Sunday, October 04, 2009

Even Macro-Economics Suffers From Diminishing Returns

Capital, by persons wholly unused to reflect on the subject, is supposed to be synonymous with money. To expose this misapprehension, would be to repeat what has been said in the introductory chapter. Money is no more synonymous with capital than it is with wealth. Money cannot in itself perform any part of the office of capital, since it can afford no assistance to production. To do this, it must be exchanged for other things; and anything, which is susceptible of being exchanged for other things, is capable of contributing to production in the same degree. What capital does for production, is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process. These are the services which present labour requires from past, and from the produce of past, labour. Whatever things are destined for this use—destined to supply productive labour with these various prerequisites—are Capital. J. S. Mill
How many macro-economists does it take to create a profitable venture?


How many profitable ventures does it take to create a prosperous nation?

Quite a few, in a more or less continuous fashion.

I pose the above riddles not to suggest that macro-economists are worthless but to highlight the apparently ever increasing faith the state seems to place in the policies they recommend. Newspapers, TV broadcasts and web sites increasingly debate the need for stimulus and the forms it should take.

Those in favor of stimulus argue about the effectiveness of monetary vs. fiscal policies usually based on the expected multiplier effects (the change in GDP per unit of stimulus).

Some, usually the most dogmatic proponents, argue from the view that multiplier effects are constant across time and economy- they find a period and economy which exhibits a multiplier effect proving their view and rest their case. Their opponents, in response, argue that the chosen period and economy is not representative and then suggest either a "better" model, or mitigating/accentuating factors no longer present which proves their view. All, not without cause (even the physical sciences require this assumption to be meaningful), presume some constancy over time within an economy- which is assumed to only change "on the margin."

Most of the time these assumptions of rough constancy are demonstrated in reality. Sometimes they are not.

Sometimes, even in the physical sciences, durability and constancy of effect are just apparent waiting for the next earthquake, volcano or rainstorm to demonstrate a "fat tail"- that is, behave in a manner not captured in a series of medium term observations.

The fundamentals of an economy are always in flux, most of the time, "on the margin" captures the pace well. Sometimes, changes in trade routes- European discoveries of sea routes around Africa to "the Indies" and the opening of the Suez Canal are two of many such- discoveries of raw materials- crude oil in Pennsylvania, Texas and the Middle East- and technological innovations- Bessemer process and the steam engine locomotive- can lead to very rapid change in both a positive and negative sense.

On the positive side, new routes, resources and technologies lead to improved growth, some of which is "stolen" from those areas which used to supply the old routes, resources or technologies- that is, the negative side.

Often the negative effects are initially masked by increased debt or mispriced assets- the residual self image noted in the film, The Matrix. The capital stock of the nation or area is assumed to be as profitable as it had been in the past, but the underlying conditions that engendered the profitability have shifted. The implicit point being that economic growth is ultimately based not on the efficiency of monetary or fiscal policy but on the profitability of the capital stock.

Sometimes the shifts in underlying conditions that lead to decreases in capital stock profitability are not so stark- rising productivity in other nations, relative declines in key resource production (namely, in the US's case, oil) and a variant of the resource curse that afflicts some oil producing nations, but in the US's case, it's US$s.

For decades the US has clung to a residual self-image as the only economic power-house in the world, aided by the world's willingness to accept US$s in trade for goods. The capital stock of the US was designed for a world in which oil was both cheap and available in the US and has been maintained based on the continued acceptance of US$s- a practice which will eventually end. In my view, we need to retool the stock to reflect these changing conditions.

Our problems, it seems to me, are not solvable by macro-economic stimulus, although the necessary changes can be either helped or hindered by such policies. Far more important for the US is the realization that things need to change. Capital needs to redeployed. The more money spent maintaining a financial super-structure which has obviously misallocated capital, the less money that will be available for this purpose.

Recalling Shakespeare's Caesar, we need to regain that "lean and hungry look." I have faith we can accomplish this task, but only if faith in macro-economics and finance is replaced by faith in engineering and civil design.

To paraphrase Bill Clinton, "it's the capital, stupid!"