Colonial First State Global Asset Management

Capital Consequences: The Value of the Intangible

In this paper we look at the decline in physical investment capital and how the rise of Google, Apple, Facebook and Amazon (now often referred to as 'GAFA') are at the forefront of an entirely new economy with its own rules.

Why have the physical investment rates in the developed world been so meagre, despite extraordinary monetary policy, zero interest rates, high profitability and rising asset prices?

The answer, according to the ‘Secular Stagnation’ thesis, highlights two substantial problems. The price of capital goods, in real terms, has declined and the financial crises have created substantial uncertainty amongst investors such as they want to lower risk. By contrast, The Great Transition takes a different view. First, the rise of China has shifted investment in the manufacturing industry. As the first paper in the series ‘Towards Perfect Competition’ highlighted, perfect competition limits the propensity of firms to invest with external capital. As productivity determines profitability, investment is a function of retained earnings rather than access to external capital. Second, information is changing the production side of the economy. As the previous paper The Erosion of Capital highlighted, the firm faces substantial challenges from more efficient market information. The destruction of firm capital, in turn, diminishes the incentive to invest within firms. This report focuses on the replacement of information capital that currently resides within firms.

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Capital Consequences: The Tetris Economy

Tetris may be an appropriate metaphor for understanding the macro-economy¹. In this metaphor, the pieces are resources, capital and labour.

When space is efficiently filled, it is representative of stable, low inflation, economic growth. As pieces speed up, and space between shapes begins to appear, it might be said the economy is beginning to over-heat or become inflationary.

The ability of a player to avoid leaving space is dependent upon available information, and the ability to react to that information. As The Great Transition has demonstrated, this is becoming ever easier in the digital economy. In The New Industrial State, Galbraith argued that successfully managing an economy with full understanding of the market was near impossible. It was hard to play Tetris well. Increasingly, the opposite is true: the ability of the economy to accommodate more resources is accelerating because the pieces can be placed more optimally.

This amounts to the economy being able to grow with fewer inflationary pressures which is a function of three broad trends. First, resources (or Tetris blocks) are able to talk to each other; second, resources are becoming more efficient and third, there are entirely new and more efficient ways of doing things. We are using fewer resources to do the same thing.

Again, however, there are consequences for capital. It may be possible to increase the capacity of an asset or network without significant new investment which improves asset utilisation and profitability. However, once dominant assets or networks may become redundant as they are replaced with more efficient methods. Either way, and as with so much of The Great Transition, these changes exert downward pressure on prices. Broadly, these phenomena are grouped within the descriptor The Internet of Things or the Industrial Internet. The Internet of Things has emerged rapidly in the last three or four years however, one way to think about it is to use a quote from the scientist Nikola Tesla, from 1926:

“When wireless is perfectly applied, the whole earth will be converted into a huge brain…”

It is not clear from the ensuing paragraph whether Tesla was speaking solely for the connections between humans or, as is coming to pass, objects as well. Either way, the rise of the connected device is allowing assets and networks to work more effectively because they have the ability to make data and share it.
This is happening for two reasons. Smartphones allow the movement and behaviour of users to be shared with a broader network so as to make the entire network more efficient and connecting devices are becoming increasingly cheap. According to the US Department of Energy’s Oak Ridge National Laboratory, a wireless sensor costs in the region of $150 to $300. However, new technology may reduce this cost to between $1 and $10. The energy industry is one of many where these technologies, and others, are being applied successfully.

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^{1. Tetris (first developed as Tetriminos in the USSR) is an arcade game where players seek to manoeuvre falling shapes, made of four squares, into positions that best fill available space.}

Capital Consequences: The Permanence of Savings

The Great Transition has focused to date on the demand for capital. The series has explained the way in which technology is shrinking the demand for capital. This piece examines the supply of capital.

