Natasha Xingyuan Che

Structural Coherence and the Better Way to Make Cellphones

2011-02-21T13:48:00.004-05:00

An interesting article in the Economist about the quagmire the Finnish cellphone giant Nokia finds itself in right now, lagging behind in the smartphone race against Apple and other phone makers. On the surface, this is an all too familiar story of creative destruction: the industry incumbent was too enamored of its own success, became tunneled-visioned, got caught off guard by the disruptive technology from new competitor(s), stumbled and fell... and the rest is history.

Of course the Nokia story can be told this way. However, this particular article raised a point that is not usually mentioned behind the success and failure of Nokia and its competitors:

"The first generations of modern mobile phones were purely devices for conversation and text messages. The money lay in designing desirable handsets, manufacturing them cheaply and distributing them widely. This played to European strengths. The necessary skills overlapped most of all in Finland... ... As microprocessors become more powerful, mobile phones are changing into hand-held computers. As a result, most of their value is now in software and data services. This is where America, in particular Silicon Valley, is hard to beat. ... ... the Valley boasts an unparalleled ecosystem of entrepreneurs, venture capitalists and software developers who regularly spawn innovative services."

In other words, Nokia used to be successful partly because its products and processes were "structurally coherent" to the economic fundamentals of its larger environment. Similarly, Apple and Google are successful today because their products and processes they invented are structurally coherent to THEIR economic environment. This is a piece of insight that lots of business narratives--mainly focusing on firms' innovative culture and visionary leadership-- largely ignored.

When I presented my research on structural coherence at various meetings, I told people that countries grow faster when the factor intensities of their industries are structurally coherent with the country's endowment fundamentals, and an industry has the best chance to grow if its production process uses the country's existing abundant factor intensively (see a previous post). Then I got asked the following question a lot: Ok, this may be true at industry level, but how about at firm level? Don't best firms succeed by innovating "ahead of the curve", thinking outside of the box, and not being constrained by existing "industry standards"? It seems that the formula for success at micro level is the complete opposite to that at macro level.

So is there a contradiction here? I don't think so. Of course there are countless factors that can determine a firm's fortune, but being structurally coherent with its larger economic environment, though not a sufficient condition for success on its own, is one of the basic necessary conditions. Nokia took advantage of the existing human capital in hardware engineering in its home country, applied it to the design & manufacturing of handsets and prospered. Apple tapped into the abundant resources in software design in Silicon Valley and flourished. The product strategies of both companies, at their best, are coherent with and fully exploit the fundamentals of their larger economic environments.

Of course, structural coherence alone doesn't make any single firm successful -- there may be tens of thousands of software companies in the Silicon Valley, but few achieved the same level of success as Apple or Google. Many factors play important roles in determining a firm's future. And some might say that such companies as Apple are successful because they are "innovative". However, although innovation is a much hyped word in our time, all innovations are not equal. The most successful innovations are "ahead of the curve" in terms of conceptualization of ideas and market judgment, but they are rarely ahead of the macro fundamentals of their economic environment. Just to the opposite, even the best idea can't fly high if its implementation demands inputs so different from what its macro environment can offer.

Therefore, structural coherence and product innovation are in fact complementary factors that make things happen. A country's specific factor endowment combination carries potential of success for specific types of firms and products, but this potential is only manifested in reality by firms' innovations that are structurally coherent with the environment.

Judging from this perspective, the best strategy for Nokia is to innovate on products and services that match its existing advantages and expertise, rather than trying to compete in a product (smartphone) that is more coherent with its competitors' environment. Unfortunately, it seems that the exact opposite is what they are doing.

Why Quantitative Easing Will Work Better in the US than in Any Other Countries

2010-12-14T11:30:00.003-05:00

The Federal Reserve announced a month ago its plan to buy an additional $600 billion of Treasury securities in order to stimulate the economy. This second round of “quantitative easing” made some people cringe, for some very different-- even contradictory-- reasons. On the one hand it stirred inflation phobia in those that see excess liquidity as one of the root causes of the financial mess that we were (and still are) in. They argue that QE2 would only encourage another round of reckless financial speculation and bubbles, at a time that we least need it. On the other hand, pessimists about the Fed’s plan see no way that QE2 would accomplish the job that it is intended to, for mainly two reasons. First, the private sector is heavily in debt already and therefore has little capacity to borrow more, consume more, and invest more, not to mention that the financial intermediation sector itself is barely surviving. Lower policy rates are thus difficult to be arbitraged to the private sector’s benefit. Second, with the growth prospect in emerging markets much brighter than in the advanced economies, additional liquidity added to the system here will be quickly moved to, say, the other side of the Pacific, and ends up as emerging markets’ capital inflow and even higher foreign reserves.

While the inflation worry is still far-fetching given the currently depressed level of economic activities in this country, the skepticism about the effectiveness of QE2 seems justified. However, I’m going to argue that quantitative easing is probably more likely to work in the United States than in any other countries in the world, for two reasons. First, although the credit channel may be clogged, the policy-induced asset price increase will likely to encourage consumption through wealth effect. The asset price channel can be especially effective in the US because of the high percentage of stock ownership. Half of the US households own stocks, either through investment in individual stocks or through investment in mutual funds. This means that the wealth effect generated through higher stock prices can be far reaching, directly to half of the population and indirectly to an even wider range.

Secondly, higher asset prices are especially beneficial to the intangible-capital intensive industries and technology sectors, which in the long run drive the growth potential of the US. Partly because of the nature of their assets, intangible-capital intensive firms are more likely to seek finance through equity offering than borrowing from banks, as the latter normally requires tangible collaterals. Thus a depressed stock market is extra restrictive to the growth of high intangible sectors by making equity financing difficult. Moreover, the US has a much higher percentage of enterprises financed by venture capital and private equity firms than any other countries. Active venture investment is an important source of American innovation edge and long-run productivity growth. Venture capital firms typically exit from their investments in portfolio firms through selling their shares to other firms or to the public market. If the asset market is doing well, it’s easier for venture capitalists to exit and then invest in new firms. In contrast, when they can’t sell their existing portfolios, new start-up companies that carry productivity-enhancing potentials will be starving, too. Investing in long-term productivity and innovation is arguably the wisest thing a country can do during a downturn. But unfortunately, the funding constraints for long-run investments are most severe in the recession. People often neglect long-term goals when faced with immediate urgencies. To put things in perspective, the projected total investments in US new enterprises for 2011 is around $20bn (that’s already a significant increase from this year); in contrast, the auto bailout in the US cost $80bn, and that was only estimated in 2009.

Again, whether QE2 will be all that effective in stimulating the economy in the short run is debatable. But at least we know that if it is going to be of help, it will be most helpful here in the States. And even if it doesn’t have immediate effect on the economy, it will still have long-term benefit, though a lot of it may not be directly measurable.

What Can the Government Learn from the Structural Coherence Principle? (And Why It was Probably A Bad Idea to Bailout Detroit)

2010-11-28T17:16:00.003-05:00

Structural coherence is the degree of alignment between a country’s factor endowments and the factor intensity level of the country’s industrial composition. For example, a country that has high capital endowment would be structurally coherent if the country’s industrial composition is dominated by capital-intensive industries; in contrast, if a capital-abundant country has an industrial composition that concentrates on labor-intensive industries, it would be structurally incoherent. My research found that the countries that have higher structural coherence level achieve higher economic growth. For a group of OECD countries, the differences in their structural coherence level explain about 25% of the variations in their economic growth.

Why should policy makers care about this? Because this result suggests that whatever can be done to maintain/increase the structural coherence level of a country would be good for its economy. In this light, government policies, investment decisions and regulatory reforms can be evaluated according to whether they help increase structural coherence or pull the economy away from structural coherence. And if the economy is in trouble, the government can think about what it can do to enhance structural coherence, either by bringing the capital intensity of the industrial composition closer to the existing level of capital endowment, or by changing the capital endowment level to meet the capital intensity of the present industrial composition, depending on which way is less costly. In general, the capital endowment of a country is probably slower and harder to change than the choice of industrial composition, though high capital mobility in today’s globalized world certainly makes it easier. That’s why it makes economic sense for the government to do whatever it can to help the industrial structure match the country’s capital endowment, instead of doing things the other way around. But we probably shouldn't take this as a rigid rule. The bottom line is: whenever there is incoherence, change whichever variable that is easier (less costly) to change.

Now let’s see how this principle can help guide the policy decisions. Let’s say there is a developing country. One day it got a large sum of foreign aid money, and it is supposed to invest the money in productive project(s) that help the country’s long-term growth. The government decides to invest in Project A: to build a factory producing electronic gadgets using the most advanced technology. The factory needs to employ local people to operate the fancy machineries. But since the country is very poor and the majority of its labor force uneducated, the government has to hire foreign experts to come train the local employees so that they become competent enough to handle the machines. Now what the government is doing here is essentially trying to marginally elevate the country’s human capital endowment in order to fit the human-capital intensity of its industrial investment plan. Can it work? Of course. Is it a good idea? Probably not. The government’s intention is a good one—to increase the country’s human capital through the investment project? (And don’t they all say human capital is important for growth?) But such a strategy is so costly to implement given the country’s original endowments that the profit level of Project A may turn out to be too low to make the investment even sustainable.

Now alternatively, the country can use the money to invest in Project B: to expand the country’s basic manufacturing industries, e.g., crafts& furniture, textile, food processing, that employ the country’s abundant manual labor but require relatively little physical and human capital investment; and at the same time to invest in infrastructures like roads and port facilities, which makes it easier for the expanding industries to transport and export their products. What the government does here is to bring the country’s industrial structure to match the country’s endowment fundamentals, by assisting the development of the “coherent” industries and removing the hurdles for these industries’ growth. By coherent industries I mean the industries whose factor intensity is in line with the country’s factor endowments. Since these industries are profitable given the macro fundamentals of the country, they can stand by themselves and generate savings for the country’s future development, which eventually becomes a virtuous cycle. This example is very stylized and the development puzzles in reality are often more nuanced. Each country has its own unique endowment and bottlenecks that need to be overcome. Yet the structural coherence principle as a guideline for policy and investment decision-making should hold in general.

