Mittwoch, März 05, 2008

Commodity Prices, Missing Investments and Illusions...

Martin Wolf is one of the reasons I read the FT.

Today he comments on commodity prices, and I think his take is, as usual, very good, but doesn't take the story far enough.

Inflation has many definitions, but let us center on two of them.

First, inflation is fundamentally defined as too much money chasing too few goods.

Second, inflation is fundamentally defined as money supply outstripping productivity growth.

All central banks and economic policy makers walk a rather narrow road. On the one hand, everyone wants economic growth: it is only through growth that the pie becomes bigger and allows flexibility in making consumption decisions, consumption here in the broadest sense. Without growth, economic policy becomes strictly a zero-sum game, and in reality a negative-sum game, where the best you can hope for is to be least effected by shrinkage.

On the other hand, central banks and economic policy makers don't want price increases merely for the sake of price increases, which creates the illusion of growth: the "real" growth of the economy doesn't happen if prices and only prices go up.

As an aside: there are some lovely language conundrums in the economics field: on the one hand, you have real investments, which are investments in real things, as opposed to virtual things, like financial instruments. Economists like to understand what drives real growth, which is, however, a theoretical construct of nominal growth and price developments, hence turning the normal concept of real on its head. People in the real world aren't that interested in knowing the "real" rate of wage growth, but much more the nominal one, since that is what "really" ends up in their bank accounts (I almost said pay envelopes, that dates me...). Hence there is real (as in real estate) and real (as in deflated figures), but one is really real, while the other one is only real to economists... you just gotta love the English language. Those who truly master English as a language can be extraordinarily precise when writing, while I always tell my students and colleagues, none of whom are native English speakers, that English is a simple language to learn and a difficult one to master. They never believe me until I get some of their writing to edit. Then they do...

Back to the subject at hand: we have, here, a complex story of supply and demand. Martin Wolf is correct in saying that increased international demand for commodities in the face of wealthier markets outside of industrialized nations cannot explain the strong increases in commodity prices fully, but it does explain them to a certain extent. One thing that Martin Wolf doesn't touch upon is the increasing monopolization of commodity producers, but that is largely driven by the increasing prices and at least to date not the primary cause.

What drives commodity prices? As always, they are fundamentally driven by the fact that commodities are scarce goods. But this is nothing new: commodities are inputs into the industrial process, where goods are made to be sold. Here is where technology has made and continues to make a difference in the use of commodities, with the relative intensity, for instance, of steel in industrial goods falling fairly dramatically over the last 30 years or so. Go look up the figures yourself: the same is true for virtually all commodities. This was, has been, is and will be the core of industrial success: it's called material productivity, and is a fairly ignored area of economic analysis outside of the manufacturing sector. There it is usually analyzed by non-economists whose sole interest is in improving the bottom line: make something using 5% less steel, for instance, and you've improved your profitability (or you can drop your prices to increase market share, ceteris paribus).

Now, material productivity is dependent on three things: engineering, design and investments. Can you see now where I am heading with this?

Engineering can tell you what you can actually do with raw and partially finished metals and other commodity inputs. Steel has a certain tensile strength and, hard to believe for non-engineers, it has a specific elasticity. Play around with the chemical components of your everyday steel and you can increase, for instance, the drawing elasticity of steel, allowing bonnets and doors of cars to be made with thinner gauges of steel than would be otherwise possible, resulting in weight savings (better mileage) and lowered costs.

Design takes this engineering knowledge and creates the products that people buy. The factories make them.

But to take advantage of such developments you invariably need to invest. Invest in your people, in new machinery, in new intellectual property, be it own or other patents, all leading to investing in new technologies that lead to significant improvements in both material and labor productivity (both together are called total factor productivity).

So, if your eyes have not glazed over at this point, what does this mean?

Martin Wolf concentrates, in his article, on what strong price increases in commodities mean to the central banks, who are the actors specifically charged with addressing the problem of inflation (which basically means working out how, in lieu of being able to dictate prices, companies in the real world can be persuaded to keep prices down): this task has been significantly made more difficult for those making the decisions of what to do by strong commodity price increases that are themselves part of the problem.

He makes three good points:

1) Central banks cannot turn the clock back and return to people purchasing power that they have lost to higher costs.

2) Central banks cannot run after each and every price increase, as economic policy based on this would lead to significant instability.

3) Central banks may ignore the trend development of commodity price increases at the risk of their mortal souls, such that they have, as this is where they face ruin.

The Fed is currently doing the obverse of this second point, which is counter-productive. Inflation expectations - which will invariably feed long-term interest rates - are on a strong upswing in the US, as the actions that the Fed takes are not having the impact that is desired, but rather the opposite, which is an extremely dangerous development.

You see, an enormous amount of economic activity is based on what I would term illusions. But not the illusions of magicians or charlatans, but rather agreed-upon illusions, agreements on how to do things that enable things to get done.

Money itself is an illusion; it's not, in and of itself, actually worth anything, but rather the value of a currency is what you can buy with it. Illusions here are, however, based in reality, but reality itself, of course, is made up of illusions that we call perceptions.

As long as everyone accepts the illusion, things work. There is no sense in trying to call these illusions to be anything but what they are: they are consensual agreements that make the world go around.

The danger is when these illusions break or become distorted. This is, after all, what happens in bubbles: people believe, even at increasingly high prices, that the objects that drive the bubble will be worth even more within a reasonable period of time with a fairly high level of certainty. If people believe that prices will fall over time, deflation occurs.