The supply of financial capital available for transformation into physical capital has been a topic of substantial global debate in the last 10 years. A group of economies have become large net savers and consequently a group of other economies have necessarily become net dis-savers, or borrowers. This phenomenon has become known as ’global imbalances’ and has been seen as a threat to the stability of the global financial system. The economist Barry Eichengreen has suggested “Global imbalances continue to place the stability of the global economy at risk.”¹

The problem of ’global imbalances’ or the ’global savings glut’ was first discussed at the highest level in a speech given by then Chair of the US Federal Reserve, Ben Bernanke, in 2005². Bernanke highlighted many of the drivers of high savings in particular economies. These included ageing populations and the rise in Asian savings as a consequence of the Asian Crisis of 1997/98. He went on to highlight the three broad problems with ’imbalances’. First, developing economies in the long term, should be investing in their own economy, not exporting capital. Second, developed creditor nations seem more likely to spend these savings on consumption rather than on more productive, long-term, non-residential investment. Third, the large current account deficits of the dis-saving nations risk being impacted by a disorderly adjustment where foreign funding disappears quickly.

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1. http://www.voxeu.org/article/g20-and-global-imbalances  

2. http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/

Productivity: Towards Perfect Competition

The great transition’ acknowledges two trends, the rapid growth of the information economy and decline of the industrial economy.

In many ways China is at the forefront of both these trends. It is putting smartphones and much more into the hands and homes of a population that now numbers at least 1.75 billion. But in achieving this, it is fundamentally changing the nature of the industrial economy. If there is just one chart to demonstrate these trends, it is the price of an LCD television. From 2006 to 2011, Witsview collected daily price data for a 42 inch LCD television. The results are startling. From a high near USD4,000, prices fell to just USD800 by February 2011. A newer series, measuring an LED screen shows prices reaching USD384 by January 2015. The fall in price has been rapid, constant and driven by China.

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How?

The information economy needs hardware in the hands of as many people as possible. At the cost of great disruption, China has led this achievement. The most common explanation for China’s rise has been a seemingly endless supply of cheap labour. Yet, for some time now this cheap labour has become more expensive.

From 2006, China’s wages have risen 15% per year in US dollar terms. But none of this increasing wage bill shows up in the price of a TV or other manufactured goods. Instead, as chart 3 demonstrates, across the board China’s share of global exports has continued to grow. Rather than cheap labour and a devalued currency, China’s dominance should be explained by productivity improvement. China’s productivity improvement has three main drivers: process improvement, at the level of the firm, and infrastructure and industrial structure at the level of the economy or industry.

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Productivity: Information and a Frictionless Economy 

At the height of the financial crisis in 2008/09, it appeared that the best reference book for the months and years ahead was The Grapes of Wrath by John Steinbeck. On the verge of global economic collapse, and perhaps even a depression, it seemed essential reading. But upon consideration, its value as a handbook diminished as the story reflects an economy long past. The world still has problems, but they do not include those faced by the Joad family in the US Depression era.

The great majority of conflicts in The Grapes of Wrath arise from a lack of information. Tom Joad arrives home from prison to find his family gone. They have travelled to California on hearsay, and as they search in vain to find work, they are exploited. Today, it is unlikely that these kinds of scenarios would arise.

However, the economic problem faced by the Joads does remain. As capital becomes relatively scarce, it leads to a surplus of labour that essentially becomes unemployed. The solution is the same: labour must move to where capital is relatively plentiful. The best current example of this is the migrations from Europe’s periphery as a result of the euro-zone’s debt crisis.

The difference today is in the way this re-allocation can be resolved. Tom Joad would be able to call his family to find them. They could, via their smartphone, locate an orchard looking for labour and would probably secure a job. They could also locate accommodation and purchase an airline ticket for around half a week’s minimum wage. This could all be done from Oklahoma and work could begin within a day or two. Simply, the ability of the economy to transition is made easier by information.