The principle not only applies to the developing countries, but also to advanced economies. Take for example, the recent controversial bailout of several car manufacturers in the US. How do we evaluate the government decision from the structural coherence point of view? We know that the US is a capital-abundant country and also one of the largest recipients of foreign capital inflow in the world. Automobile industry used to be capital intensive, say, thirty years ago. But nowadays, despite the popular perception, car manufacturing has slid down the capital intensity ladder compared to the expanding industries such as pharmaceuticals and communication, (Note: higher fixed set-up cost, as in steel and automobile industries, should not be confused with higher capital intensity, though the two may correlate.) In fact, in the US, even agriculture industry is more capital-intensive than car manufacturing. (These rankings are, to be sure, highly country-specific, as different countries adopt different technologies in the same industry. Most countries’ agricultural sector is far less capital-intensive than that of the US.)

Now this leads to the question: is it a good idea for the government to artificially keep an industry alive that is no longer coherent with the country’s endowment fundamentals? The answer, according to the structural coherence principle, is obviously no. Simply subsidizing the incoherent industries won’t make them sustainable or productive; in the long run, this is a drain on government resources that can be better invested somewhere else. Then the next question is: is it an accurate description of what the US government has actually done? Sounds like so to me. But how about the employees of Detroit? If such a large industry collapsed, where would they go? Shouldn’t the government help them? Sure the government should help. And the government can do it in several ways: (1) hand them cash directly; (2) help them to relocate to profitable industries/thriving geographical areas; (3) provide trainings\continuous education to make them more employable in other jobs. All of these are probably more direct and efficient than trying to keep a dying industry alive. (This is related to the structural unemployment problem in the US right now. But that should be the topic of another article.)

But here is a caveat. Is it ALWAYS a bad idea for the government to prolong the life of an industry that is incoherent with the country’s endowment fundamentals? No, but for the bailout to work, it requires significant changes in the industry itself, which can be improbable in some cases. In other words, the temporary government assistance would only work if the incoherent industry finds ways to change and become coherent again. Following the car industry example, what should the auto makers do to save their own lives? The answer, according to the structural coherence principle, is deceptively simple. It’s not financial restructuring. It’s not negotiating with creditors. It’s not squeezing their suppliers. It is to FIND BETTER WAYS TO MAKE CARS AND MAKE BETTER CARS! Specifically, that means to survive in a capital-abundant country like the US, they need to change their input structure to use more of capital and human capital in the production process, and less of manual labor, which is way more expensive in this country than in its far-East competitors. It also means to reduce the scarce input the cars need themselves to function, in this case petrol fuels, the endowment of which is becoming less and less abundant globally. But both these measures require significant, if not revolutionary, changes in the technology US firms use to make cars. If these changes do not happen and status quo maintained, then any government subsidies will only save these firms temporarily, and more troubles will be coming. So an important question the government should be thinking about when making the bailout decision is: how likely are these changes gonna happen? If the government doesn’t ensure the implementation of these changes, then simply subsidizing the dying industries is a dead-end strategy. But again, how skilled are the governments in general when it comes to monitoring the direction of technological change?

Now I’ve argued that to maintain the structural coherence of the economy, the government should help bring the factor intensities of industrial composition closer to the levels of factor endowments. Are there situations where doing the opposite is advisable, i.e., to bring the levels of factor endowments into alignment with existing industrial structure? It will generally be far more costly, if not impossible, as mentioned earlier. But it can be a good strategy if given the following conditions:

The underlining industries are already profitable and expanding on their own;
The industries’ factor intensities are broadly in line with the country’s factor endowment levels, except for maybe one or two factors that is becoming the bottleneck for the industries’ future development;
It is possible and not overly costly (in terms of both resources and time) to change the endowments in these couple factors.

For example, the growing industries in the US nowadays are generally human capital and intangible capital intensive, industries like pharmaceuticals, computer services, and part of financial services, which require a lot of research and design work and technological supports. Some of these industries are faced with the shortage of domestic talents. Although the US is already human capital abundant, apparently the growth of US human capital is not catching up with the growth of certain industries. As a result, these industries are aggressively hiring immigrants and even from abroad, but it is not always easy due to administrative hurdles. Is it suggestible for the US government to do something to help increase further the human capital endowment of the country, so as to accommodate the need of existing industries? To answer the question we can check if the above three conditions are met. (1) Are these industries already thriving in the US? Yes. (2) Are they generally coherent with the endowment profile of the US? Yes, the US is abundant in physical and intangible capital, and other factors that these industries use heavily. But certain types of human capital are becoming constraining factors. (3) Is it possible and cheap enough to increase the human capital endowment of the US? Of course it is possible. All the government has to do is to change its immigration policy to allow more immigrants with high human capital. So it is doable and cheap in a pure economic sense. But of course, the political cost to the administration is another matter, which is how things often times start to deviate from the optimal state.

The Optimal Extent of Trading?

2010-06-29T11:31:00.012-04:00

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.)

SG&A and Management Quality

2010-06-20T11:57:00.005-04:00

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.

Global Economic Inequality: Why It Exists and How to Change It

2010-03-23T15:15:00.006-04:00

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 20^th century is no different from that of the 19^th century except that knowledge is so much more emphasized in production process of the 20^th 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.

Hoodwinked

2010-03-22T12:00:00.006-04:00

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.

Spiritual Capital

2010-02-13T22:16:00.007-05:00

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:

"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!

The Price of Free Market

2010-02-05T08:40:00.014-05:00

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.

Is a New Growth Model Possible?

2010-01-24T08:31:00.016-05:00

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.

A Peaceful Revolution: How Knowledge Capital Can Solve the Growth-and-Sustainability Dilemma

2010-01-05T17:39:00.017-05:00

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.

Is SG&A Expenditure "Missing" in GDP?

2009-09-07T21:34:00.007-04:00

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.

Principal- agent Problem? Or Clash between Two Capitals?

2009-06-27T20:16:00.005-04:00

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.

A Solution to Correct Externality and Ease Unemployment at the Same Time

2009-06-24T22:12:00.009-04:00

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.

What Types of Capital Really Matter?

2009-04-29T19:35:00.010-04:00

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.)

How to Make Sensible Economic Predictions

2009-04-25T08:47:00.004-04:00

The rule of thumb is always using as much scientific evidence as you can find, and... ... your hunches.
(Via Dan Pink)

Trend of Intangible Investment: 1980 - 2008

2009-04-15T10:48:00.000-04:00

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.

Overstretched Truth or Substantive Myth?

2009-03-30T16:30:00.019-04:00

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.

List is Long, Life is Short...

2009-03-24T16:34:00.008-04:00

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:

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.

Empirical problems:

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 problems:

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

Suggestions:

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

Deconstrucing Structural Change

2009-03-10T21:45:00.006-04:00

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:

industry multifactor productivity
average SG&A intensity
proportion of college-educated workers
R&D intensity
physical capital intensity

These are basically all supply-side factors. To test demand-side stories, I'll need income elasticity of demand for all industries, which is less than possible, if not totally unthinkable. One way out might be to use an industry-year fixed effect regression specification to take the demand variation as some un-observed factor. Not sure if it can work. But at least for now, it may be wiser to just focus on the half of glass that's already filled.

Self, Work and Creativity

2009-03-08T22:34:00.005-04:00

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.

Evidence Hunting: Sectoral Structural Change and Intangible Capital

2009-02-23T13:48:00.006-05:00

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:

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.

Won't bother with regression tables and technical details here. But a good graph can speak volume. The first graph below shows the average SG&A intensity trends for growing and declining industries. Intangible investments are increasing in both groups, but the rise is much sharper for growing industries.
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.

The Best Statistics You've Ever Seen

2009-02-22T22:41:00.003-05:00

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.

The Ingredients of A Jobless Recovery

2009-02-07T11:11:00.002-05:00

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.

Asymmetric Business Cycle and Asymmetric Organizational Investment

2009-01-31T09:44:00.004-05:00

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.

The Future of Financial Innovation

2009-01-16T08:45:00.006-05:00

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?

Corner Solution?

2008-12-28T10:24:00.008-05:00

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.

Looking for Motivation to Build the Bridge...

2008-12-23T10:48:00.002-05:00

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.

If the result turns out good, I'll have more than enough incentive to proceed with modeling work, though in principal, the sequence should probably be the opposite. I suspect I'm not a headstrong theorist after all.

Multi-equilibria with Consumption of New Products

2008-12-19T13:02:00.006-05:00

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...

Provocative Accounting: Do Financial Statements Need Re-definition?

2008-12-18T11:10:00.005-05:00

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.

The Many Purposes of Science

2008-12-08T15:33:00.004-05:00

A very inspiring article on metaphysical aspect of science and everything else related. Some excellent quotes that really touched me:

From physicist Robert Wilson's congressional testimony --

Pastore: Is there anything connected with the hopes of this accelerator that in any way involves the security of this country?

Wilson: No sir. I don't believe so.
Pastore: Nothing at all?
Wilson: Nothing at all.
Pastore: It has no value in that respect?
Wilson: It has only to do with the respect with which we regard one another, the dignity of men, our love of culture. It has to do with, are we good painters, good sculptors, great poets? I mean all the things we really venerate and honor in our country and are patriotic about. It has nothing to do directly with defending our country except to make it worth defending.

From Nobel prize winner Leon Lederman on what motivates him --

If you are mortal, like most of the scientists I know, the far sweeter moments come when you yourself discover some new fact about the universe. It's astonishing how often this happens at 3 a.m., when you are alone in the lab and you have learned something profound, and you realize that not one of the other five billion people on earth knows what you now know. Or so you hope. You will, of course, hasten to tell them as soon as possible. This is known as "publishing."

Surely this applies to social science as well.

Why are Some Industries More Innovative than Others? Or are They?

