, which costs $1 million. In Company B's income statement, sales increase by $1 million. Suppose the machine costed $0.7 million to produce, which, for simplicity, is assumed to be only labor costs. Company B's earning increases by $0.2 million. The $0.2 million will enter national income as corporate profits, the $0.8 million enter as wages. Now look at Company A's financial statement. The $1 million paid will be treated as capital expenditure. It doesn't affect current period earning or Company A's contribution to the current GDP. But what if the transaction is about intangible capital? Suppose Company B is a consulting firm. Company A buys a consulting service product from Company B, which creates new intangible organization capital for Company A. Suppose, again, the consulting product costs $1 million. For Company B, it recognizes $0.2 million earning and $0.8 million wage costs, which enter national income accounts as in the equipment example. But look at Company A. The cost of consulting product, $1 million, is included in SG&A expenditure and substracted from sales to get current period earning. Compared with the case of equipment purchase, Company A's earning is decreased by $1 million. Consequently, in the national income account, corporate profit is less than in the equipment case by $1 million. In this senario, the $1 million SG&A expenditure should all be added to GDP to allow equal treatment of physical and intangible capital investment.
However, sometimes IC investment goods are created within the company, instead of purchased from outside. And the expenditure is also included in SG&A. In this case, the increase to GDP is understated. To see how, let's still use the previous example. Suppose now, instead of buying a consulting product from Comapny B, Company A uses internal staff consultants to produce the same product. The cost of the product-- $0.8 million wage bills-- is expensed as SG&A expenditure. The $0.8 million enters national income as wages. In this sense, the part of SG&A is "counted". But an equal amount is substracted from Company A's earning, thus from the corporate profits part of national income. In other words, the IC investment is still not recognized. Furthermore, the market value of the investment is actually $1 million instead of $0.8 million. So in this case, to allow full recognition of the IC investment, Company A not only should add the $0.8 million SG&A back to its earning, but should also add the $0.2 million to earning as the value-added in this IC investment good.
So the bottom line is: No, the intangible investment goods included in SG&A expenditure is not counted in GDP.
The issue is easy to understand at a theoretical level. But when it comes to really specifying a linkage between micro and macro adjustments, i.e., between firms' financial statement and aggregate GDP accounting, it takes more than a one-liner to explain.
For example, in the firm-level empirical studies of my recent two papers, I used sales, general & administrative (SG&A) expenditure to approximate firms' IC investment. SG&A generally includes most of IC investment cost items-- R&D, management fees, software, marketing expenditure, etc. The usage of SG&A as IC investment approximation was adopted from accounting research literature. In the presentations of my papers, a recurring question from the audience is: "If as you claimed, IC investment is largely missing from GDP, then is SG&A-represented IC investment currently counted in GDP or not, if the income approach of GDP accounting is used?"
Good question. After thinking about it, my answer to the question is: "sometimes no, sometimes seemingly yes, but still no."
To see how SG&A should be treated to allow full recognition of intangible investment. Let's compare the current accounting rules for physical and intangible capital investments and their different effects on national income. Suppose Company A buys a machine from Company B, which costs $1 million. In Company B's income statement, sales increase by $1 million. Suppose the machine costed $0.7 million to produce, which, for simplicity, is assumed to be only labor costs. Company B's earning increases by $0.2 million. The $0.2 million will enter national income as corporate profits, the $0.8 million enter as wages. Now look at Company A's financial statement. The $1 million paid will be treated as capital expenditure. It doesn't affect current period earning or Company A's contribution to the current GDP. But what if the transaction is about intangible capital? Suppose Company B is a consulting firm. Company A buys a consulting service product from Company B, which creates new intangible organization capital for Company A. Suppose, again, the consulting product costs $1 million. For Company B, it recognizes $0.2 million earning and $0.8 million wage costs, which enter national income accounts as in the equipment example. But look at Company A. The cost of consulting product, $1 million, is included in SG&A expenditure and substracted from sales to get current period earning. Compared with the case of equipment purchase, Company A's earning is decreased by $1 million. Consequently, in the national income account, corporate profit is less than in the equipment case by $1 million. In this senario, the $1 million SG&A expenditure should all be added to GDP to allow equal treatment of physical and intangible capital investment.
However, sometimes IC investment goods are created within the company, instead of purchased from outside. And the expenditure is also included in SG&A. In this case, the increase to GDP is understated. To see how, let's still use the previous example. Suppose now, instead of buying a consulting product from Comapny B, Company A uses internal staff consultants to produce the same product. The cost of the product-- $0.8 million wage bills-- is expensed as SG&A expenditure. The $0.8 million enters national income as wages. In this sense, the part of SG&A is "counted". But an equal amount is substracted from Company A's earning, thus from the corporate profits part of national income. In other words, the IC investment is still not recognized. Furthermore, the market value of the investment is actually $1 million instead of $0.8 million. So in this case, to allow full recognition of the IC investment, Company A not only should add the $0.8 million SG&A back to its earning, but should also add the $0.2 million to earning as the value-added in this IC investment good.
So the bottom line is: No, the intangible investment goods included in SG&A expenditure is not counted in GDP.
Saturday, June 27, 2009
Principal- agent Problem? Or Clash between Two Capitals?
Interesting article on NYT about the conflict between the prestigious Four Seasons Hotel's management and its property owners. At the first sight, it is just another typical example of the incentive conflict between owner and manager, which has been relentlessly examined by microeconomists in the past fifty years. The manager, who is hired by the company owner, should have operated and made choices solely based on the owner's interest, that is, in an ideal world. But because manager has his personal utility which might not be in line with the owner's, when information is asymmetric, the manager's action would deviate from the optimal choice according to the owner.
The Principal-agent perspective was largely built on the traditional standpoint that managers are "hired hands", merely one of the many production factors controlled by the owner, who is in command of physical properties and financial resources of the company. Back 50 years, this perspective was probably valid. At that time physical and financial capitals are probably more than sufficient to grand their owner all the power in the production process. However, the concept of capital has changed drastically since and management itself has become one of the most critical resources of a firm, part of its intangible capital. How to effectively use this resource has developed into a full-fledged discipline. Some would even go so far as to call it management "science".
From this perspective, the relationship between manager and owner is more like the dynamics between two kinds of capital: human/intangible capital and physical/financial capital. And the balance of power seems to be more and more tilted towards the former. For Four Seasons Hotel's management, the choice of owning only the former was a deliberate and well-thought-out one. When the CEO of the management company first started his business decades ago, the firm actually bought and owned hotel real estates. But then it realized that for the hotel business, it was actually the intangible capital-- brand, reputation, experience, know-how-- that is more valuable. So it changed its business model to become a management company that owns the Four Seasons brand instead of physical properties: "the model eliminates all the costs associated with buying land and buildings and allows Four Seasons to earn money the moment the doors start revolving."
