|A leaky tyre -- time to use soap spray to spot the leak . . . |
and what if you've got a bent rim? (HT: LifeHacker )
I know, I know, my titles tend to approach unfashionably Victorian era length . . . but they lay out the topical/thematic focus and help us begin to think through the matter.
Now, this time, having looked at AS-AD and how an economy can saturate while having significant unemployment and idle resources, then at how savings and long-term investments can help us move to a growth path, we need to highlight what others and I have come to call the leaky tyre economy effect.
Back in February 2011, speaking of the Montserrat case, the observation was made that the local economy was acting like a car that hit a bad pothole and dented the rim.
Even after an obvious leak or three were patched, pfft, still leaky.
More is needed than simple patches, something structural is wrong.
Let's picture the economy's growth trend with injections, to see what is happening:
So, if an economy is artificially pumped up by making a raw injection of money and throwing it at pumping aggregate demand up, the effect will be temporary (except that the population may become addicted to such money rushes). And likewise, ill-considered grandiose development projects are more of the same. Also, in both cases, inflation is liable to ratchet up and a wage-price spiral may be set off.
In the Caribbean, pressure on foreign exchange reserves is sure to follow.
Enter, stage left, the infamous devaluation debate.
With the latest International Monetary Fund structural adjustment recommendations hovering in the wings.
Scramble for the exits . . .
Not so fast.
Dr Hayek to the rescue with his investment triangle model, here set in context of the wider community basis for sustainable growth and development:
In steps of thought:
1 --> Hayek [more or less Haah-yek] and other "Austrians" have emphasised that the macro view of an economy is inevitably, inextricably tied to its micro, case by case foundations.
2 --> For instance, when we see a given product on a market (such as a new model of car or a PC), there has been a long period of research and development invested in by the firms behind the product, leading up to the inventory on store shelves and in warehouses.
3 --> This is a risky process, with heavy casualties all the way along the chain, and even after hitting the market, a lot of products fail or only have so-so sales. Problem children and dogs, to use some colourful terms.
4 --> These have to be paid for by a steady flow of rising stars that become the cash cows milked to keep the firms and their share-holders happy. (And cash cows, just like the real ones, need to be properly fed and cared for to keep the milk flowing. [Also, yes, I am using the Boston Consultants Group Growth-Share matrix investment portfolio model, with a few mods.] )
5 --> As is now usual, aggregate across an economy: bingo, we see an overall time- and- phase- of- product- development linked structure to capital investments that keep an economy going. Hayek's triangle.
6 --> An investment triangle in which, due to the inherent riskiness of investment, the stars and cash cows have to support an inevitable proportion of failures and mediocrities.
(And the temptation to then pounce on what has succeeded against the odds, recklessly accuse it of being "exploitation"without good reason, and drain its profitability though excessive taxation, regulation etc, will need to be resisted. Or the chain of investments will dry up; slowly draining the economy of innovation, competitive advantage and productive capacity. Leaving it ripe for a gust or two from Schumpeter's gale of creative destruction. . . . and BTW, as the name suggests, Joseph Schumpeter was one of the Austrians, though a bit of a fringe member. [Of course, this is not an excuse for running sweatshops or other clearly abusive behaviour by firms. Nor, for granting certain favoured firms undue protection from competition. Nor, for special favours based on under the table deals with regulators and politicians, or other similarly corrupt practices, etc.])7 --> But, as our diagram illustrates, Hayek's investment triangle does not pop out of nothing, for no reason, with no adequate cause.
8 --> Instead, like a plant growing from a seed in properly rich soil,
- it is seeded from valuable ideas coming from innovators,
- it then requires capable developers, engineers/scientists and technical staff, managers and implementers, as well as
- financial backing attuned to the degree of risk at each phase, leading to
- a pattern that lays out a critical mass for strategic change:
9 --> Once that cluster has been laid out, it is easy to see why even good and sound ideas have such a hard run of it to succeed.1: idea innovators and champions
2: sponsors, who provide resources, mentoring and support
3: incubators to provide space and resources to prove itself at least to proof of concept demonstrations
4: godfathers/ godmothers to protect at decision-maker levels, especially given
5: the inevitable reality of idea hit-men who seek to shoot down even good or potential breakthrough innovations
10 --> Indeed, for many years, there were venture capitalists in Silicon Valley, California who were making 20 - 30+% return on investment by simply hanging around in watering holes and looking for circles of sound and innovative engineers and programmers crying into their beer.
11 --> Accordingly, we also see that at each phase of the development, there are different risks, a need for different types of work force, and different levels of funding. This naturally implies different markets for different kinds of labour [with top talent being very valuable indeed . . . ], and for different interest rates that reflect the degree of risk and time of exposure to risk.
12 --> But also, we see something else, there is a community that provides the context and foundation for the triangle. (Some "Austrian" thinkers and too many Libertarians with anarchist tendencies forget this, and misunderstand that it is appropriate and even necessary and valuable for a community to set up a department to see to the required common affairs, i.e. a properly tasked and limited, ethically responsible, accountable government. [Where, on history of the past 500 years, a properly set up small-d democratic Constitutional order is a good framework for such good government.])
13 --> Thus we see a place for steady funding of such good government through taxes, and for the role of saving and investment in funding the investment triangle process and the businesses that provide the goods and services we all consume.
14 --> This then brings back up the concept of the circular flow of income and the way that across time this framework should support and sustain efforts to keep the AS-AD framework in the "safe" intermediate growth band, despite inevitable wobblings and shocks:
15 --> AS-AD, again:
16 --> In that context, as noted yesterday, we face the challenge of the production possibilities frontier and the implications of a shift to a higher propensity to save, to trigger initial slowdown and then faster growth as the triangle acts:
17 --> Of course, as was noted, the dip involved in higher savings may have harsh impact, so the issue of judicious intervention by Government and/or Development agencies, is relevant. Structural adjustment that -- in light of the Hayek triangle -- will take years, is hard.