2008-12-05T16:40:00.002-05:00

According to national science foundation, 80% of US R&D expenditure happened in 4 industries. The same highly concentrated pattern is also true in patent numbers. Does that mean that industries like communication, electronic equipment, drugs& medicine are more innovative than others? Not very likely, unless you have a very elitist view about human talents. Or does it mean that other sectors don't need that much innovation? Not true, either. A good example is energy industry. The alarmist argument that we are running out of fossil fuels has been around for quite some time and there's no shortage of buyers into the argument. However, US energy research expenditure and venture investment is far less in quantity than in such sectors as electronics.

My hypothesis is the following. For any new innovations to fly, there must be enough complementary investments made within and without the organization. Sometimes new innovations have to go through a long period of technological trial and error and interaction with the market and to grow mature. At the same time, newer innovations in the same or related field can provide much-needed externalities to increase the market value of a particular product. In contrast, incumbents in the field which already has a firm grasp on the market offers greatest obstacles. So successful innovations usually possess some common characteristics. For example,
1. targeting a niche market that doesn't have incumbents.
2. standing on itself, not requiring much complementary investment in the market environment.
3. other similar innovations mean more positive externality than competition.
4. not relying too much on the economy of scale to be profitable.
In contrast, in some industries such as energy, innovations are difficult not because of technological barrier. The difficulty for any new energy source to be successfully developed is from:
1. huge complementary investment needed in infrastructure and equipment; e.g. new types of cars.
2. different new energy technologies are down-right competitors with each other.
3. production has to be scaled to cover high upfront investment.

I wonder whether some kind of government-private sector partnership can help solve the problem.

America's True Competitive Advantage

2008-11-30T15:20:00.003-05:00

I'm 80% agree with Amar Bhidé and his book. Read the related NYT article here.

Yes, US needs to keep its competitive advantage in technology and innovation. The question is how. Increasing investment in basic scientific research or boosting the number of scientists and engineers is an obvious answer. But as in tacking many complicated questions, the obvious answer is rarely the right one. There are more than one ingredients in the mysterious thing we call "innovation". Scientific knowledge is one, which is seldom the scarce resource in innovation for many disciplines. Creative and market-savvy application of knowledge is another, arguably the ingredient that is more in a shortage of supply. But this is where America's real competitive advantage lies, with the nation's long-held institutions and traditions cherishing individuality, practical thinking, risk taking and entrepreneurship. And this is where US can keep an upper hand over others. Work on your strength, not weakness. Work smarter, not harder. These are advices applying to individual growth, but they are no less suitable to a nation.

Creativity and Motivation

2008-11-28T12:57:00.002-05:00

Renowned choreographer Twyla Tharp on what kind of motivation really promotes innovation. In fact, she's saying what we have already known for thousands of years, that valuable work is done when you forget about power, money and fame and sincerely focus on the intrinsic value of your work.

A Question Concerning the Survival of Modern Civilization

2008-11-26T15:59:00.002-05:00

Whether the title is an overstatement or not depends on your personal value. But I just read this intriguing research on investment in energy innovation. It surprised me that both federal and private investment in energy R&D had actually declined since 1990s. This is puzzling if the starting point of your thought experiment is a no-friction, no-externality environment where agents have perfect foresight. In a world like that, new energy research and investment should be carried out in full scale as soon as people realize that fossil fuel is not sustainable. All other structure and equipment investment should adapt to new energy source immediately. And oil price should remain constant (if not declining) and equal to its marginal productivity which is inturn equal to productivity of other energies, while in terms of quantity, less and less of oil is available and is used. So here is the question: if it sounds like a perfect plan, then why is this not actually happening in reality? This is an important question that not only relates to sustainability of economic development, but also various phenomena in both Main Street and Wall Street. I've got a couple hypotheses. But I still need to work them through and refine some ideas. Hopefully they will show up in my next paper.

Random Thining about Innovation

2008-11-22T11:02:00.006-05:00

A recent article on business model innovation from HBR. It points out some aspects of creative activities that echo my own observation. People have all kinds of misconception about what is "innovation". The easiest mistake is to confuse it with research & development, or to associate it with a picture of a group of geeky scientists running around in a bustling lab. The other extreme of the perception is to think of innovation as merely "aha moments" -- something happening when geniuses are working in the flow, occationally favored by a nitpicking Muse.

But the reality is much more messy than any simple abstraction. Yes, innovation starts from an idea in someone's head. It can be anybody, but there are something characteristic about this person. He or she is probably an avid observer, by nature or cultivated, of market behaviors, of people's needs and wants, and of life in general. She should be an independent thinker, also, rebellious in a structured way. She probably has substantial knowledge in a certain field, as frequently new discoveries are only possible when we can dip deeper. If you believe in Briggs-Myers typology, this person is likely to be a ST (sensing-thinking) type.

Next, she must be able to convey the idea to others in the organization. Here is when organization capital comes into play. What type of people she works with determine to a great extent whether the idea can fly or not. Because for a nascent model to be finally implementable, people with different backgrounds and expertise must be able to take interest in and contribute to its perfection. None of the technical, marketing, financing, or personnel departments can be absent in the development process. It often requires the idea person to have good marketing and communicating skills. Her work would be easier if other people she has to work with all share at least one or two of her personality type (I'm using Briggs-Myers again, because it's a handy model). In other words, the organization's HR policy would affect the efficiency of innovation in the future. They'd better have a clear idea of what type of people, besides experience and education, they want to recruit to maximize the firm's communication capacity.

If you look carefully, you will notice that there are basically two types of entrepreneurs. One type is young, curious, has a lot of wacky ideas, and their innovation requires relatively less technical human capital and financial resources. The other type is often well-trained veterans in a certain profession, having accumulated substantial knowledge, practical experience and social network in her field. Consequently, the two types of entrepreneurs offer different things to the market. Successes of the first type often win by good design, new business model, and by seeing the "obvious" opportunity that others fail to notice. In contrast, the second type's innovation is much more complicated in technology, and requires serious financial inputs, and probably not something you can start from scratch in your garage.

A Beautiful Life in the Making

2008-11-02T14:27:00.007-05:00

This is an entry only for private view. Sorry about that.

Action-Based Marketing

2008-10-21T19:01:00.004-04:00

It's an arguable truth that man is an animal of action, though people certainly disagree about what it actually means. Nevertheless, most people will agree that we do respond more to a message that calls for action than one that simply presents passive information. This explains why the marketing campaigns that involve the targeting group in some specific activity are more effective than others.

But this is not the most interesting part. The really intriguing thing is that the "call for action" doesn't need to be complicated, costly, or even have any concrete substance at all to be effective, as the piece of junk mail I received today. I got 5 or 6 junk mails today, all in envelops of quality paper. Glancing over the senders, I knew they were of no use to me. The one in the above picture is not different, except that it had two additional words on it. Mind you, the words are quite ambiguous -- not a command, not a warning, not even a direction. It almost sounds like redundant: of course people will form a reaction after reading the material, no matter whether you ask for it or not. I knew it is an ad I didn't want and I was not going to do anything it asked me to do. However, it was the only one I actually openned among all the letters. Not a bad result at all for the sender, given the cost of ink...

Does More Data Means More Questions? Absolutely!

2008-10-18T13:40:00.004-04:00

I've been playing around with my panel data set quite some time. Another short summary is due now.

Three findings are pretty clear so far:

Firm volatility increases with sg&a spending level and physical capital intensity.
The R-square of regressing individual firm growth on market and industry growth decreases with sg&a level.
The correlation between industry sales growth and market-aggregate sales growth decreases with the total sg&a level of the industry, and increases with physical capital intensity of the industry.

The conclusion I get from these results is that organization capital investment (approximated by sg&a spending/sales) increases the impact of firm-specific risk shocks, a risk factor independent of macro/market shock. The 3rd result is particularly interesting; it confirms my hypothesis that diverging trend of macro and micro level volatility is caused by decreasing correlations among firms, and the trend is associated with increasing organization capital investment.

It's also thought-provoking to compare the effect of organization capital investment and physical capital intensity. While they both increase firm level volatility (result 1), capital intensity is positively related with correlation at industry level (result 3). This suggests that physical capital's positive impact on firm volatility is associated with macro shocks, rather than firm-level, idiosyncratic shocks.

Ok, done with the 2nd order. Let's look at 1st order effect of different production inputs. I regressed firm's sale growth on previous years' growth rates of sg&a/sales, cost-of-goods-sold/sales, physical capital/sales. It turns out that sg&a growth and physical capital growth are both positively correlated with sales growth in subsequent years, while the impact of cogs on sales growth is negative.

Besides, sg&a spending's effect on sales seems to last longer than physical capital: the impact of physical capital growth on sales growth die out after 2 years, while that of sg&a growth remains significant forward 5 to 6 years. One possible explanation I can think of is that organization capital may have a lower depreciation rate than physical capital. If that's the case, it runs counter to the assumption made in many related studies, where the researchers generally assign a much higher depreciation rate to such "intangible inputs" as R&D and brand equity.

Reduced-form Regression only suggests correlation, to be sure. To go from correlation to cause-and-effect is the job of theory. Now I'm working on revising my general equilibrium model to accommondate structual changes in factor intensity and industries. Hopefully I will make it account for more regularities in the data.

Freedom or Extinction: That is the Question

2008-10-09T19:09:00.006-04:00

Last week I got in touch with a friend of mine in Beijing, a very bright young scholar in economics and political science. We chatted about research methodology and recent events, and I mentioned that I think the financial crisis indirectly indicates that the economy is in some sort of "transition", but not in a negative way. And this is neglected by most people. I explained my view in the following letter I sent him.

Hi Jian Lian,

When I used the word "capital", I had a simple and specific definition in mind. Something is capital if it satisfies 3 conditions, if:
1. it is productive in generating consumption of future periods;
2. its formation requires input of resources, which could have been used to produce current period consumption;
3. it lasts more than one period.