In this specific case, the details of the conflict between management and physical capital owner is even more telling. The disagreement between the two sides is not over how much efforts the management should devote into running the hotel or the short-sightedness of managers due to personal interests, as the principal-agent theory often focuses on, but over whether the hotel should lower its price in the recession, which strategy is advocated by property owners and would probably increase short-term profits, but is strongly objected by the management, whose concern is that it will tarnish the brand image and thus detrimental to the intangible asset's long-term value.
The Principal-agent perspective was largely built on the traditional standpoint that managers are "hired hands", merely one of the many production factors controlled by the owner, who is in command of physical properties and financial resources of the company. Back 50 years, this perspective was probably valid. At that time physical and financial capitals are probably more than sufficient to grand their owner all the power in the production process. However, the concept of capital has changed drastically since and management itself has become one of the most critical resources of a firm, part of its intangible capital. How to effectively use this resource has developed into a full-fledged discipline. Some would even go so far as to call it management "science".
From this perspective, the relationship between manager and owner is more like the dynamics between two kinds of capital: human/intangible capital and physical/financial capital. And the balance of power seems to be more and more tilted towards the former. For Four Seasons Hotel's management, the choice of owning only the former was a deliberate and well-thought-out one. When the CEO of the management company first started his business decades ago, the firm actually bought and owned hotel real estates. But then it realized that for the hotel business, it was actually the intangible capital-- brand, reputation, experience, know-how-- that is more valuable. So it changed its business model to become a management company that owns the Four Seasons brand instead of physical properties: "the model eliminates all the costs associated with buying land and buildings and allows Four Seasons to earn money the moment the doors start revolving."
In this specific case, the details of the conflict between management and physical capital owner is even more telling. The disagreement between the two sides is not over how much efforts the management should devote into running the hotel or the short-sightedness of managers due to personal interests, as the principal-agent theory often focuses on, but over whether the hotel should lower its price in the recession, which strategy is advocated by property owners and would probably increase short-term profits, but is strongly objected by the management, whose concern is that it will tarnish the brand image and thus detrimental to the intangible asset's long-term value.
Wednesday, June 24, 2009
A Solution to Correct Externality and Ease Unemployment at the Same Time
There is no detailed statistics. But my personal observation suggests that the recession has worsened labor market inequality. In spite of the roaring unemployment figures in the economy, some groups of workers, including less-educated, unskilled and recent graduates that have little real experience, are hit much harder than highly-educated and experienced groups. Some unofficial estimates say that no more than 25% of college graduates have actually found a job this year. However, the labor market for experienced workers seem to be affected much less.
There are different reasons for the heightened heterogeneity in labor market condition. One major reason is that many employers find it difficult to keep investing in intangible/human capital when their companies are not doing that well and the future highly uncertain. Despite the ever-increasing college tuition, the somewhat unfortunate fact about our higher education is that it only prepares its freshly-minted graduate with general analytical skills and basic knowledge foundations in certain disciplines. To make them productive and competent in real jobs, an employer has to conduct various forms of training and job-specific education before a brilliant young employee's general human capital becomes useful to the company. This process is an important way to create future intangible capitals for the firm. And of course, it costs resources. When the economic environment is unfavorable and a company's immediate bottom-line is threatened, intangible investments like employee-training, which may have a longer and more uncertain return profile, is easy to sound like a luxury and be pushed to the corner. That directly leads to a disinterest in hiring inexperienced recent-grads.
In an ideal world, making intangible investment pro-cyclically is definitely not a wise strategy. But reality has much more constraints imposed on a firm. And it might be an inevitable choice for some companies to cut back intangible investment in a recession. To make things even worse, investment in such assets as employee experience involves a lot of externality. Employees are, after all, independent individuals. They can easily walk out of the company's door when they feel like it, carrying their human capital with them to another firm. Society-wise, the free mobility of labor facilitates the spread of knowledge and ideas and is highly beneficial to the advancement of economic productivity. But it also means that the firm who invested in its employees' experience may not be able to fully reap the return, which, as in any other externality-creating scenarios, results in under-supply of intangible investment. And it is very likely that the distortion is worse in the recession, when the economy as a whole actually needs to invest more in human capital.
A possible solution is for the government to subsidize firms' training programs for inexperienced employees. It kills two birds with one stone-- correcting the distortion caused by externality therefore raising the supply of intangible investment, and giving firms' incentive to increase hiring therefore helping with high unemployment in the economic downturn. Besides, it is more efficient than setting up additional training programs in school: given the highly practical and learning-by-doing nature of experience accumulation, it makes sense to turn the un-experienced, but formally-educated workers to the hands of the master--real firms who are the end user of workers' future skills and have better information of market skill demands.
There are different reasons for the heightened heterogeneity in labor market condition. One major reason is that many employers find it difficult to keep investing in intangible/human capital when their companies are not doing that well and the future highly uncertain. Despite the ever-increasing college tuition, the somewhat unfortunate fact about our higher education is that it only prepares its freshly-minted graduate with general analytical skills and basic knowledge foundations in certain disciplines. To make them productive and competent in real jobs, an employer has to conduct various forms of training and job-specific education before a brilliant young employee's general human capital becomes useful to the company. This process is an important way to create future intangible capitals for the firm. And of course, it costs resources. When the economic environment is unfavorable and a company's immediate bottom-line is threatened, intangible investments like employee-training, which may have a longer and more uncertain return profile, is easy to sound like a luxury and be pushed to the corner. That directly leads to a disinterest in hiring inexperienced recent-grads.
In an ideal world, making intangible investment pro-cyclically is definitely not a wise strategy. But reality has much more constraints imposed on a firm. And it might be an inevitable choice for some companies to cut back intangible investment in a recession. To make things even worse, investment in such assets as employee experience involves a lot of externality. Employees are, after all, independent individuals. They can easily walk out of the company's door when they feel like it, carrying their human capital with them to another firm. Society-wise, the free mobility of labor facilitates the spread of knowledge and ideas and is highly beneficial to the advancement of economic productivity. But it also means that the firm who invested in its employees' experience may not be able to fully reap the return, which, as in any other externality-creating scenarios, results in under-supply of intangible investment. And it is very likely that the distortion is worse in the recession, when the economy as a whole actually needs to invest more in human capital.
A possible solution is for the government to subsidize firms' training programs for inexperienced employees. It kills two birds with one stone-- correcting the distortion caused by externality therefore raising the supply of intangible investment, and giving firms' incentive to increase hiring therefore helping with high unemployment in the economic downturn. Besides, it is more efficient than setting up additional training programs in school: given the highly practical and learning-by-doing nature of experience accumulation, it makes sense to turn the un-experienced, but formally-educated workers to the hands of the master--real firms who are the end user of workers' future skills and have better information of market skill demands.