18 --> But also, the "Austrians" are right to point out that ill judged Government interventions can be damaging, given the leaky tyre effect. Here, Garrison points out an "Austrian" perspective on some roots of the 2008 on global recession that yet has lingering effects here in the Caribbean:
Of all the losses suffered during the current recession, one of the most notable (and well deserved) is the loss in reputation suffered by today’s macroeconomics textbooks. J. Bradford DeLong admits as much—even of his own textbook—in a recent lecture on our current financial crisis. While the events that have unfolded over the past year have required some outside-the-box theorizing by mainstream macroeconomists, the economists of the Austrian school can offer a straightforward, fill-in-the-blanks explanation by drawing on the theory first articulated by Ludwig von Mises and then developed by Friedrich A. Hayek . . . .
A true-to-Hayek nutshell version of the Austrian theory is not difficult to produce: The central bank is central to our understanding of the current crisis.
The Federal Reserve under the leadership of Alan Greenspan kept interest rates too low during 2003 and 2004 and then ratcheted the rates steeply upward. Time-consuming investments that were initiated while cheap credit made them artificially attractive were then made prohibitively costly to carry through.
Macroeconomically, that sequence translates into an Austrian-style boom and bust. The background against which the story unfolded was a long-running, politically motivated sequence of housing policies whose dubious goal was to increase home ownership beyond what mortgage markets themselves would allow. The actual effect of the various policies was to desensitize both lenders and borrowers to the risk of default, causing mortgage markets and hence housing markets to play leading roles in this particular boom-bust episode.
The Austrian theory couldn’t be more tailor-made for understanding our current situation. Dealing with the unfortunate consequences of artificially cheap credit, a memorable passage in Mises’s Human Action (3 ed., 1966, p. 560) alludes to an overbuilt housing market:
The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan ...[that cannot be fully executed because] the means at his disposal are not sufficient. He oversizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure.
The foiled plans in Mises’s parable represent the upper turning point of the business cycle. The subsequent compounding of the downturn in the form of a downward spiral into deep recession should not distract attention from the underlying problem of the credit-induced misallocation of resources. The solution must entail, in the first instance, a reallocation of those misallocated resources.19 --> I would, however, modify this by mixing in not only (a) the prior folly of forcing banks to create a sub-prime lending market for housing under the false notion that effectively people and regions were being red lined more or less out of veiled racial prejudice, but also (b) a global factor: the surge in oil prices from US$ 30 - 40 in 2004 that peaked at nearly US$150/barrel in 2008, and which has now led to oil prices hovering for several years at or near US$ 100 - 120/barrel:
20 --> So, also, the leaky tyre effect has broad applicability, as could be inferred from its root: the downside of the Keynesian multiplier effect. No surprise, Garrison goes on to say (his emphasis):
Policies based on mainstream thinking—cheap credit and stimulus packages—are politically attractive, a circumstance that makes any theory, particularly as it might apply to the long run, wholly irrelevant. Attempts to rekindle the boom also satisfy the “don’t-just-stand-there criteria” for political viability. In the long run, a boom will get you a bust; but in the short run, a boom will get you votes. No doubt, many elected officials are oblivious to the first part of this long-run/short-run distinction. And virtually all those not so oblivious see the second part as trumps.21 --> Further on he notes:
For the Austrians, the liquidation that is essential to the economy’s recovery is the liquidation of the malinvestments. Resources need to be reallocated. Hence, any government spending program that serves to rekindle the housing boom or even to keep resources from leaving the housing industry is counterproductive. It locks in the misallocated resources. Similarly, restoring macroeconomic health requires the liquidation of many other long-term or early-stage investments whose expected profitability depended upon artificially low borrowing costs.22 --> So, the job is hard, and given the likelihood of downturns, likely to be thankless.
This needed liquidation does not imply that “a panic would be not altogether a bad thing,” a judgment that DeLong also attributes—via Hoover—to Mellon. What Mellon (or Hoover) called a panic, Hayek called a “secondary contraction,” meaning a self- reinforcing spiraling downward of economic activity that causes the recession to be deeper and/or longer-lasting than is implied by the needed liquidation of the malinvestment. Hayek argued, in effect, that the “ideal” policy would be one that allows the needed liquidation to proceed at market speed while the monetary authority curbs the secondary contraction (i.e., the panic) by maintaining a constant flow of spending. In terms of the equation of exchange (MV = PQ [--> best understood as saying that money stock, M, circulates V times per year to support Q number of transactions at price level P, cf. here]), Hayek argued that the ideal policy was to keep MV—and hence PQ—constant by increasing the money supply (M) just enough to offset declines in money’s velocity of circulation (V). Hayek used the word “ideal” in recognition that the monetary authority may lack both the technical ability and the political will actually to implement that policy.
23 --> But that does not absolve us, the onlooking educated public, from a duty to seek a sound understanding and to support -- not: those who tickle our itching ears with what we want to hear -- but instead to support the sound; bitter and painful though it will often be.
Thus, back to the kairos challenge and the Mordecai trumpet call to hard and perhaps dangerous duty: If not here, then where? If not now, then when -- and why? If not us, then who? END
PS: Next, DV, the Kondratieff long wave perspective. (I think this even more unusual perspective -- one favoured by Schumpeter -- provides a partial guide to making sound long-term decisions on development.)