Whether the definition is too wide, too narrow, or completely irrelevant depends on who are talking and what are under discussion. It won't be a useful definition, for example, to someone who believes that symbol has substance and the objects symbols represent are mere shadows. If that's the case, then one might have completely different views about such "measurement" as money, credit, and unemployment rate. But for the specific question we discussed, I assume the unsophisticated opposite -- that symbols have no independent meaning. Even if they do not reflect their objects temporarily, eventually they will.

I absolutely agree with you that researchers should explore different methodologies. But regarding your apparent dislike of what you called "orthodox economics", I have another view. Here is an analogy. Two men, a zoologist and a geometrist, set out to study, say, the bee nest. The zoologist takes a very "realistic" approach. He observes the functions of every bee in a bee society, records bees' daily activities, studies bees' relationship with each other. Then he generalizes and concludes that a bee nest must have a so-and-so structure. The geometrist, in contrast, looks at the bee nest abstractly from the beginning. To him, regardless of how different bees grow and what they do for living, a bee nest will inevitably end up being --- a matrix of hexagons, and he can use very simple math to describe its structure.

It's very likely that the two guys will hold mutual contempt towards each other, because "apparently, the other's approach just doesn't make any sense". But in fact, both of them should know better. There is nothing intrinsically wrong with either method. Both have the potential to produce knowledge; yet there are traps on each path. Whether a methodology can yield insights depends more, indeed much more, on the individual explorer himself, than on any specific cannon that he follows. The discontented always think they are fighting against some sort of "orthodox", but in fact, their frustration is originated from the limitation of human knowledge itself, instead of any specific school of thoughts. In this sense, no "paradigm shift" can eventually help.

I'm not saying that there is one single reason to financial crisis. What I'm emphasizing is the fundamental side of the story that people tend to be blind to. Asset value eventually reflects the asset's productivity. In the past 200 years, people had found numerous ways to transfer different sources of energies into productivity and substitute for manual labor. Every time the energy source changes, the economy "shifts gears", and in the transition period, the asset markets suffer (compare the periods when we shifted from steam engine to petrol, then to electronics, and the times of major financial meltdowns; you will see what I mean.) In the transition period, the installed assets, whose value the market prices reflect, have proved that they will apparently be incompetent in the coming era. Similar rationale applies to the time of major technological shifts, say, right before the emergence of massive computerization 20 years ago. How was stock market doing then? I'm sure you will make a good guess.

Now look at the time we are in. The technology that uses dead ancient animal bodies as major energy source, as we've been doing for 100 years, will definitely not last long, which means that death is close, too, for the fixed assets that are associated with the technology. On the other hand, computerization, which has created the US productivity boom in the past twenty years, is facing a bottleneck now. Not because the technology advancement itself has slowed (it doesn't), but because complimentary investment and innovations are lagging behind.

So what is the next energy gear and what are the necessary complimentary innovations? I don't know. But will people find them? Now here is the part where faith triumphs logic --- it is my firm belief that we will. And any problems we face in between the two eras are only temporary, and if we overcome them, the door will be wide open towards a higher level of human freedom and evolution. Another person, following the same logic as above, may conclude that with all the obstacles, we are heading towards extinction. I have no interest in betting on the direction of financial market or the fate of "US hegemony", but if you'd like to bet about this one, I'll be very willing to :)

Best,
Xingyuan

Microscoping Structural Change

2008-10-04T16:02:00.009-04:00

When people talk about structural change of economic sectors, a commonly used categorization is that the economy is shifting from manufacturing sectors to service sectors. This is not a particularly useful dichotomy in analyzing the change, since the so-called "service" and "manufacturing" both consist of very different industries. Different embodiments of their output don't necessarily tell a lot about the difference in the production process. Then how about categorizing the sectors according to their inputs, say, their capital intensity?

The graph below is an attempt to do so using publicly-traded firm data. I divided industries into two groups according to their fixed asset turnover ratio. A high Y/K ratio corresponds to low physical capital intensity. We can see quite clearly that low-capital-intensity industries are taking over, both in employment and output. If your idea of "service industries" involves relatively low capital intensity, then the graph is generally in line with "the triumph of service" story.
But wait a minute; this is not even half of the story. I did another exercise: dividing industries into 2 groups according to their spending in SG&A, a rough measure of intangible capital investment. Both groups contain some "manufacturing" industries and some "service" industries:
Mix up the two partitions. Now we have 4 groups. Here are different groups' sales as percentages of total sales (panel sequence: : high intangible-low tangible capital; high intangible-high tangible; low intangible-high tangible; low intangible-low tangible. )
It's clear that among high physical capital industries, those of high intangible investment have gained shares, while the ones of low intangibles have lost. Industries with high intangible and low physical capitals expanded significantly, while fate is less clear for those of low intensity in both capitals. Notice that all the 4 groups have some manufacturing and service industries.

There are certainly different ways to model and explain these changes, but one thing for sure is that a model with only two inputs, K and L, won't cut it, no matter how you manipulate their different shares and technology progress. The ideal model needs to take into account of intangible capital's role in different industries, while keeping the K and L's shares in final output, as measured in the way of BEA, relatively constant.

Why PhDs are not the Richest Guys in Town (and What to Do about It)

2008-09-20T16:11:00.004-04:00

A more sophisticated way to post the question: human capital and physical capital are both capitals. They should be able to exchange with each other and obey similar rules when it comes to capital investment. The book value of a PhD's human capital (the cost to reproduce the capital) is greater than the book value of a, say, MBA, MPA or MFA -- think about the more years and resources they occupy. However, the market valuation doesn't seem to reflect the difference. You always hear such kind of jokes as "the faster you drop out of school, the more you earn". Empirical studies also show that master degree holders' pay increases far more than PhDs. Another way to put it, the Tobin's q of PhD human capital is less than that of MBA human capital. I suspect it is probably even <1. This is puzzling if you assume competitive market and efficient investment decisions.

This is no trivial question. People are talking about how to keep US economy competitive in the 21st century, when emerging markets have cheaper labor and larger population. A common, though loose, argument is that US should invest more in education (read: human capital), innovation and technology (still built on human capital) to keep productivity growing. However, the more is not always the better. The efficiency of human capital investment is equally important, if not more than, the quantity of human capital investment, when the optimization of social benefit from the investment is under concern. We consider Tobin's q less than one as lousy investment of physical capital. There is no reason why we should have double standards in human capital investment.

Go back to the question posted in the beginning. I have two hypotheses.

1. Indivisibiltiy of human capital: HC is stored in individual human beings. You can't cut a person in two and let them work in different places. When a person commands a large chunk of HC, it will cause an allocational problem. Say, a firm's optimal hiring of PhD human capital is 3.3; of course this is not gonna happen. You either hire 3 or 4, a concrete number anyway. So if you decide to hire 4 eventually, you are over-staffed with PhDs. The marginal return of the HC investment is not maximized, though it's probalby better than hiring 3. But with masters, since the HC stock in one person is smaller, allocation decisions are more flexible and easier to be optimized. So it is likely that the marginal value of installed MBAs are often greater than PhDs.

But the story is not finished yet. If market doesn't appreciate so many PhDs, wouldn't its supply decrease to the level that q ratios of HCs are equlized? Yes, if the market is running on its own. But in reality, the production of PhDs is sponsored by the government, under the name "investment in advanced education, human capital, future productivity, bla, bla, bla..." In other words, the cost of building PhD human capital is not fully internalized by the capital owner herself. The result? Yes, you are right -- oversupply! Ironically, the government's attempt to increase the quantity of human capital encourages its inefficient investment and allocation.

2. Insufficient complementary investments: Economists till today generally have a quite naive view about the linkage between technology and productivity. In most macro models, it was as if that new technology progress would automatically equal productivity. Nothing can be more far away from truth. Technology doesn't mean value. It needs to be complemented with organization strategy, marketing, comsumer behavior research, product design, and other intangible capitals. In other words, only the "right" technologies create economic value. No wonder so many research on the return/ stock market valuation and R&D activities fail to find any linkage between the two. Without complimentary organization capital investment, it's just not gonna work no matter how many PhDs you have in your research lab. In other words, we need organization capital to transfer HC into economic value. Without investment in the former, the marginal productivity of PhDs can't be very high. The policy implication is that if government wants to sponsor anything, it should sponsor the investment of the "transfering machanism", and leave the HC investment decision to the individuals themselves.

I'm not going that far to say that government should sponsor MBA education instead. But at least, it is probably no worse an idea than sponsoring PhDs.

The Urgent and the Important

2008-09-18T12:52:00.005-04:00

Go ask any person that is famous for being effective, I bet she would tell you that a rule of thumb for getting things down is to never let the urgent but minor issues get in the way of the really important things you need to think and do. See the big picture; know your major goal; otherwise you will be bogged down by frivolous concerns and mundane chores -- they are in abundant supply -- and never become anything extraordinary.

The same logic applies to the way you see the economy. Open any major newspaper this week and you'd see that the sky is falling -- we are experiencing the worst financial crisis in the past fifty years; big institutions are turning up-side-down; the whole Wall Street is going bankrupt; the government can barely keep up with the development of turmoil ... The general message is: our economy is in big trouble.

But is it?

It's no secret that financial volatility has been going up since the post-war era, while macro-economic fluctuation is becoming less and less dramatic during the same period. Whatever the reason of decreasing volatility in macro-economy -- I discussed it in other posts -- the dis-linkage between real and financial fluctuations is a well-known phenomenon. But most people, perhaps for multiple psychological reasons, still somehow see the two as one, and get the conclusion about how the economy is doing from reading financial news.

Another example is the Asian financial crisis in 1997. You read in newspaper back then that "(country's name) economy was set back 20 years because of the crisis." The analogy seems to be a huge hurricane destroyed massive amount of physical assets in the region. But hey, mind you, financial "storm" is not a storm really, no matter how much it sounds like one. See how those countries are doing now? If the above mentioned logic is correct, these economies must have magically bounced forward > 20 years since the crisis.