Wednesday, April 29, 2009
What Types of Capital Really Matter?
Updates on my project about intangible capital and sectoral structural change. We all know (more or less) that sectoral composition of the economy is constantly changing. Industries emerge and disappear, rise and fall, just like everything else we encounter in life.
The "supply-side" view of structural change emphasizes the difference in production function/factor intensity/rate of technological progress across sectors as causing factors of industry composition change. To see what types of productive resources really contribute to the structural change in US economy, I calculated the intensities of different capital inputs across industries and looked at their respective impact on industry size. The result is simply fascinating.
I ran year-by-year regression of industry real value-added share in total GDP on inudustry's input intensity indices for intangible capital and physical capital. The graph below plotted their respective coefficients.
Both intangible and physical capitals have positive impact on industry shares. But the impact of intangible capitals are rising consistently over time, while the impact of physical capital declining. Another way to look at it is to say that industries with high intangible capital are growing, while those with ONLY high physical capitals are declining. But I prefer the first interpretation because input intensities of an industry can be changing over time, too. Separating out the cross-sectional aspect of the change from changes within industry panels gives us a more consistent picture of the trend in different capitals' impact.
Next, let's add two more independent variables, intensities of human capital and information technology capital, to the same regression. Here's what the result looks like.
One thing interesting to notice is that the impact of human capital intensity on industry size was initially declining from 1960s to 70s, and began to continuously rise afterwards. I suspect it has something to do with technology progress. Before 70s, the economy hadn't quite figured out how to make high-skilled workers really productive. And since then, technological progress has been more and more high-skill-biased. Also, adding human capital to the equation seems to "dampen" the impact of intangible capitals a little bit. It's probably because part of SG&A expenditure, the measure of intangible investment in this study, does tend to correlate with the level of human capital used. Nevertheless, the upward trend of intangible capital's impact remains.
The coefficients of IT capital are quite small throughout the whole sample period, so I won't read too much into its trend. But notice that the impact of IT started to rise since 1990s, exactly corresponding to the period of so-called "IT revolution", when IT was started to be recognized as an important element in US "productivity resurgence".
Now turning to employment side. I regressed industry employment share in total workforce on its intangible and physical capital intensities:
Again, intangible capital's impact on employment size is positive and increasing over the years. The coefficients of physical capital are all negative, indicating a substitution effect between capital and labor. And this effect has been growing stronger and stronger.
Adding human capital and IT capital in the regression doesn't change the trend of the first two variables. But the impact of human capital intensity on employment size started to rise in mid 70s, which is probably not surprising.
(A note on variable construction. Intangible capital intensity = median level SG&A expenditure / sales across firms in an industry. Physical capital intensity = capital income / industry value-added. Human capital intensity = # of workers having at least some college education / total industry workforce in CPS sample. IT capital intensity = IT investment / industry value-added. All variables are indexed; i.e. divided by the median level across all industries of the year, to get rid of the trend component in variables.)
The "supply-side" view of structural change emphasizes the difference in production function/factor intensity/rate of technological progress across sectors as causing factors of industry composition change. To see what types of productive resources really contribute to the structural change in US economy, I calculated the intensities of different capital inputs across industries and looked at their respective impact on industry size. The result is simply fascinating.
I ran year-by-year regression of industry real value-added share in total GDP on inudustry's input intensity indices for intangible capital and physical capital. The graph below plotted their respective coefficients.
Both intangible and physical capitals have positive impact on industry shares. But the impact of intangible capitals are rising consistently over time, while the impact of physical capital declining. Another way to look at it is to say that industries with high intangible capital are growing, while those with ONLY high physical capitals are declining. But I prefer the first interpretation because input intensities of an industry can be changing over time, too. Separating out the cross-sectional aspect of the change from changes within industry panels gives us a more consistent picture of the trend in different capitals' impact.Next, let's add two more independent variables, intensities of human capital and information technology capital, to the same regression. Here's what the result looks like.
One thing interesting to notice is that the impact of human capital intensity on industry size was initially declining from 1960s to 70s, and began to continuously rise afterwards. I suspect it has something to do with technology progress. Before 70s, the economy hadn't quite figured out how to make high-skilled workers really productive. And since then, technological progress has been more and more high-skill-biased. Also, adding human capital to the equation seems to "dampen" the impact of intangible capitals a little bit. It's probably because part of SG&A expenditure, the measure of intangible investment in this study, does tend to correlate with the level of human capital used. Nevertheless, the upward trend of intangible capital's impact remains.The coefficients of IT capital are quite small throughout the whole sample period, so I won't read too much into its trend. But notice that the impact of IT started to rise since 1990s, exactly corresponding to the period of so-called "IT revolution", when IT was started to be recognized as an important element in US "productivity resurgence".
Now turning to employment side. I regressed industry employment share in total workforce on its intangible and physical capital intensities:
Again, intangible capital's impact on employment size is positive and increasing over the years. The coefficients of physical capital are all negative, indicating a substitution effect between capital and labor. And this effect has been growing stronger and stronger.Adding human capital and IT capital in the regression doesn't change the trend of the first two variables. But the impact of human capital intensity on employment size started to rise in mid 70s, which is probably not surprising.
(A note on variable construction. Intangible capital intensity = median level SG&A expenditure / sales across firms in an industry. Physical capital intensity = capital income / industry value-added. Human capital intensity = # of workers having at least some college education / total industry workforce in CPS sample. IT capital intensity = IT investment / industry value-added. All variables are indexed; i.e. divided by the median level across all industries of the year, to get rid of the trend component in variables.)
Saturday, April 25, 2009
How to Make Sensible Economic Predictions
The rule of thumb is always using as much scientific evidence as you can find, and... ... your hunches.
(Via Dan Pink)
(Via Dan Pink)
Wednesday, April 15, 2009
Trend of Intangible Investment: 1980 - 2008
Updated time-series of intangible investment in US economy. The graph below plotted the median level of SG&A expenditure over revenues- a measure of intangible capital investment intensity- for publicly-traded US firms over the years. It's very clear that during the 1990s' boom, intangible investment has risen sharply: the mid-level SG&A expenditure increased from 24% of firm revenues at the beginning of the decade to around 30% at the end of the decade. However, after the turn of the century, the trend reversed, especially during the 2001 recession and the current downturn starting 2007. Now we are back to the mid 1990 level.
It's also interesting to notice how close the trend of intangible investment correponds to the growth features of the economy in the past two decades-- rising intangible investment correlates with strong output growth and muted aggregate volatility; declining intangible investment forsees lower growth and higher volatility. Correlation doesn't necessarily lead to causation, to be sure. But combining different aspects of evidence, my belief is becoming stronger and stronger that intangible capital is indeed a crucial source of economic growth for an advanced economy.
