Wednesday, April 09, 2014

Capacity focus, 80: Addressing the Caribbean's "leaky tyre" economy challenge by applying Hayek's investment triangle set in the context of long term community investments in sustainability

A leaky tyre -- time to use soap spray to spot the leak . . .
and what if you've got a bent rim? (HT: LifeHacker )
Series: 78, 79, 80, 81, 82, b/g

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
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
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.

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.

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.
22 --> So, the job is hard, and given the likelihood of downturns, likely to be thankless. 

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.)