Set aside the political controversy, I agree with John McCain -- "our economy is fundamentally sound." I'm talking about the real economic life you and I are living everyday, the production of useful goods and services, the creation of new ideas and processes, the various activities that are maintaining and improving people's standard of living for now and for the future. To this "real" economy, what is crucial is not the increase and decrease of monetary "assets" recorded in accounting books, but how to maintain the upward trend of productivity growth and hence, economic welfare of real people. In this sense, we are doing ok now, not superbly, but still ok, if we don't let the urgent crisis diverge our focus for too long, from the truly important concern.

If you look at August's industrial output data, you'll see that except automobiles, the sales in other industries are still stable, some slightly increasing. The major hi-tech sectors are doing fine, at least from the sales figure. Whether they are making necessary investment in intangible and human assets for the future, we need more information to make an assessment. But they are by no means in an "unprecedented crisis" or whatever fancy negative situations you can think of.

The financial crisis may, in the end, do a favor to real intangible investments in this country, which we terribly need for the future. I suspect many college kids, due to the negative coverage of financial sectors, will choose other majors to invest their human assets in, and we'll consequently see more engineers, artists, designers and scientists entering the labor market in the near future, instead of more investment bankers. They are the real assets of the economy, and the increase and decrease of these intangible assets is of first-order importance, something policy makers, media, and everybody else should devote their relentless attention to. Don't let the urgent attract your focus for too long. Get back to the important!

Elusive Boundary between Manufacturing and Service

2008-09-15T19:49:00.004-04:00

The boundary between manufacturing and services industries are becoming less and less clear, with manufacturing firms increasingly base their value-added on intangible assets, and boost the service content in everything they sell.

Hewlett-Packard recently acquired a major outsourcing service company for $14 bn and obviously thinks it's worth the money. The firm will cut 25,000 jobs during the merger, and reinvest the saved wage cost in, guess what, other intangible assets:

Once completed, the restructuring program should result in annual costs saving of $1.8 billion, H-P, which the Palo Alto, Calif., company will reinvest in areas including sales and emerging markets.

Four months ago, H-P unsettled investors when it announced it was considering the complex deal, which will expand its small presence in outsourcing and consulting. They dumped shares, unpersuaded that the combination would benefit H-P and worried that H-P was overpaying.

This is also an example to show why and how cost of goods sold decreases, while sales, general & administrative expenses are rising. The trend is really just a reflection of the fact that firm growth is relying more and more on intangible investment.

Empirical Findings Confirmed Hypotheses, So Far

2008-09-14T22:14:00.003-04:00

It's time to do a short summary of the empirical results I got so far.

Time range:
1955- 2003

Dependent variable:

9-year rolling standard deviation of sales growth for publicly-traded US manufacturing firms.
Average firm std for manufacturing industries (sic code 20-39).

Explanatory variable:

market/book ratio
sales/fixed asset (gross plant, property, equipment) ratio
5-year and 10-year lags of (1) and (2)
sg&a expense/sales ratio
cogs expense/sales ratio
employment
total asset
market value
R&D expense
gross fixed asset
year dummies (49 in total)

Result:

Positive, significant: sales/ppe ratio; m/b and 5-year lagged m/b; sg&a/sales; market value.
Negative, significant: lagged sales/ppe; total asset; employment;
Positive, insignificant: sales; R&D expense;
Negative, insignificant: 10-year lagged m/b; cogs/sales

The results for firm and industry are different, to be sure, but the signs are generally the same. And as expected, coefficients of year dummies show an increasing trend over the years.

Interpretation:
sales/ppe corresponding to Y/K in my theoretical model. In the model, Y/K decreases as share of K in the production function increases, i.e. tangible-intensive firms have low Y/K. The model predicts that tangible firms are generally less volatile, as confirmed by result (1). But as intangible's share increases, tangible firms' volatility rises sharper. If we assume that intangible does increase over time, then result (2) -- negative coefficent for lagged Y/K -- seems to confirm the theory. And of course a basic implication of the model is that volatility increases with intangibles' share. If sg&a is an approximate for intangibles' importance, then result (1) also confirms this implication.

This is just tentative conclusion. I'm still thinking about it.

The Value Added of Tap Water

2008-09-14T20:32:00.002-04:00

Thinking selling water is no fancy business? Think again. There is tremendous value can be added using such mundane input as the plain water running directly out of your tap, as this New York based water company has shown. Yes, you can sell your tap water with a by no means low mark-up. How? Read the firm's manifesto:

Year after year, bottled water companies have told us that their water was somehow healthier or better for us than our own water. They spent billions of dollars on marketing to make us believe that we needed exotic water, in sleek packaging, from far away Arctic glaciers, tropical islands, and European volcanoes.

We fell for the fancy marketing gimmicks, too, and the brands we drank started to become status symbols.

But we're New Yorkers and are ready for an honest change. It's time for a better way of thinking drinking: A Tap'dNY Manifesto for the new age.

Again, we are living in an age when intangible value-added through innovative design and ideas triumphs the value created by simply adding capital and labor together. Productivity is a concept that needs to be redefined. The question is how.

Why macro shocks are less powerful in intangible economy

2008-09-13T19:29:00.004-04:00

Some people asked me why I said investing in intangible capitals insulates the firm from common shocks. Let's examine the different kinds of shocks that would affect an economist's peace of mind one by one.

Demand shocks: a major goal for companies to invest in brand capital is, in economists' words, to decrease the price elasticity of the product. The demand fluctuation for a firm with huge brand equity would be lower than firms that produce homogeneous goods (Think of coke-cola, starbucks, etc.)
Supply shocks (e.g. shocks in material prices): it's well known that output per unit of raw material input has been going down since 1920s (e.g. Drucker, 1990). For a firm that builds its added-value upon intangible assets, materials constitute a relatively small part in its output. Thus the effect of supply shocks would be less dramatic for intangible-intensive firms.
Monetary policy shocks: firms whose assets are largely intangible have less collaterals that can be used in debt financing. They borrow less than "tangible" firms, therefore affect less by interest rates and the propagation of shocks through credit channel.

Hope it helps to answer the question.

Amazing Change in Cost Structure

2008-09-11T22:05:00.012-04:00

I calculated the average "cost-of-goods-sold/revenue" (mcogs_y) and "sales-general-administrative-cost/revenue" (msga_y) ratios for publicly traded US manufacturing firms from 1950 to 2007. Here is what I found:

The total amount of COGS and SGA, over total revenues:
Look pretty, don't they? The interpretation: cost related to intangible capital investment has increased sharply since late 1970s, while the cost directly occurred in production has declined. The decline in cogs can also be related to trade and outsourcing (cheaper material and labor inputs from overseas), which further boosts the trend of firms creating value-added in their products through intangible investment. (It'd be interesting to study how much of the decrease in cogs is caused by foreign inputs.)

An interesting comparison --the trends of firm-level sales volatility and aggregate sales volatility:
I'm really not selling my theory. Think for yourself.

BTW, here is the US GAAP definition of "Sales, General, Administrative Cost"; it captures many aspects of firm-specific intangible capital accumulation (e.g. brand equity, R&D, organization management, IT, professional training):

Advertising expense
Amortization of research and development costs, including software costs
Bad debt expense, provision for doubtful accounts
Commissions
Directors' fees and remuneration
Engineering expense
Foreign currency adjustments when included by the company
Freight-out expense
Indirect costs when a separate cost of goods sold figure is given
Lease expense
Marketing expense
Operating Expense – Totals when a separate cost of goods sold figure is given and there is no selling, general, and administrative expenses
Parent company charges for administrative services
Pension, retirement, profit sharing, provision of bonus and stock options, employee insurance, and other employee benefit expenses, for non-manufacturing companies
Research and development expenses, unless included in cost of goods sold by the company
Research revenue that is less that 50 percent of total revenues for two years
Software expense
Strike expense
Extractive industries' lease rentals or expense, exploration expense, research and development expense, and geological and geophysical expenses

Definition for cost-0f-goods-sold: COGS "represents all costs directly allocated by the company to production, such as material, labor and overhead."

Two Hypotheses on Value Stock Premium

2008-09-06T20:29:00.003-04:00

I was thinking of two related hypotheses on why low M/B (value) stocks outperform high M/B (growth) stocks. Both involve intangible capital accumulation.

The value premium can be a result of elevated volatility of tangible-intensive firms when the intangible's share increases. Compared with less tangible firms, their volatility increases more, thus investors need to be compensated by higher returns. Because the explanation is based on volatility, I call it a 2nd order hypothesis.
Alternatively, the premium can be a indicator of real value generated during the period when a tangible firm increases investment in intangibles. Intuitively, a unit increase of intangible's share generates more value marginally in an tangible-intensive firm than in firms which are already relying heavily on intangibles. Thus the increase in market value for value firms is more than in growth firms, provided that they both raise their intangibles' share over time. I call this explanation a 1st order hypothesis.

My intuition is that the 1st order factor is more important than the 2nd order one, though preferably they both matter.

But how the hell am I gonna test them? ... ...

The Innovator's Dilemma in Cellphone Market

2008-09-05T20:02:00.005-04:00

Traditional cell phone makers' product margin and market shares are threatened by the entry of "smart phone", which is in fact a new product category that covers the function of cell phones. The case can be seen as a typical "innovator's dilemma":

Incumbent firms owe large market shares of a mature product.
They innovate diligently to improve the function and quality of the product.
Competition is intense and prices go down continuously, but firms with sufficient R&D and good marketing strategies survived. Eventually there are only several big players in the market. For cellphone, they are such firms as Motorola, Nokia, Samsung, LG, etc.
Over the time, a relationship model emerged between firms, their suppliers, distributors and customers. Firms innovate according to the need of their "market", i.e., their strategies cater to the demand of their partners. E.g. firms developed pricing strategy that uses the profit of high-end products to supplement low-price product lines, so that the firm can acquire a big market share, but keep decent margin. Firms also built long-term relationship with service carriers and base their product designs on the need of carriers.
A disruptive new product is invented, e.g., smart phone. It initially has very limited market share and the margin is low. The technology is not mature and requires a long period of trial-and-error to test and market the product.
Large existing firms don't invest significantly in this new product, because their R&D and capitals are tied in improving their old product lines, and also because a change of focus would upset their present partners.
Small, new firms which exclusively focus on this new product are born. They expand quickly, along with the growth and maturing of the new market.
Large firms start to develop their own product in the new category. But unfortunately, it's already too late. They are chasten out of the market and eventually... ... become history.