It's also interesting to notice how close the trend of intangible investment correponds to the growth features of the economy in the past two decades-- rising intangible investment correlates with strong output growth and muted aggregate volatility; declining intangible investment forsees lower growth and higher volatility. Correlation doesn't necessarily lead to causation, to be sure. But combining different aspects of evidence, my belief is becoming stronger and stronger that intangible capital is indeed a crucial source of economic growth for an advanced economy.
Monday, March 30, 2009
Overstretched Truth or Substantive Myth?
I was looking at a recent JPE paper by Acemoglu and Guerrierri about sectoral structural change. It's an interesting one, and related to my current project. In the paper, they documented the following "puzzle": the real outputs of high capital intensity industries as percentage of total GDP has gone up in the past 50 years, while high capital intensity industries' employment share has gone down. The phenomenon can be summarized in the graph below, taken from their paper.
The authors went on to provide a recipe for resolving the puzzle. They argued that economy-wide capital deepening-- it could happen because of, say, technological advancement in capital production-- increased the relative output of more capital-intensive sectors, but at the same time triggered reallocation of capital and labor away from those sectors. A nice application of some classical international trade theory, and very intuitively appealing.
Intrigued by their claim, I looked at related data and tried to replicate their empirical exercise--divide all industries into high capital intensity and low capital intensity groups, calculate their real output and employment shares respectively, and divide the high-capital group's output and employment by those of the low-capital group. Here is the result--
It doesn't take a professional graphic designer to tell that the above two figures are not the same-- actually, they are in drastic contrast against each other regarding the trend of employment shares between the two groups. According to my calculation, the puzzle that the two respectable authors tried to unravel-- a divergence in the trend of output and employment shares between the two groups-- basically doesn't exist at all: capital-intensive industries gain both output and employment shares over the years. So what's going on? After all, we did the same simple straightforward calculation for the identical country, no?
After some more detailed examination of both procedures, I finally found the reason. In determining capital intensity, they calculated an industry's capital share as its "average capital share between 1987 and 2004", while the capital intensity in my exercise, though using the same definition, is the average between 1948 and 1997. In other words, their industry capital intensity captured a shorter and more recent period. Indeed, when I regrouped industries using average capital share between 1987 and 1997-- a period closer to theirs-- the employment share's trend looks much closer to their finding. The graph below compared the employment results of the two grouping standards.
Here is another way to look at it. I carried out cross-sectional regressions of industry employment on capital intensity (plus some other controls) by year. The following graph plotted the time series of estimated coefficients. The estimates are all negative, indicating a strong substitution effect between capital and labor. However, the degree of the effect is hump-shaped-- the importance of this substitution was decreasing until mid 1970s, and became stronger after that. No wonder adopting different time frames in classifying capital intensity would produce very different predictions about its effect on industry employment.
So what does this happen? I think there are several possibilities. One, the composition of capital may have changed over the years, and some types of physical capital that are better substitutes for labor-- IT related equipments, for example-- have contributed a larger share to the total capital stock. Two, some industries' capital intensity may have changed big time in the past decades, that they are included in different capital-intensity groups using different time periods. (I don't think this is a major reason, though.) Three, the nature of labor input and industry employment have been evolving-- some types of work that used to complement capital input and constituted a large share of employment are disappearing, while knowledge-intensive work have emerged in industries that don't require significant capital investments. But of course, these are just my very preliminary guesses.
In the end, Acemoglu and Guerrierri is right in that there is something perplexing about the relationship between sectoral shifts and capital intensity. But the puzzle is probably not in the way they perceived it.
The authors went on to provide a recipe for resolving the puzzle. They argued that economy-wide capital deepening-- it could happen because of, say, technological advancement in capital production-- increased the relative output of more capital-intensive sectors, but at the same time triggered reallocation of capital and labor away from those sectors. A nice application of some classical international trade theory, and very intuitively appealing.Intrigued by their claim, I looked at related data and tried to replicate their empirical exercise--divide all industries into high capital intensity and low capital intensity groups, calculate their real output and employment shares respectively, and divide the high-capital group's output and employment by those of the low-capital group. Here is the result--
It doesn't take a professional graphic designer to tell that the above two figures are not the same-- actually, they are in drastic contrast against each other regarding the trend of employment shares between the two groups. According to my calculation, the puzzle that the two respectable authors tried to unravel-- a divergence in the trend of output and employment shares between the two groups-- basically doesn't exist at all: capital-intensive industries gain both output and employment shares over the years. So what's going on? After all, we did the same simple straightforward calculation for the identical country, no?After some more detailed examination of both procedures, I finally found the reason. In determining capital intensity, they calculated an industry's capital share as its "average capital share between 1987 and 2004", while the capital intensity in my exercise, though using the same definition, is the average between 1948 and 1997. In other words, their industry capital intensity captured a shorter and more recent period. Indeed, when I regrouped industries using average capital share between 1987 and 1997-- a period closer to theirs-- the employment share's trend looks much closer to their finding. The graph below compared the employment results of the two grouping standards.
Here is another way to look at it. I carried out cross-sectional regressions of industry employment on capital intensity (plus some other controls) by year. The following graph plotted the time series of estimated coefficients. The estimates are all negative, indicating a strong substitution effect between capital and labor. However, the degree of the effect is hump-shaped-- the importance of this substitution was decreasing until mid 1970s, and became stronger after that. No wonder adopting different time frames in classifying capital intensity would produce very different predictions about its effect on industry employment.
So what does this happen? I think there are several possibilities. One, the composition of capital may have changed over the years, and some types of physical capital that are better substitutes for labor-- IT related equipments, for example-- have contributed a larger share to the total capital stock. Two, some industries' capital intensity may have changed big time in the past decades, that they are included in different capital-intensity groups using different time periods. (I don't think this is a major reason, though.) Three, the nature of labor input and industry employment have been evolving-- some types of work that used to complement capital input and constituted a large share of employment are disappearing, while knowledge-intensive work have emerged in industries that don't require significant capital investments. But of course, these are just my very preliminary guesses.In the end, Acemoglu and Guerrierri is right in that there is something perplexing about the relationship between sectoral shifts and capital intensity. But the puzzle is probably not in the way they perceived it.
Tuesday, March 24, 2009
List is Long, Life is Short...
Went to MEA annual meeting in Cleveland last weekend. I had a remarkably wonderful time there, thanks to both a most awesome companion and a highly productive conference presentation. My excellent, excellent discussant Alexander was both knowledgeable and insightful. And the audience was unusually interested in the topic, very engaged throughout the whole session. (Special thanks to Nicolas Ziebarth and Dave Amdur.) I made a list of the problems/suggestions about the paper that people offered during the conference. Most of them are helpful. Some can be easy fixes, others not. But one thing for sure is that they will keep me very busy with life.