The problem we are now facing is two-fold: one is a crisis of illusion, the other is a crisis of management.

The crisis of illusion is fairly straight-forward and has been laid out for you briefly.

The crisis of management is a crisis of what to do.

Now back to investments. It is my opinion that most industrialized nations have been underinvesting for several decades at this point, both in terms of industrial investment and in terms of investment in infrastructure. The former is what companies are responsible for, the latter is what governments are responsible for.

Let's look at investment in machinery and equipment: generally speaking, corporate investments here have been to improve labor productivity, although quite a bit is involved in the technological imperative. Investments, however, largely come out of profits, either directly or indirectly via financing. Here is where the problem has started.

Within the manufacturing sector, engineers and the like no longer, largely, make the decisions of what the company should or should not do. That has become the realm of lawyers and bookkeepers, aka management. As a matter of fact, any company still run by engineers is a take-over candidate, because they - the lawyers and bookkeepers - can take it apart and sell the parts for more than what the whole is worth. This is also partially true for the services industry as well.

Investments are needed for future profits, but those profits are unknown, and it makes more financial sense, from a lawyer's or accountant's point of view, to maximize profits now at the cost of potential profits later. Hence dividends are paid and stock is repurchased to increase the value of existing stock (usually a significant amount of which is held by management). This drives up stock prices and increases the theoretical value of the company, allowing it to leverage what sort of money it can call up to do ... whatever with.

What has happened is that the connection between profits of a company and its investments has been at least partially severed, as lawyers and accountants turn manufacturing companies into financial institutions. Sometimes they still make things, but Enron has shown the madness that this path can lead to.

This development has further risks: with stock prices becoming the key metric for success, the pressure is not to make good products, but rather to obtain the highest possible rate of return (once the lawyers and accountants have driven out the engineers from running the company). Manufacturing has a fairly pedestrian rate of return, generally speaking, while financial companies, willing to take on risks, will have a higher rate of return. This in turn places the pressures on manufacturers to realize high rates of return, a vicious spiral of increasing risks and expectations of high rates of return without risks.

This isn't possible: high rates of return are always associated with high levels of risk. This is basic financial economics 101 (or really, really should be!).

The fact that this rule, this law, is so blatantly - as in the examples of subprimes, Enron and other tales of capitalistic greed and stupidity - ignored is, in my opinion, the result of the fact that management is dominated by lawyers and accountants. They are the ones whose professional careers center around "what am I allowed to do" and "how can I finance what I want to do", rather than what is more important for any industrial company, which is "how can I build what my customers need at the lowest cost for the most money".

That is the core of the problem of missing investments: if you want to stay on the curve ahead of any inflation, you need to have material productivity improvements that are in excess of commodity price increases; you also need labor productivity increases that are in excess of labor costs.

Anything else leads to a reduction in profitability. That's not my opinion: that is how the numbers work.

Hence the missing investments: the investment in new technologies, new manufacturing methods, but more fundamentally in basic science that leads us to these engineering improvements. No industrialized country is investing enough in both material and labor productivity, since that means sacrificing profits that the lawyers and accountants insist be used for other purposes.

Why? Lawyers and accountants are chasing an illusion that they never learned, or may have learned but have chosen to ignore: that high rates of return need not be associated with high levels of risk. The problem is that most risk is not visible. The dot-com startups were extraordinarily profitable, but also extremely risky, but the relative capital needed to do a start-up was relatively small and hence, for the venture capitalists, not much risk that they would lose their entire investment sums entrusted to them by their investors. That's only a relative risk, though: any start-up is a highly risky undertaking.

Sometimes you have to be an expert to see where the risks are, and while lawyers and accountants are experts in their field, they are not experts in all fields: the hubris, the false pride of both professions, that they don't need to understand a business, just understand the balance sheet, has been extremely dangerous. They tend to grab consultants to explain the business to them, who are in turn themselves ... lawyers and accountants, resulting in the deaf leading the blind, oblivious to reality.

Hence commodity price increases should be the driving force for technological innovation, rather than the threat to the bottom line that leads to price increases and inflation: while I recognize that there is a lag involved, a good company anticipates such developments. Or at least they would if they still employed economists in their strategic planning, but that is a topic for a later post. The drive for higher returns has led to missing investments, ignoring economic development for short-term financial gain and actually worsening the long-term outlook.

What needs to be done?

Oddly enough, this is where government can actually play a positive role: finance basic science. The basic science here must be aimed at solving real-world engineering problems to improve total factor productivity, and not based on what scientists want to study. It is the job of government to make the political decisions. Austria, for instance, has one of the very few well functioning government investment plan for education: they made the decision 30 years ago to create academic chairs in engineering (diesel engines) and Austria is now one of the foremost world-wide providers of diesel technology. They are now creating academic chairs in nanotechnology.

That is proper government investment in the sciences.

What else can be done?

First of all, the government should concentrate on getting its infrastructure in place, which is one of the best ways of spending government money. The Japanese have shown how it shouldn't be done, but their general direction wasn't wrong.

Second, I wish I could be as simple as Shakespeare was and expand on his famous saying from Henry VI, Act IV, Scene II, spoken by Dick the Butcher:

The first thing we do, let's kill all the lawyers.

to be

The first thing we do, let's kill all the lawyers and bean-counters.

But that is not sensible in any sense of the term, and indeed the character speaking the lines wants to kill them in order to create chaos and anarchy.

But the role of lawyers and accountants really does need to be put into perspective, instead of having reached its level of dominance in both the corporate world and elected officials.

But that, unfortunately, may prove to be ... illusive.

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