It doesn't look like the incumbent cellphone makers are avoiding this trap in any way smarter than their ancestors. Nokia might be an exception. But I have no access to more detailed information about the firm. In any event, the play just started. Time will tell.

The Battle between Two Capitals

2008-09-05T15:45:00.005-04:00

Calstrs, the 2nd largest pension fund in US, decided to decrease investment in Blackstone's new fund. Read WSJ story here.

The nation's second-largest pension fund intends to invest just $250 million into Blackstone Group's newest private-equity vehicle, a rollback from the $1.7 billion it committed to the firm's prior fund, according to people familiar with the matter.

The move by the California State Teachers' Retirement System, or Calstrs, which manages $160 billion in assets, is an example of obstacles piling up before the private-equity business. Buyout funds depend on a constant stream of outside investors, known as LPs or limited partners, for the capital used to make deals.

On the backs of a buyout binge in 2006 and 2007, private equity raised record amounts of capital and are now sitting on about $450 billion of cash, according to data provider Preqin.

The so-called "venture capitalists" or private equity fund general partners are really not capitalists in a traditional sense. Because these funds are not major owners of any monetary or physical capitals. What they do is to take "other people's money", invest it in industries, and charge something out of the return. But as the record of past decade has shown, they are more critical part of the process than capital owners when it comes to investment. You can think of what they contribute as the intangible capital in an asset management business, i.e. the knowledge, experience, network and structures required to make investment decisions.

It's not appropriate to dismiss the relationship between LPs and GPs as principals and agents. Because GPs are not strictly "hired" by LPs to run the business and get compensated for what they do. The return on PE investment is shared between LPs and GPs, i.e., they are both residual claimers. Of course, you can argue that the shared part is merely an incentive package to encourage diligence on the part of GP, and we go back to the old principal-agent framework. But the problem is that P-A framework emphasizes on the friction caused by asymmetric information between the two parties, and assumes the "principal"'s dominant decision-making right. It hides the crucial aspect of the relationship, that the bargaining powers of the two sides are at least equal, if GPs don't have even more power.

Therefore, it's more favorable to see the relationship as between two "capitals", tangible (monetary assets) and intangible (knowledge, information and expertise). The private equity binge during the past two years is a sign that intangible asset, in a world abundant of tangible capital, is becoming the real scarce resource. If the economic history of the 20th century is one about the war between capital and manual labor, ending with the sweeping victory of the former, the battle field is now shifting to between the two different capitals. Although the balance of power will change from time to time, depending on their relative short-term supplies, the long-run trend will probably favor the intangible one.

Macro Policy in A Heterogeneous World

2008-08-28T13:20:00.007-04:00

I was just looking at the memo of Fed open market committee's August meeting on the 2nd quarter's fundamentals. My general impression is that heterogeneity is looming large in every aspect of macro data.

Look at price level first. Yes, inflation is rising. But the increase of price index is mainly driven by energy and food (and the latter is driven by energy, too, as bio-fuel makers are bidding against your breakfast cereals for corns). In contrast, it is well-known that prices of machines and equipments, and consumer electronics such as computer hardware and software, have been constantly going down. They still are.

Then look at labor market. Sure, unemployment rate is heading up. But again, it's mainly happening in a bunch of sectors that are the victims of soaring energy price and housing bust, like motor vehicle and construction. Some sectors, such as non-business services, including health and education, are still net gainers of employment, even in this seemingly unfavorable time.

Look at manufacturing output. Motor vehicle sector tumbled, to be sure. Maybe some other traditional semi-durable goods declined, too. But high-tech equipment production is still expanding.

Look at business spending. Again, some categories declined, like things related to transportation. But spending on computer and software is still rising.

To sum up, what were brought down by the oil shock and credit crunch are sectors relying heavily on materials and tangible assets. Intangible-intensive industries, like electronics, software, business and non-business services, are left relatively intact by either shocks. The reasons are pretty clear. First, value creation in these industries doesn't crucially depend on energy consumption. Second, partly for the lack of tangible collaterals, these industries borrow much less than their brick-and-mortar peers; thus keep themselves away from the shock propagation mechanism through credit channel. Fortunately, they are also the growth sectors in US economy.

Of course, the economy has always been heterogeneous -- no two firms are ever the same. But at a time when all major industries tend to be affected by the same macro factors to a considerable extent, individual heterogeneity can be treated as a 2nd-order concern for macro economists, in considering policy response to shocks. It is not a time that we are in, and will be an assumption farther and farther away from reality.

The textbook response of central bank for rising inflation is to raise interest rate accordingly. In a heterogeneous world, the execution of the rule is much more tricky. In some cases, it might not be a relevant policy tool at all -- interest rate is important for a relatively "tangible" firm, say, GM; but for Google, it probably means nothing more than another headline in the company's news channel.

Why anti-trust regulation may no longer be relevant

2008-08-27T18:46:00.004-04:00

Microsoft just announced its new web browser IE8, which seems pretty good. NYT's technology blog comments on the substitutability between browser and other data precessing applications:

Today, the browser challenge — though not Netscape — is alive and well. And it is far more realistic now. The tools for making richer Web-based applications have vastly improved. There is the rise of cloud computing, with its promise of shifting all sorts of computing tasks from e-mail to word processing onto the Web. And there is the proliferation of powerful cellphones that can handle many computing tasks via a mobile browser.

So the browser could become “the universal client,” noted Peter O’Kelly, an independent analyst. And Mr. Andreessen was “just ahead of his time,” Mr. O’Kelly said.

This is just another example of the fact that "monopoly" is becoming less and less a threat to market competition. Industry boundaries are no longer fixed, as technology innovation speeds up the creation of new product categories and re-defines the old ones. The result: monopoly power in an established product market is less favorable an advantage; even if you beat all the other similar products, the fatal competitor may well be from a completely different industry.

41 effective ways human beings created to entertain each other (since this year)

2008-08-27T13:47:00.007-04:00

trendwatching's new collection: 41 innovative products and services launched this year that have received global attention. An amazing gathering. Notice that few of them fit into the traditional idea of systematic "research & development". And most of them come from small, new enterprises, which are actually a major engine of intangible-capital creation. Entrepreneurial efforts, mainly made in intangible investment, are largely missed out by GDP accounting. To add a R&D satellite account to GDP measurement - BEA is doing this - is no big help because these activities are happening outside of established firms' research departments. Actually, R&D data, as those gathered by the National Science Foundation, is a poor description of economy-wide innovative activities -- 80% of reported R&D expenditures occurred in 4 industries, and they are dominated by large firms with 1000+ employees. Maybe what we should do is to set up a "IPO production account" for the valuation of "idea capital" creations that are materialized and traded in the marketplace.

Sorry, this is not a hotel - Part 2

2008-08-26T10:53:00.005-04:00

Because of my weird experience Sunday night, I searched for "King Arthur's Motel" online and here is a review I found about the place. Now I feel very grateful to the doorman at the motel...

Nestled between the "New England Produce Distribution Center" and the "Cash and Carry" and directly across from a porn/buritto vendor this place takes up the prime real estate of downtown Scaryville. STAY AWAY. Do not go after dark. Should you chose to go during daylight hours, do not stay longer than 15 minutes. Sure the strip club is totally nude... sure its only a 10 minute drive from downtown Boston. STAY AWAY. You only have one life to live, and King Arthur's is the prime locale to lose it.

One testament to how shady this place is: some enterprising young man saw a business opportunity from the mounting body count of King Arthur's - so they built a Dunkin Donuts next door for the cops to hang out at while they wait for the next '187'. Business at Dunks is booming... while I was at King Arthurs there were a minimum of two police vehicles parked outside.

At King Arthur's speaking Spanish/Portugese will be to your advantage... I speak broken Italian.. which can only get you a broken arm... so I chose not to speak.

Ok. you say... ok. But what about King Arthur's Motel and Lounge.. I want more details... well here they come -

King Arthurs used to be a sketchy motel and bar in an sketchy industrial part of town... the years have not been too kind.

It is now a strip club/lounge/bar/pool room/motel... don't play pool here. Just get back in your car and drive away. As I drove by, I saw this place as a potential real diamond in the rough dive bar - boy did I underestimate it. I walked through the sidedoor and was impressed by the blaring hispanic music, poor decorations and multiple gaming opportunities... my buddy and I sidled up for a $3.50 Bud Light (pricey) and just enjoyed taking in this dive. I decided to go exploring for the men's room... After being thoroughly impressed with how far the fake suits of armor in the 'motel lobby' had fallen into disrepair I found my way to the bathroom. In addition to fully operation indoor plumbing (a surprise) I saw some pretty wild items available for purchase in the men's room, the kind of stuff I have only seen available in during my trip to Byelorussia (you will have to wait until Yelp goes international to hear those stories) - after exiting I noticed a second bar on the far side of the motel lobby... low and behold it was a strip club... a packed strip club at 4:30 in the afternoon. After quickly surveying the surroundings I decided it was in my best interest to flee.

I have no idea what the Motel section is like. I think by the time you are asking those sorts of questions you are probably reading this on my stolen laptop as you drive to the nearest pawnshop for some crack money... I can't tell you any details, but I am guessing the rooms are rented by the hour... just like the ladies.

Should you chose to visit King Arthur's despite my warnings here is what you will need: a 4X4 vehicle (preferably something more intimidating than my girlfriend's Jeep Liberty) because Beecham Street is like navigating the Trans-African Highway through the rough part of Kenya; a flak vest - for when the natives get restless; a mounted 50mm - for cover fire during the get away; a fist full of quarters for the Men's room vending machines; and a fist full of dollars (because its not just a great movie, its how you get the ladies attention).