General problems:
General problems:
- Model too stylized.
- The statement that OC decreases the impact of market risk and firm correlation are not analyzed/testified in the model.
- The assumption that OC increases firm-specific risk is funny: why do firms want to invest in OC if it increases risk? Shouldn't more OC lead to better risk management (e.g. better logistics, more product differentiation)? Need better theory to motivate assumption. Also, why high OC firms would be less vulnerable to macro shocks, e.g. oil shock?
- Over generalization of the concept "organization capital": seems to include all business activities?
- Link between 3 hypotheses and great moderation is weak.
- sg&a not good measure for OC? Contains management fees and incentive packages which are increasing since the 80s. --Maybe should argue that management fees increase can be seen as indicating OC becomes more important, but it might need a whole new paper to make the argument
- Spurious regression: monotone variables (OC, sales volatility) can be correlated but not related. -- Can be dismissed with, say, cross-sectional regression results and other tests
- Regression shouldn’t juxtapose flow and stock variables: shouldn’t use sga (flow) and ppe assets (stock) in the same regression
- Investments are too state-dependent and volatile; should use OC stocks in regressions instead.
- Causality: the reverse causation-- lower aggr. risk exposure leads to more OC investment also can be true.
- Model is in “reduced form”, exogenously force OC and firm-specific volatility to increase
- Didn’t produce great moderation very well.
- Calibration inconsistent with labor income share data, or overstate the importance of OC to make volatility increase
- Huge increase in OC over years means economy not in steady state, so can’t use log linearization to solve the model
- Calibration shouldn’t base on steady state relationship
- Try to better understand sources of sg&a increase and its impact on output
- Try two-sector model to avoid over generalization?
- Or provide a theory for OC share increase
- Focus on firm volatility increase for publicly-traded firms instead of great moderation
- Verify all hypotheses in model simulation
Tuesday, March 10, 2009
Deconstrucing Structural Change
Working on collecting data and designing empirical strategy for the structural change paper. As mentioned in a previous post, I identified a new factor-- intangible capital intensity-- as the cause of sectoral shifts. Currently, there are several competing theories in the literature (not necessarily against each other), from both demand side and supply side.
The demand-side story generally goes like this. People's needs have priorities; some needs have to be satisfied before others when confronted with limited budget (read: different goods have different income elasticity of demand/non-homothetic preference). Therefore, when a country becomes richer, the sector satisfying higher-order needs tend to expand. The authors using this line of reasoning include Echevarria (1997), Kongsamut, Rebelo & Xie (2001), and Laitner (2000). I know my outrageous simplification of the story has done horrible injustice to these papers. Sorry guys, just trying to be succinct.
The supply-side story plays with the elasticity of substitution among different goods. If for some reason, sector A starts to produce relatively larger quantity of goods than other sectors, the price of sector A's product can go down so much as to reduce the nominal share of the sector in total outputs. There can be various reasons why sector A is so out-performing. You can exogenously assume that its multi-factor productivity is just higher than others (Ngai & Pissarides, 2007); sector A can be more capital intensive, when the economy happens to be experiencing capital deepening (Acemoglu & Guerrieri, 2006); or the sector can be skilled-labor intensive when the economy is producing more well-educated young men (Buera & kaboski, 2007).
Of course, now there is another theory based on intangible capital accumulation (Che, 2009) that needs to be added to the supply-side inventory.
But here is an interesting empirical question: to what degree does each of the above factor contribute to the industry shifts in reality? Surely, to answer the question, regressional analysis is necessary. But there is a whole lot of heavy data work and identification issues involved. The regressors I located so far, in terms of data availability and general practicality:
The demand-side story generally goes like this. People's needs have priorities; some needs have to be satisfied before others when confronted with limited budget (read: different goods have different income elasticity of demand/non-homothetic preference). Therefore, when a country becomes richer, the sector satisfying higher-order needs tend to expand. The authors using this line of reasoning include Echevarria (1997), Kongsamut, Rebelo & Xie (2001), and Laitner (2000). I know my outrageous simplification of the story has done horrible injustice to these papers. Sorry guys, just trying to be succinct.
The supply-side story plays with the elasticity of substitution among different goods. If for some reason, sector A starts to produce relatively larger quantity of goods than other sectors, the price of sector A's product can go down so much as to reduce the nominal share of the sector in total outputs. There can be various reasons why sector A is so out-performing. You can exogenously assume that its multi-factor productivity is just higher than others (Ngai & Pissarides, 2007); sector A can be more capital intensive, when the economy happens to be experiencing capital deepening (Acemoglu & Guerrieri, 2006); or the sector can be skilled-labor intensive when the economy is producing more well-educated young men (Buera & kaboski, 2007).
Of course, now there is another theory based on intangible capital accumulation (Che, 2009) that needs to be added to the supply-side inventory.
But here is an interesting empirical question: to what degree does each of the above factor contribute to the industry shifts in reality? Surely, to answer the question, regressional analysis is necessary. But there is a whole lot of heavy data work and identification issues involved. The regressors I located so far, in terms of data availability and general practicality:
- industry multifactor productivity
- average SG&A intensity
- proportion of college-educated workers
- R&D intensity
- physical capital intensity
Sunday, March 8, 2009
Self, Work and Creativity
Elizabeth Gilbert's excellent reflection on the nature of creative work is thought-provoking. Her essential point is "don't take genius personally". There can be millions of reasons that determine the fortune of a new venture/research project/art piece. The person who is doing the work should only take ownership of her efforts, but not her "genius". For those engaging in innovative activities, it is wiser to see "genius" as random inspirational moments than to attach one's self identity to it. The "explorer"'s only responsibility is to show up for work, persistently and patiently. How the rest of the story would play out is not within her control, and she'd better let go of that part. It reminds me of something I read long ago by Sri Nisargadatta, who rendered the idea in an even more thorough way:
Unselfish work leads to silence, for when you work selflessly, you don't need to ask for help. Indifferent to results, you are willing to work with the most inadequate means. You do not care to be much gifted and well equipped. Nor do you ask for recognition and assistance. You just do what needs be done, leaving success and failure to the unknown. For everything is caused by innumerable factors, of which your personal endeavor is but one. Yet such is the magic of man's mind and heart that the most improbable happens when human will and love pull together.Beautiful description of an ideal work attitude. But whoever have tried would know that it is not an easy practice, the attainment of which can be a life-long, yet absolutely worthy pursuit for anyone with the ambition to introduce something new to the world.
