Absolute Return Letter for the month of December 2016, titled, “A Lesson In Microeconomics – How To Get The Economy Going Again.”
“There is a delusion that macroeconomics is both viable and useful – a delusion encouraged by its extensive use of mathematics, which must always impress politicians lacking any mathematical education, and which is really the nearest thing to the practice of magic that occurs among professional economists.” — F.A. Hayek
Closing the loop on last month’s Absolute Return Letter
“Will you marry me?” The young man, not yet past the pimple stage, could hardly contain his excitement. “Yes, if you make me two promises”, the girl said. “Don’t ever ride a motorbike and promise me never to go into politics.” “I promise”, he said, and the rest is history.
The conversation took place in 1984, but I remember it as if it was yesterday. The young man was obviously me, and the girl was my wife-to-be. I bring it up now, because the recent US elections taught me (and my wife) an important lesson. Not only should I have promised never to enter politics. I should also have undertaken never to engage in politics of any kind – not even write about it.
The amount of offended US readers last month, when I made fun of Trump, made me realise that while I obviously cannot avoid commenting on politics altogether, as it has always had, and always will have, a major impact on financial markets, I can certainly stay away from commenting on individuals. Lesson learned.
The stagnation conundrum
Now to something more productive – a different way to look at how we get the economy going again. I apologise if this month’s Absolute Return Letter is a tad theoretical in places, but there is no way around it, and I hope you can follow my thinking. Our long-standing economic consultant Woody Brock visited us only a few days after the U.S. elections, and he inspired me to write this month’s Absolute Return Letter.
Charts 1a-d below tell a story of stagnation along several dimensions in some of the world’s leading – and most open – economies (the US, Germany and the UK). The picture is not 100% consistent. Germany, for example, went through a period of dismal productivity growth in the 1970s and 1980s, followed by a period of exceptionally high productivity growth in the 1990s post-reunification, but the trend line is consistent enough that it warrants further work and commentary.
Nominal as well as real GDP growth is in a multi-decade decline. Productivity gains have lost momentum for many, many years, and inflation is lower than ever. One could certainly be forgiven for asking the question – what on earth is going on?
Why the stagnation conundrum?
Economists – both those in academia and those in the ‘real’ world – have spent endless amounts of time looking for an explanation. Going into detail on every suggestion that has been put forward over the years would be overkill, but it would probably be fair to say that the following six reasons cover the vast majority of suggestions made when commentators have looked for a reason why ‘everything’ appears to be stagnating:
1. A statistical mirage.
Argument: There really isn’t a problem. Smartphones replacing cameras, etc., underestimate actual economic growth.
2. A hangover from the Global Financial Crisis.
Argument: Severe financial crises make recovery from a downturn all the more difficult.
3. Secular stagnation.
Argument: Reduced population and workforce growth, lower prices for capital goods, and the nature of recent innovations (e.g. online shopping replacing brick and mortar shops) all hold back economic growth.
4. Slower innovation.
Argument: The pace of innovation has declined; almost everyone now benefits from the things that matter the most to productivity – e.g. electricity, cars, etc., and recent innovations are more marginal in nature in terms of benefit.
5. Policy Missteps.
Argument: An increase in government spending combined with tax hikes (which is a policy pursued by many governments in recent years) has had a strong negative impact on private investment spending.
6. Increased ‘rent-seeking’ behaviour.
Argument: Abuse of market power, monopoly profits, etc., have contributed to the slowdown in wages and output (think Apple vs. the EU).
In fact, not a single one of those six suggestions provide a satisfactory explanation for the stagnation conundrum. They have all played a role – some more than others – but not a single one deserves to be credited as the main reason.
The weakest is probably the second one. How can something that materialised around 2007-08 explain a trend that began in earnest in the 1980s? My professor at university was fond of telling us students that, however intricate the question is, as an economist you are expected to always provide an answer, but I am afraid I have to pass on this one.
So, are we heading back to the drawing board? Could years of hard work possibly be wasted? Should I ask for a refund on my tuition fees? No, fortunately, it isn’t that bad, but you’ll have to put your macroeconomic wisdom to one side for a while and instead tune in to something most investors spend little time on these days – microeconomics. Let’s get started.
A new microeconomic way to interpret GDP growth
So that we can make the appropriate comparisons, let’s start from first principles and define GDP in a very orthodox (macroeconomic) way. Just about every civilised country on planet earth defines GDP as the sum of consumer spending, corporate investments, government spending and net exports (defined as exports minus imports), or:
GDP = C+ I + G + (X-M)
That formula was one of the very first I learned when I started to read economics back in the early 1980s, and it was presented to us still-wet-behind-the-ears students as the holy grail, but there is another way.
Think microeconomics. Assume there are n companies in the private sector, and think of GDP as the sum of the value-added created by those n companies. The value-added can be defined as total revenues (r) less the cost of generating those revenues (c). All one would have to do to arrive at the same number for GDP as above would be to add government spending (G). That said, the private sector GDP can thus be expressed as follows:
GDP Private Sector = ?(rn – cn)
In microeconomics, the price and quantity that a company can achieve on its goods and services is a function of where demand (D) meets supply (S) which, in geometric terms, is where the two lines cross each other in chart 2. The equilibrium (A) is precisely where S meets D, and the shaded area under A equals price multiplied by quantity (pq).