As a final comment. Please don't go here. I will feel terrible if someone gets shot/shived/crucified because my stupid Yelp review aroused too much curiosity from a good, albiet foolhardy soul.

A Tale of Two Cities - Part 2

2008-08-25T19:43:00.002-04:00

Lowell, MA is a small town about 35 mins' drive to the north of Boston. It was named after Francis Cabot Lowell (1775-1817), one of the founders of New England textile industry and inventor of "Lowell System", the innovative industrial practice of employing local women as mill workers, offering them lower pay than men, but better benefits and training opportunities than traditional factories. The system was later adopted by Amoskeag Company and the entire textile industry, and transformed the whole concept of employment for women.

Before the 19th century's textile manufacturing boom, fabric and clothes were manually made and very expensive. As a result, a better part of a lower-class woman's day was engaged in knitting, sewing and cloth-repairing. Textile-related work was a major form of household production, and you may call it a typical "career" for a woman, except that she didn't have many other options anyway. I took this picture of a 18th century "home office" at Strawbery Banke, Portsmouth, NH -- a working-class neighborhood where houses and streets were largely kept in their original structure from the 17th century:
The room is called a "sewing room", in which the housewife was supposed to spend a lot of time busily working.

Then came the textile mills, and the career path for a small-town girl was entirely changed. To attract women workers from local communities, textile companies provided clean boardinghouses, ordered working environment, and various religious and educational activities. Since working on a loom doesn't require much heavy physical labor, but emphasizes patience and attention to details, women were no less productive than male workers, yet could be hired at a lower wage. The Lowell System greatly increased productivity of the mills. By the end of 19th century, there were more women workers in Amoskeag mills than men. Like Manchester, Lowell's economy was entirely tied to textile manufacturing. With the decline of the industry, the city stumbled. I didn't find any textile looms in Lowell, either. But where have all the girls gone?

I got some ideas when I met Tegan in a parking lot in downtown Lowell. The parking lot is affiliated to an old-mill-transformed apartment building, which is also the home of a small museum and a local newspaper. Young, energetic and professional, Tegan works for Siemens Company as a sales manager of radiology equipment. She grew up in New England, and bought a two-bedroom in the old-mill building when she moved to Lowell not long ago, attracted by the small urban environment that is both modern and historical. Under the assumption that I could be a potential tenant, Tegan invited me to visit her apartment. The unit was contemporary-looking and well designed. It's pretty cool to have the mill gate as the door of your walk-in closet, isn't it?
The idea of remodeling a mill into apartment units is indeed quite appealing to modern knowledge workers, who constantly seek expressions of uniqueness and creativity. The intangible-intensive industries thriving around today's Lowell, supported by excellent research institutions and a financial center in the region, make the city look very attractive to them. Tegan is very happy with her apartment, and engaged her professional skills as a sales manager in persuading me to move to Lowell. I said I would think about it. Actually, I saw a company named PhD, Inc. on the business tenant list of Mill #11. Maybe that's a good place to work :)

A Tale of Two Cities - Part 1

2008-08-25T17:14:00.002-04:00

I'm back from New England. Before the trip, I said I was going to look for some old textile machines. I didn't get to see any and I will tell you why.

Manchester is the largest city in New Hampshire. It was built in the early 19th century as a pure textile-mill town. The ambition of the town's designer is conspicuous in his own words:

The town was home of once the biggest manufacturing company in the world -- Amoskeag Textile Company. At its peak in 1910s, the company operated 24,200 looms and employed 17,000 workers.
To attract workers, Amoskeag built apartments, schools and hospitals around Manchester. The superior infrastructures, along with the income brought by the booming textile industry, made Manchester an affluent and most modern city by the 19th century standard. The thriving working class also created vast markets for other industrial products and attracted other companies to set up their manufacturing bases in the region. I found this 1910s' ad poster of Budweiser beer in the nearby Anheuser-Busch plant in Merrimack, MA:Notice what's at the bottom of the poster -- a textile mill! The ad obviously had its textile-worker customers in mind. I bet you rarely see any commercial so narrowly targeting a single demand group. Its mere existence tells you the impact of textile industry to the local economy at the time.

However, the gigantic Amoskeag failed to make a flexible transition when electric engines began to replace water power. The coming of great depression was certainly no help. Amoskeag went bankrupt in 1935. And Manchester lost its growth engine accordingly.

The city was mostly left out by the second industrial revolution, its economy struggling for a better part of the 20th century. Today, you can hardly find any trace of the once thriving textile industry except from those beautiful red-brick plant buildings, which are still the major landmark of the city.This is why I didn't get to see any textile machines. They were all sold or abandoned long ago. But the story hasn't finished yet. When I went inside the mill buildings, I found that they have acquired new occupants recently. You can see what are in them now from the pictures I took in mill #11:You can probably guess what I'm gonna say next. Yes, the textile mill has re-invented itself as a cool-looking habitat of small, young companies in a wide variety of intangible-intensive industries, raging from software design, health care to graphic design and business services.

In fact, this is the economic direction of the whole city. Today, 85% of Manchester's workforce is employed by sales, finance and other services companies. And it is emerging as a major insurance and financial center with businesses, attracted by lower rents and convenient transportation, increasingly moving from Boston area.

Sorry, this is not a hotel...

2008-08-24T21:51:00.002-04:00

I just checked in at a hotel (a normal-looking one) close to Boston airport, will fly back to DC tomorrow.

I got to Boston pretty late tonight and thought I'd better choose a hotel near the airport, to make sure I catch the early flight tomorrow morning. With no map, no phone number, no internet connection, I, as a kid used to relying on high-tech stuff to acquire information, was literally powerless. But I was very confident about the task at hand, because I was armed with a most powerful and efficient road-trip gadget of our time -- a GPS!

So I told my electronic buddy to find a hotel nearby. It did a splendid job and offered me more than a dozen options. But unfortunately, most of the names listed belonged to fancy hotel chains, not the kind of places I usually stay on a road trip. "Baby, why don't you show me something cheaper?"... I went through the whole list again and finally spotted a hotel with an ironically contradictory name, which I interpreted as meaning "cheap" -- it's called "King Arthur's Motel". And my GPS said it should be within 15 mins' drive.

Perfect. Let's go! In the next 10 minutes or so, the GPS guided me drive through some convoluted streets in an unknown neighborhood of East Boston. Though it was too dark to see anything clearly, I sensed it was not a decent area, with dim red lights flashing at street corners here and there. I was very confused and increasingly suspicious, but thought maybe I was just driving by.

After almost like forever, I arrived at King Arthur Motel. I was satisfied at its bawdy appearance outside. See, I told you it must be a cheap hotel. A middle-aged, serious-looking man greeted me at the front desk:

"Hi, can I help you?"
"Yes, do you have rooms available?"
"Rooms?"
"This is King Arthur's Motel, right?"
"Yeah... but the hotel is closed."
"Closed?"
"Well, it used to be a hotel. But right now we have a bar here," he is friendly smiling now. "Well, actually... this is a strip club."

Good job, GPS!

New model ready to weather the brutal empiricals

2008-08-21T21:29:00.000-04:00

Just got some preliminary results from my heterogeneous-firm model --

As in previous model, firm-level volatility increase with intangibles' share in production.
Firms with more tangible capitals are less volatile, controlling for the share of intangibles.
When intangibles' share increases, volatility of relatively "tangible" firms increase more than their counterparts.

The graph below says it all. Volatility changes with rise in intangibles' share for three types of firms, in terms of their capital tangibility (you guessed right: the more solid the line, the more "tangible" the firm is).

I'm thinking that if (2) and (3) are true, it can provide an answer to the growth stock/value stock question Pete mentioned the other day. The intuition: generally value stocks (low M/B ratio, "tangible" firms) tend to be less volatile, but their volatility increases more than growth stocks over the course of rise in intangibles. So perhaps their higher return is to compensate for the greater increase in volatility.

Anyway, I should do the much-delayed data crunching first and test this baby with reality... I mean, after I come back from New England. I'm heading to Massachusetts tomorrow morning for the weekend. The main mission is to hunt for small textile-mill towns. Maybe sitting beside some ancient machine of early industrial age will give a glimpse of insight into the future. Who knows...

Closed form solution

2008-08-19T13:09:00.000-04:00

This week I've been working on finding a closed form solution for heterogeneous industries with different levels of asset tangibility. An analytical solution is wanted because it's more straightforward to draw other empirical predictions based on a model that presents itself fully right in front of you.

It's coming together gradually. I can solve this now seemingly more complicated version in closed-form mainly because I used a special modeling design of capital accumulation by Robert Lucas Jr. in 1970s. Thanks, Bob!

Volatility in tangible-intentive industries

2008-08-17T11:29:00.000-04:00

Tangible intensive firms, like this one in construction industry, are more affected by macroeconomic factors, as they have greater capacity to leverage, thus prone to monetary policy shocks. At the same time, since tangible-intensive firms are relatively homogeneous, they are more vulnerable to market-wide demand shocks than their intangible-intensive counterparts.

Seth Godin on intangibles

2008-08-14T20:48:00.000-04:00

From the marketing guru, on why intangibles can decrease price elasticity of a product and how to make it happen.

News agency's organization chart changing

2008-08-13T07:58:00.000-04:00

Technology is fundamentally changing the organization structure of large news agencies. The definition and size of a "bureau" is shifting. Story about CNN's recent move:

... in a reflection of the way television networks are reinventing the way they gather news, the journalists will not work from expensive bureaus — rather, they will borrow office space from local news organizations and use laptops to file articles for the Internet and TV. When news happens, they will use Internet connections and cellphone cameras to report live.
“We are harnessing technology that enables us to be anywhere and be live from anywhere,” said Nancy Lane, the senior vice president for news gathering for CNN/U.S., a unit of Time Warner. “It completely changes how we can report.”
... a new breed of reporter, sometimes called a “one-man band,” has become the new norm. Though the style of reporting has existed for years, it is being adopted more widely as these reporters act as their own producer, cameraman and editor, and sometimes even transmit live video.
... ...