Monday, February 23, 2009
Evidence Hunting: Sectoral Structural Change and Intangible Capital
Having been thinking about this for more than a while, finally churned some data out. I matched 55 SIC two-digit industries' median SG&A expenditure intensity from COMPUSTAT database with their shares in total private industries' output from BEA. The results:
The second graph divides industries into high-SG&A and low-SG&A groups, and calculates their shares respectively. The change over the years is quite dramatic: high-SG&A industries have expanded remarkably while low intangible industries' shares declined.
Although I've already got a basic model to replicate this, I'm more interested in what has happened during those transition periods when the importance of intangible capital in the production process unexpectively goes up. Theoretically, this kind of change can be a cause of economic downturns/ recessions, but to what degree? How important? What's the implication for labor market and synchronicity of cyclical movements for different aggregate variables? I need to add some other ingredients, say, adjustment cost or search frictions, into the baseline model if I want to focus on transitions and use the model to explain more facts.
- Growth in a industries' share-- over 10, 15, 20 year windows-- is significantly correlated with growth in its intangible capital investment.
- Size of an industry is positively correlated with lagged (5, 10, 15, 20 years) intangible investment levels.
- Share change of an industry over the entire 48 year window-- 1950 to 1997-- is significantly correlated with the industry's mean intangible capital investment level.
The second graph divides industries into high-SG&A and low-SG&A groups, and calculates their shares respectively. The change over the years is quite dramatic: high-SG&A industries have expanded remarkably while low intangible industries' shares declined.
Although I've already got a basic model to replicate this, I'm more interested in what has happened during those transition periods when the importance of intangible capital in the production process unexpectively goes up. Theoretically, this kind of change can be a cause of economic downturns/ recessions, but to what degree? How important? What's the implication for labor market and synchronicity of cyclical movements for different aggregate variables? I need to add some other ingredients, say, adjustment cost or search frictions, into the baseline model if I want to focus on transitions and use the model to explain more facts.
Sunday, February 22, 2009
The Best Statistics You've Ever Seen
Hans Rosling on health care and economy from Ted Conference. I'm sure most people never imagined that stats can be presented with such style, rhythm, energy and drama! It also gives the best example of power point use I've ever seen. It's not that the materials he offered were anything new. As Rosling said himself, those are all publicly available data. It is the way that he organizes, combines and synthesizes that is truly amazing. No data is of any use without a perspective. Analysis turns cold numbers into information. These are all common senses now. But the really challenging thing is to make information register and to provoke changes with the analysis, which may require much more than right logic and accuracy of information. To make an impact, the data presented has to engage multiple levels of cognitive function in the audience' information-receiving system, and that's where good design and creative communication come into play.
Saturday, February 7, 2009
The Ingredients of A Jobless Recovery
More on the topic of employment dynamics I mentioned in the last post. The United States is experiencing a major structural transition right now. The jobless recovery is a consequence of the economy's morph from manufacturing-based value creation to knowledge-based one.
Traditionally, a recession was a cyclical phenomenon. When the demand couldn't catch production, the excess inventory needed to be sold off. During the period, workers were laid off, but only temporarily. When inventories were cleared and demand went back, workers were asked to return to their previous positions in factories, or they can easily find similar jobs in similar companies. As a result, when the recession's over, employment could quickly bounce back.
But over the past decade, IT technology advancement has greatly enhanced firms' ability to efficientize their demand and supply chains, outsource low-end jobs and expand market information capacity. The result is of course elevated productivity. But many workers were let go, this time permanently. People were forced to switch industries, sectors and skills to find a new job.
A direct implication: now employment growth much more depend on creation of new types of positions than inventory or physical investment cycles. Employers incur risks and trial-and-errors in creating new organizational assets, thus require additional time to establish positions, even when the economic condition turns favorable. In any event, tangible investment is no longer the major driving force of employment swings.
Instead, intangible capital investment has become, and will remain crucial to job creation and attainment. For a firm, its value-producing capacity largely depends on its design, marketing, management and research know-now, that is, its organization capital. For an individual, his or her market value is a function of human capital, a concept that has been around for five decades but still mysterious. The median to long-term challenge of the economy is to find out ways to efficiently produce and utilize these two kinds of capitals. Herein lies that answer to the jobless recovery.
Traditionally, a recession was a cyclical phenomenon. When the demand couldn't catch production, the excess inventory needed to be sold off. During the period, workers were laid off, but only temporarily. When inventories were cleared and demand went back, workers were asked to return to their previous positions in factories, or they can easily find similar jobs in similar companies. As a result, when the recession's over, employment could quickly bounce back.
But over the past decade, IT technology advancement has greatly enhanced firms' ability to efficientize their demand and supply chains, outsource low-end jobs and expand market information capacity. The result is of course elevated productivity. But many workers were let go, this time permanently. People were forced to switch industries, sectors and skills to find a new job.
A direct implication: now employment growth much more depend on creation of new types of positions than inventory or physical investment cycles. Employers incur risks and trial-and-errors in creating new organizational assets, thus require additional time to establish positions, even when the economic condition turns favorable. In any event, tangible investment is no longer the major driving force of employment swings.
Instead, intangible capital investment has become, and will remain crucial to job creation and attainment. For a firm, its value-producing capacity largely depends on its design, marketing, management and research know-now, that is, its organization capital. For an individual, his or her market value is a function of human capital, a concept that has been around for five decades but still mysterious. The median to long-term challenge of the economy is to find out ways to efficiently produce and utilize these two kinds of capitals. Herein lies that answer to the jobless recovery.
Saturday, January 31, 2009
Asymmetric Business Cycle and Asymmetric Organizational Investment
Empirical studies show that the evolution of business cycle is somewhat asymmetric-- downturns are steeper than booms. In other words, the drop in GDP at bad times is sharper than the rise at good times. Also, the troughs are "deeper" than the booms in terms of their deviations from the trend. Another related phenomenon: since late 1980s, every transition out of a trough period has been a "jobless recovery"-- employment doesn't come back promptly even long after the economy gets better. From anecdotes about recent layoffs, it's probably reasonable to expect that the economy would most be faced with another jobless recovery when we finally get out of the current mess.
I'm thinking about how all these are related to the asymmetry in organizational investment. Accounting research shows that sg&a expenditure is sticky-- the increase in organizational investment when revenues go up is higher than the decrease when revenues go down. It can be due to multiple reasons. Certain organizational cost may be hard to reduce, in order to maintain the proper operation of the company. Things like R&D and advertising has to be done continuously to maintain market competitiveness. Human resources (an important part of OC) that the company has previously invested in may well be kept on the payroll even if the time is tough, as they are very unique assets and not easily regain if lost, not like production workers. All these may contribute to less operational leeway for the firm during a downturn, thus making the squeeze of recession steeper than the expansion in a boom.