Smartphones as the driver of a new economy

Lewis Mumford¹ argues that it is not the steam engine, but the clock, that provided the impetus for the machine age. The clock was the first piece of machinery that could co-ordinate work and leisure. It saved time, our most scarce resource. It allowed activity to be more streamlined and so more diverse. It led to increased production but also innovation. The information provided by a town clock improved economic exchanges in the town; and since then, information has continued to drive better functioning markets. The falling cost of information re-shapes markets, whether for goods, services, or financial assets, and the value we get from them. It also changes the way we approach and deal with problems. As the clock set off the machine age, the smartphone is the true start of the information age. The smartphone has two essential characteristics, first of which is its capability. It is estimated that the equivalent computing power of an iPhone 5 might have cost as much as US$3.56 million in 1991 according to analyst Bret Swanson². Second is its connectivity. A smartphone connected to a mobile network in New York City or in Africa, has access to more information than conceivable just 10 years ago. But more important is the connectivity to others, and the data that is created every minute of every day. It is this networked information that fundamentally changes the structure of the global economy. The World Bank collects data outlining the growth in mobile phone and broadband internet penetration. Most recent data show there are 92 mobile phone subscriptions per 100 people³ and 10 fixed line broadband internet connections per 100 people, globally. Growth in mobile subscriptions has been most rapid in the emerging world. Compound annual growth in the emerging world was 22% in the 10 years to 2013, compared to 5% for the developed world. Clearly, for emerging economies, the mobile network has allowed them to jump a stage in development by avoiding fixed line infrastructure. Fixed line connections in the emerging world peaked at 14 per 100 people and are now just 12.

To continue reading and find out more about the impacts of the growth information download the four page report below.

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1. Mumford, Lewis “Technics and Civilization” 1934, Harcourt, Brace and Company, London.

2. http://www.techpolicydaily.com/communications/much-iphone-cost-1991/. This includes $1.44 million for memory, $620,000 for the processor and $1.5 million for its communication capacity.

3. This number is somewhat distorted by multiple subscriptions per person. For instance, in Hong Kong there are 238 subscriptions per 100 people.

Productivity: Services- more than just 'would you like fries with that?'

The rise of productivity, doing more with less, raises one essential policy question: what to do with labour? Is productivity growth and full employment compatible? The only possible answer is an increasing dependence on employment in the services sector. Increased services provision represents a welfare enhancement for citizens of developed economies. In particular, because services become the primary means by which households ration their time. This is problematic because services appear to be less productive, however this perceived lack of productivity is a function of poor measurement. Therefore in order to optimise the growth of the services sector, better measurement and an improved perception are required. This paper outlines the case against services and responds with two counter-arguments: poor measurement of service quality and the high income sensitivity of the demand for services.

Baumol and the services sector

William Baumol made, perhaps, the most significant case against the services sector in a 1967 paper¹ that outlined his ‘unbalanced growth model’. It describes the services sector as being stagnant in real terms and its nominal expansion a function of productivity growth in the manufacturing sector. He re-stated that as technology improves, the productivity of labour in the manufacturing sector rises too, which allows firms to pay higher wages. However, Baumol did observe that productivity is disparate across sectors and that it is generally only experienced in manufacturing, whilst productivity growth in services seems to be stagnant. Famously, Baumol argued that there has been no productivity improvement in the performance of a Mozart symphony since the 18th century, as it cannot be played any faster. Using this logic, firms playing Mozart (services) must pay wages equal to those in the higher productivity manufacturing firms. As wages rise in the absence of labour productivity growth, prices too must rise. The stagnant sector becomes the biggest contributor to inflation in an economy.

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1. Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crisis, William J. Baumol The American Economic Review Vol. 57, No. 3 (Jun., 1967), pp. 415-426

Capital Consequences: The Erosion of Capital

The changes to markets outlined in the first three parts of this series are transformational for consumers. They allow consumers to access markets more cheaply in the pursuit of products and services that best match their preferences. If access to productivity improvement is democratised, it has the power to raise living standards, globally.

But such changes also transform the production side of the economy. They cause the shift to services, as described in the previous paper, and also change the shape and value of capital. The value of capital is eroded; it is replaced with less and what is still valuable is used more efficiently. Simply, technological change, in the first instance and all other things equal, shrinks the demand for physical capital. The fast growth in financial assets is unmatched by the increase in physical assets.

The process of capital erosion is the subject of this piece. It occurs as a consequence of the way in which markets are changing. From an economy guided by managerial decision, the global economy is once again being driven by the decisions of the market. This fits with the theory of Coase and Williamson, though the application is different. However it differs from the conditions observed by J. K. Galbraith in his New Industrial State lectures. These will be discussed in further detail in this paper.

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