“Even the word ‘bureau’ has changed over the years,” Mr. Reiter said in an interview on Tuesday. “Not that long ago, one person couldn’t go out and do the shooting, the reporting, and the feeding of video into New York. There are easy ways to do so now. The technology and the demand have come together to make these one-person bureaus realistic.”

Advanced statistics

2008-08-12T22:30:00.000-04:00

How many times egg whites increase in size when whipped?
-- 7

How much a ten-gallon hat holds?
-- 3/4 gallon

What's the average number of times African elephants defecate per day?
--16

Productivity and firm size

2008-08-12T21:58:00.000-04:00

“Research by the European Union on small and medium-sized enterprises (1-499 employees), has shown that whereas SMEs are less productive than larger enterprises in capital-intensive industries like manufacturing and mining, small knowledge firms (producer services, retail trade, construction, personal services, etc) are more productive than their larger counterparts.” (European observatory for SMEs, annual report 1995)

When the production content gets intangible-intensive, optimal firm size becomes smaller. The higher labor productivity in small firms, along with increased intangible reliance of traditional manufacturing industries, pushes labor to flow from huge corporations to SMEs and help the latter grow. The question is, how to use the data available on market -- mainly cross-sectional -- to make a convincing empirical argument for the hypothesis?

Quote of the day -- the nature of capital

2008-08-12T15:14:00.000-04:00

I'm sorting through some old literature, and just found this little gem from Thorstein Veblen, which is probably too old to be quoted by most of today's papers -- sometimes I suspect the shortened social memory simply makes us create same ideas again and again...

On the nature of capital:

“Under a changed technological situation the capital goods of (previous) time have become museum exhibits, and their place in human economy has been taken by technological expedients which embody another ‘state of the industrial arts’.”

“When the specific technological expedient (the tangible tools) embodies ceases to be effective in industry, in competition with ‘improved method’, it ceases to be an immaterial asset. When it is in this way eliminated, the material repository of it ceases to have value as capital. It ceases to be a material asset.”
A major difference between industrial and post-industrial age lies in whether the majority of state-of-art intangible knowledge is embodied mainly in mega-size machines, or carried by workers and organizations. The former empowers physical capital owner, the latter empowers worker/knowledge owner.
(Well, I confess, the last paragraph is mine.)

How to get ideas?

2008-08-12T14:44:00.000-04:00

Five steps generalized by James Webb Young, a famous copywriter:

the mind gathers its raw materials -- specific knowledge about subjects and people, and general knowledge about life and events;
the mind goes through a "process of masticating those materials".
you drop the whole subject and put the problem out of your mind as completely as possible.
out of nowhere the idea appears.
take your little newborn into the world of reality and see how it fares

By the way, scientific research (definition wanted) also found that boredom is a prerequisite of break-through, and sleeping is good for your brain. So if you get bored, take a nap...

The Great Dissolution: Intangible Capital and Diverging Volatility Puzzle

2008-08-11T13:49:00.004-04:00

A short introduction to my current project...

The aggregate output volatility has been decreasing since 1980s. People call it "the Great Moderation". Economists have listed many reasons, such as:
1. We're just lucky.
2. We had a magician as Fed Chairman.
3. Our financial system is so damn good that all the risks are "diversified".
4. Companies have got a way with inventory management.
5. Other incredibly fabulous theories...
But most of these theories can't explain, if not blatantly contrary to, another aspect of data: the average volatility of sales growth for publicly-traded US firms has been going up in the same period. It's puzzling if you think of aggregate output simply as the sum of all firms' outputs.

The reconciliation lies in increasing firm-specific risk, a result of elevated intangible capital investment, and decreasing correlation among firms, due to the same reason.

Modern firms have been investing heavily in intangible assets, such as R&D, organization management, intellectual property, software, brand name -- the "stuff" that distinguish a firm from the sumtotal of its physical assets. Empirical study (Hulten, Corrado & Sichel, 2005) estimates that by the end of 1990s', the size of total intangible capital investment in the economy had surpassed the tangible part, amounting to about 15% of GDP.

Most intangible capitals are firm-specific, inseparable from the company that originally produced them, and difficult to trade on outside market. Investing in these organization-specific assets insulates a firm from market-wide shocks, but introduces higher firm-specific risk that does not equally affect its peers. When value creation is increasingly relying on intangible capital, it causes: 1) more volatile individual firms; 2) more heterogeneous firms and less correlated business performances.

Therefore, decreasing total output fluctuation is not a result of less turbulent macro environment, but simply means that firms no longer move together. In this sense, the Great Moderation is rather a story of "Great Dissolution". It may well be a by-product of greater economic uncertainty faced by individual agents, instead of less.

I used intangible investment number from HCS (2006) to simulate an economy with macro shock and uncorrelated firm-specific shocks. Here is the result:

A trillion Zimbabwean dollars...

2008-08-11T09:46:00.000-04:00

Found on the web (by my guest blogger JM)...

Very funny line from comedian Lewis Black on "The Daily Show" this week, commenting on the horrendous inflation that made 2 cans of beans and a loaf of bread exceed a trillion Zimbabwean dollars:

"A trillion dollars for baked beans? I didn't know they had a Whole Foods in Zimbabwe!"

Meet the new enterprise model: AGA (Apple-Google-Amazon)!

2008-08-11T09:07:00.000-04:00

Iphone business is reaping the benefit of mass intelligence in software design, after it opens online iphone application clearinghouse, see WSJ report here.
The model looks like a hardware platform+internet content distribution channel+collaborative content provider...

If sales stay at the current pace, Apple stands to reap at least $360 million a year in new revenue from the App Store, Mr. Jobs said. "This thing's going to crest a half a billion, soon," he added. "Who knows, maybe it will be a $1 billion marketplace at some point in time."
"I've never seen anything like this in my career for software," he said.
"Phone differentiation used to be about radios and antennas and things like that," Mr. Jobs said. "We think, going forward, the phone of the future will be differentiated by software."

What happened to debt/equity ratio?

2008-08-10T20:44:00.000-04:00

Debt/equity ratio for the entire publicly-traded company pool has been going down since mid 80s', as reported by Robert Hall in two of his 2001 papers. This fact is confirmed by Jovanovic & Rousseau, also in 2001, for all vintages of firms (so you can't say it's a small-company or newer-listing effect).

I suspect this has a lot to do with the increase in intangible assets, since intangibles are mainly firm-specific and hard to be used as collateral (of course counter-argument exists, say, it also makes firm less likely to default because if you go bankrupt, the owner of intangible-intensive firms gets little, if assets "disappear" with the firm). It can be an interesting research topic, worth further thinking.

I work for Google? Or a new type of organization

2008-08-10T18:50:00.000-04:00

Google's business is extending beyond a conduit for ready-cooked information into information-creating. Well, not exactly. The content provided by numerous sources through, say, Blogger.com, is not owned by Google, but the creators themselves. An analogue of the relationship in traditional company would be the manufacturing department and the sales department. They don't necessarily need to be with each other. I can make widgets and contract out products distribution. But sometimes it's less costly to do it in the same firm. Similar deal between an expert blogger and Google company. Should they be in one corporation or two is a matter of cost. Bloggers and blogger.com make each others' business better. But when the boundaries get vague, it scares some people, since it looks too much like a massive monopoly over the new new media. But the nature of this type of association is totally different from the massiveness of, say, Standard Oil company.

Future is no middle ground

2008-08-10T17:25:00.000-04:00

Idea of the day:

I think a result of more intangible-intensive production will probably be--- the future size of companies either tiny or huge; medium-size companies will extinct.

Communication technology makes information cheap, including information about workers' productivity and fits, while to make this kind of information handy is an important reason for the existence of corporations. When the information advantage of incorporation is down-graded by ITC advance, it's disadvantage -- lack of flexibility, bureaucratic inefficiency, etc -- becomes more obnoxious. Intangible-intensive, customized production process thus encourages down-sizing of firms.

On the other hand, since intangible investment and creative activities are risky in the idiosyncratic sense, it'd be advantageous to bundle investment "projects"-- or a bunch of small companies together into a conglomerate and sell it to investors, just like junk bonds or mortgage bundles. This kind of integration is horizontal instead of vertical.

The result: no room for middle-size companies. In fact, there are signs that the trend has started now...

Why southwest is hard to copy

2008-08-10T16:52:00.000-04:00

Unlike other major airlines, Southwest weathers the energy challenge much more skillfully. It turns out that they bid on oil future years ago and have bought enough gas inventory at an extremely bargain price according to today's standard.

The hard-to-copy part is not the sort of financial strategy. There's no reason why other companies couldn't have gone out to the commodity future market and do the same thing. Yet financial strategy is only a tree in the forest, part of the organization's decision-making culture that only rises to surface at a difficult time. The rest part remains intangible. At the end of the day, organization capital is not any single strategy. Everything is linked and mingled together. This is again another reason why intangible capitals are hard to be classified and measured item by item.

quote of the day

2008-08-10T16:23:00.000-04:00

Old, but still relevant:

Since 1900, the unit of labor needed for an additional unit of manufacturing output has been going own steadily at a compound rate of about 1% a year. Since the end of World war 2, the unit of raw material needed for and additional unit of manufacturing output has been decreasing at the same rate. Since around 1950, the unit of energy needed for an additional unit of manufacturing output has also been going down steadily at that rate,too. But from the 1880s, since the telephone and Frederick Winslow Taylor’s ‘scientific management,’ the amounts of information and knowledge needed for each additional unit of output have been going up steadily at a compound rate of 1% a year -- the rate at which businesses have added educated people to their payrolls. --- Peter Drucker

My Website

2008-08-07T20:35:00.000-04:00

Still under (considerable) construction. But it's open: www.natashaxingyuanche.com

First Try

2008-08-07T19:08:00.000-04:00

Ok, this stuff works.