I'm thinking about how all these are related to the asymmetry in organizational investment. Accounting research shows that sg&a expenditure is sticky-- the increase in organizational investment when revenues go up is higher than the decrease when revenues go down. It can be due to multiple reasons. Certain organizational cost may be hard to reduce, in order to maintain the proper operation of the company. Things like R&D and advertising has to be done continuously to maintain market competitiveness. Human resources (an important part of OC) that the company has previously invested in may well be kept on the payroll even if the time is tough, as they are very unique assets and not easily regain if lost, not like production workers. All these may contribute to less operational leeway for the firm during a downturn, thus making the squeeze of recession steeper than the expansion in a boom.
Friday, January 16, 2009
The Future of Financial Innovation
So the news came that Citigroup would be split into two companies. Not a big surprise to some people, I suppose. The names of the new entities are not the most imaginative ones. Obviously the creative minds of financial world are occupied somewhere else.
Financial service has enjoyed the reputation of being an innovative industry for quite some time, especially with the past decade's increasing technical sophistication, thriving new inventions of derivative instruments, trading algorithms, and risk management tools. In terms of attracting high quality human capitals, the industry's appeal to smartest graduates in the country has become a source of lasting complaints among the deans of top-tier engineering and physics schools. There seems to be every reason that finance should be right at the frontier of technology progress and productivity advancement, and it looks like exactly what have happened.
However, take a closer look at the history of financial innovation and you will find that most of the value-creating breakthroughs of the industry were made long time ago, mostly between 1950 and 1970. 1950s saw the first pension fund, first modern M&A bankers, and the emergence of mutual fund and institutional investors. The now ubiquitous credit card was born in the 60s. The first "global" bank with multiple headquarters started roughly the same period. These concepts, models and institutional structures are still the backbones of what the financial service industry has to offer today. And they are essentially quite old ideas. It's fair to say that most of the subsequent product innovations are merely incremental. Since the 1980s, I can hardly think of any groundbreaking inventions that truly adds to the content of "services" that the industry provides. There might be something worth mentioning at the risk management front. But again, the whole sub-sector is direct descendant of insurance business that was the buzz word in finance back in the 19th century.
But isn't this counterintuitive? Aren't the highly-educated finance geeks constantly churning out more "scientific" derivatives and new trading methods? But the problem is that these "innovations" are merely speculation tools; they are not designed to provide a service that adds real value-- one firm's gain will be another firm's loss, and nothing left over to cover either's expense.
History hasn't seen an industry that can survive, let alone prosper, without generating services and products to other sectors and outside customers. Without genuine technology and productivity innovations accompanied by waves of creative destruction, an industry's products will become commodities and increasingly less profitable, and the market gradually converges to semi-perfect competition. Finance industry has experienced huge expansion in the past 30 years, which may have a lot to do with changes in regulation and shift in demand for the industry's products. But without truly value-adding innovations, the expansion is simply not sustainable. This argument also provides a mega macro perspective to look at the current crisis and the setbacks in finance industry.
But the question is, what are the potential areas for the next "real" financial innovations?
Financial service has enjoyed the reputation of being an innovative industry for quite some time, especially with the past decade's increasing technical sophistication, thriving new inventions of derivative instruments, trading algorithms, and risk management tools. In terms of attracting high quality human capitals, the industry's appeal to smartest graduates in the country has become a source of lasting complaints among the deans of top-tier engineering and physics schools. There seems to be every reason that finance should be right at the frontier of technology progress and productivity advancement, and it looks like exactly what have happened.
However, take a closer look at the history of financial innovation and you will find that most of the value-creating breakthroughs of the industry were made long time ago, mostly between 1950 and 1970. 1950s saw the first pension fund, first modern M&A bankers, and the emergence of mutual fund and institutional investors. The now ubiquitous credit card was born in the 60s. The first "global" bank with multiple headquarters started roughly the same period. These concepts, models and institutional structures are still the backbones of what the financial service industry has to offer today. And they are essentially quite old ideas. It's fair to say that most of the subsequent product innovations are merely incremental. Since the 1980s, I can hardly think of any groundbreaking inventions that truly adds to the content of "services" that the industry provides. There might be something worth mentioning at the risk management front. But again, the whole sub-sector is direct descendant of insurance business that was the buzz word in finance back in the 19th century.
But isn't this counterintuitive? Aren't the highly-educated finance geeks constantly churning out more "scientific" derivatives and new trading methods? But the problem is that these "innovations" are merely speculation tools; they are not designed to provide a service that adds real value-- one firm's gain will be another firm's loss, and nothing left over to cover either's expense.
History hasn't seen an industry that can survive, let alone prosper, without generating services and products to other sectors and outside customers. Without genuine technology and productivity innovations accompanied by waves of creative destruction, an industry's products will become commodities and increasingly less profitable, and the market gradually converges to semi-perfect competition. Finance industry has experienced huge expansion in the past 30 years, which may have a lot to do with changes in regulation and shift in demand for the industry's products. But without truly value-adding innovations, the expansion is simply not sustainable. This argument also provides a mega macro perspective to look at the current crisis and the setbacks in finance industry.
But the question is, what are the potential areas for the next "real" financial innovations?
Sunday, December 28, 2008
Corner Solution?
I was reminded that in my model with just one sector and identical firms (except their draws of idiosyncratic shocks), it can happen that investments in organization capital are moved to firms that get the highest shocks, while other firms receive zero investment. To put it in another way, in the social planner's problem, if capitals are mobile and one firm has higher investment efficiency than the others, what prevents the social planner from choosing to put all the investment into this single firm so that the maximum amount of organization capital can be produced next period? Is there a possibility for corner solution?
I haven't come up with a strict proof. But my argument goes roughly as follows. Assume all firms start with the same amount of capitals K and O, but firm A has higher organizational investment-specific shock for next period. Suppose SP chooses to concentrate all the new O investment in firm A and starve other firms, obviously all the new K investment has to be made in firm A, too, otherwise too much O makes marginal productivity of O in firm A go down so much that it can hardly be optimal. Now think of what happens to other firms. They get zero new investment, but are still in business with the left-over K and O from last period. But K and O have very different depreciation rates. Specifically, in the model, I assume depreciation for K around 8% per year, but for O about 50%. So in the next period, MPO in other firms would be much higher than in firm A, if they don't receive any new O investment. This situation can certainly be improved if social planner had chosen to invest some O in these low-shock firms, too, which means that the investment schedule I assumed in the beginning cannot be optimal.
The key thing here is a much higher depreciation rate for O than for K. And I think this assumption is by no means unrealistic.
