Can economists learn anything from the Boston Celtics’ loss to Steph Curry’s Golden State Warriors in the NBA Finals? I’m thinking in particular about Game 5, when the Celtics devoted all of their defensive resources to stopping Curry – the greatest shooter ever to play.
The Celtics won that narrow battle. Curry scored a mere 16 points and for the first time ever in a playoff game he did not make a single 3-pointer. But they still lost the game. Why? Unintended consequences. Other players, considered lesser threats, were freed up and their scoring delivered Boston a devastating loss.
Andrew Smithers, a well-known financial analyst and author of a new book The Economics Of The Stock Market, believes economists are making the same mistake as the Celtics. Specifically, they are concentrating on one thing – the balance between intended savings and intended investment – and ignoring other threats.
His book is thorough and challenging. Market professionals prepared to roll up their sleeves and think will get a lot out of it. If that’s not for you, read on to pick up the key ideas and listen to our conversation on the most recent Top Traders Unplugged podcast.
The Stock Market Matters Too
When people see an economic slump coming, they worry. When they worry, they decide to save more. Companies – who after all are run by those same people – also alter their intentions to save more, which they accomplish by cutting back on investment. Both of these changes lead to reduced activity, which reinforces the economic downturn. The Fed counters these intentions by lowering interest rates – making saving less attractive and (theoretically) making investing more profitable.
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But lowering interest rates, especially if done through quantitative easing, has other effects – in particular it drives up stock prices. By focusing primarily on intended savings and investment, and using interest rates to bring them into balance, central banks throw other relationships out of kilter.
One of those key relationships is called “q” – the value of companies assigned by the stock market relative to the replacement cost of the net assets owned by those companies. These two things ought to be tied together; there should be a tight relationship between the value of an entity (its stock market price) and value of the stuff it owns, after netting out what it owes to others.
That isn’t controversial. However, conventional economics assumes that if q does get imbalanced it is investment that adjusts to bring things back in line. Imagine a company that has one share valued at $10 and owns one thing – an asset worth $5 at current replacement value. That might seem strange. The market is saying: “This company is able to do something unique with that $5 asset which generates extra profits. When they own it, it’s really worth $10.”
That’s not entirely crazy, at least temporarily. Theory says that the company’s managers will see an opportunity – sell another share for $10 and use the cash to buy more of those same assets. The market will quickly say that the new share is worth $20.
But all good things come to an end, and competition will ensure the company gets less and less extra profit as it invests in more assets. In other words, as investment rises, q begins to fall and, eventually, the market value of the company and the assets it owns will come back into alignment.
Right, But For The Wrong Reason
Smithers demonstrates that market value and replacement cost are indeed tied together – q rotates slowly around an average level. But it doesn’t mean-revert in the way I described. When q rises companies don’t invest more. The ratio is brought back down by a fall in stock prices. And – as we are experiencing this year – stock prices typically fall much faster than they rise. These steep falls can trigger financial crises – destabilizing the economy and causing long-last damage.
Pay Me Now
A big reason why companies don’t invest more is what Smithers’ calls “the bonus culture”. Top corporate managers derive a lot of their compensation from stock and stock options. Investing is a trade-off – lower profits now vs. higher profits in the future. But lower profits now mean a lower share price and a smaller bonus.
The alternative is to invest less, which increases reported profits, and then use those profits to buy shares in your own company. Both of these things push up share prices and lead to bigger bonuses.
One doesn’t need a degree in psychology to guess which option managers choose. They invest less, buy back shares and collect their bonuses. The problem is that these collective decisions to invest less cause both productivity and economic growth to slow. And – as I wrote last week – we need all the growth we can get to manage the rise in health and pension costs as our society ages. Thus, changing manager incentives to generate more investment is very important.
Smithers thinks the classification of intangibles like R&D as investment masks what is going on. His point: R&D is a source of competitive advantage; if successful it takes market share away from a rival company. For every winner, there is a loser. It doesn’t add to the base of productive capital in the same way as investment in fixed assets and is therefore less important for economic growth.
The graph below shows that while total investment seems to be holding up, investment in productivity-enhancing tangible assets keeps falling. The high value of q over the last 30 years has not led to increased tangible investment.
How To Raise Growth And Reduce Instability
What can we do? Perhaps I’m stretching the analogy, but Smithers suggests both a tangible and intangible change. The tangible change is to modify taxes to encourage investment by companies and pay for this by increasing taxes on current consumption.
Higher investment ought to bring two concrete benefits – over the long-term it will raise the rate of economic growth and will gradually bring stock prices in line with asset values, reducing the risk of financial crises. The tricky part is ensuring this happens without increasing the budget deficit.
If taxes are lowered to encourage companies to invest that will lower government revenue and, if nothing else changes, the budget deficit will rise. To offset this Smithers says we need to increase taxes on consumption – for you and I that means higher income or sales tax.
His “intangible” goal is also ambitious – to change economic consensus so that the importance of the stock market is widely understood and acknowledged. If this was the case, central bankers faced with recessions in the future would be in a position to say – “we’ve lowered rates as far as we can, any more and the stock market will get dangerously out of balance and another crises will happen”.
It’s an ambitious agenda with obvious political challenges. Perhaps it will take another financial crisis for us to summon the will to make the changes he is suggesting. Still, his work is giving us a clearer understanding how the economy really works and how it can perform better. That’s a good first step.