I haven't come up with a strict proof. But my argument goes roughly as follows. Assume all firms start with the same amount of capitals K and O, but firm A has higher organizational investment-specific shock for next period. Suppose SP chooses to concentrate all the new O investment in firm A and starve other firms, obviously all the new K investment has to be made in firm A, too, otherwise too much O makes marginal productivity of O in firm A go down so much that it can hardly be optimal. Now think of what happens to other firms. They get zero new investment, but are still in business with the left-over K and O from last period. But K and O have very different depreciation rates. Specifically, in the model, I assume depreciation for K around 8% per year, but for O about 50%. So in the next period, MPO in other firms would be much higher than in firm A, if they don't receive any new O investment. This situation can certainly be improved if social planner had chosen to invest some O in these low-shock firms, too, which means that the investment schedule I assumed in the beginning cannot be optimal.
The key thing here is a much higher depreciation rate for O than for K. And I think this assumption is by no means unrealistic.
Tuesday, December 23, 2008
Looking for Motivation to Build the Bridge...
I was talking with JB about the why-and-how of combing the two parts of my theory together. The first part deals with diverging volatility puzzle, the second part about structural change. To accommodate the two in a single model is more technically complicated, which means I'd better figure out in the first place why I want to do it, partly for the sake of my own sense of well-being, because a challenging job with no strong motivation feels even tougher. So what I should do first is probably to try to find empirical evidence of the linkage. An obvious way is to test whether there is a linkage between sectoral share increase and volatility. Here is my first take on what can be done.
- Check whether high sg&a industries generally grow faster in the aggregate level. Sg&a data is not available at sector level, but I can probably use public-traded firms is stead, at the risk of compromising accuracy.
- If my theory is true that high-growth sectors load heavier on organization capital, then those sectors should observe more prominent divergence between volatility of firm performance and aggregate sectoral output fluctuation, relative to low growth/declining sectors. Sectoral fluctuation is easy to calculate. I just need to match them with Compustat firm classifications.
Friday, December 19, 2008
Multi-equilibria with Consumption of New Products
I was thinking of an endogenous growth theory on the relationship between consumption and growth.
Suppose the consumption in each period in an economy is spread out among all available (new and old) products. And economic growth is modeled as introduction of new product varieties. A firm/entrepreneur's decision of whether to invest in developing and producing a new variety depends on potential market size, i.e., related to the representative agent's propensity to consume. There would be different equilibrium growth rates in the economy. At one extreme, saving rate is low, consumption high, and new innovations very active, which leads to high growth. At the other, saving rate is high, consumption low, and growth rate probably ok. The intuition is that higher consumption propensity increases the possibility of success for new products, thus encourages innovation. The model would serve as a defense for the consumption and saving patterns seen in US, and provides a theory of why the pattern can be good to growth, contrary to what neo-classical growth models would suggest.
But I can already imagine what J.B. would say -- "Too far away from your concentration. You won't finish it in a year. Put it in your back file and think about something else..." And I would, as always, grudgingly admit that he is probably right...
Suppose the consumption in each period in an economy is spread out among all available (new and old) products. And economic growth is modeled as introduction of new product varieties. A firm/entrepreneur's decision of whether to invest in developing and producing a new variety depends on potential market size, i.e., related to the representative agent's propensity to consume. There would be different equilibrium growth rates in the economy. At one extreme, saving rate is low, consumption high, and new innovations very active, which leads to high growth. At the other, saving rate is high, consumption low, and growth rate probably ok. The intuition is that higher consumption propensity increases the possibility of success for new products, thus encourages innovation. The model would serve as a defense for the consumption and saving patterns seen in US, and provides a theory of why the pattern can be good to growth, contrary to what neo-classical growth models would suggest.
But I can already imagine what J.B. would say -- "Too far away from your concentration. You won't finish it in a year. Put it in your back file and think about something else..." And I would, as always, grudgingly admit that he is probably right...
Thursday, December 18, 2008
Provocative Accounting: Do Financial Statements Need Re-definition?
Just skimmed through Charles Hulten's new paper on firm valuation and intangible assets. The observation that firm's market value premium over book value is due to intangible assets not counted in the book is, of course, not new at all. Various authors, from accounting scholars to management gurus to business economists, has expressed their discontents with the present ways that business accounting is done. Basically what they are saying is that a company's value, at a time of accelarated innovation and ourbursts of new ideas and organizations, often has little to do with the fixed assets a company possesses. By looking at the financial statement in its present form, one can get less and less information about the competitive advantage and growth potential of a company, which very likely lie in some some "soft" aspects of the firm, like specific human capital, management experience, R&D capacity...
From this line of reasoning, some people, including Hulten, suggest that investment in R&D and organization should be capitalized as in the case of purchasing a machine. And internally generagted intangible assets should be added to company's sales to make the item fully revealing about the economic value generated in operating the firm. This is where things seem to be going a little bit too far.
A major problem I have with this proposal is that there is fundemental difference between intangible asset and a machine in terms of the risk involved in making the investment. If a firm makes a machine by itself instead of buying one, it makes sense to me to add the imputed value of the machine to the company's revenues, as the machine's price would otherwise appear in the income statement of a machine manufacturerer. The imputation of value can work because: one, there is an active market for machines, since the value of asset is competely transferable from one firm to the other; two, after it's made, the capacity of the machine in producing future products is almost riskless and predictable. In contrast, most intangibles are firm-specific, and the value of the asset is subject to great incertainties difficult to foresee. (Think about it: only 8% of new drug developments eventually make it to the market.) So simply adding new "production" of intangible assets to the revenue is not going to make the number more truth-telling. Instead, it will make the door wide open for euphoric prediction bonfire of accounting gimmicks. Especially at a time like this, it may take many years before a provocative accounting innovation like this to have any realistic impact in practice.
From this line of reasoning, some people, including Hulten, suggest that investment in R&D and organization should be capitalized as in the case of purchasing a machine. And internally generagted intangible assets should be added to company's sales to make the item fully revealing about the economic value generated in operating the firm. This is where things seem to be going a little bit too far.
A major problem I have with this proposal is that there is fundemental difference between intangible asset and a machine in terms of the risk involved in making the investment. If a firm makes a machine by itself instead of buying one, it makes sense to me to add the imputed value of the machine to the company's revenues, as the machine's price would otherwise appear in the income statement of a machine manufacturerer. The imputation of value can work because: one, there is an active market for machines, since the value of asset is competely transferable from one firm to the other; two, after it's made, the capacity of the machine in producing future products is almost riskless and predictable. In contrast, most intangibles are firm-specific, and the value of the asset is subject to great incertainties difficult to foresee. (Think about it: only 8% of new drug developments eventually make it to the market.) So simply adding new "production" of intangible assets to the revenue is not going to make the number more truth-telling. Instead, it will make the door wide open for euphoric prediction bonfire of accounting gimmicks. Especially at a time like this, it may take many years before a provocative accounting innovation like this to have any realistic impact in practice.
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