JK Galbraith and the vaporous economy

John Kenneth Galbraith was never a hero of mine. To read him is to be put off, by a certain kind of intellectual arrogance that seems to hold inquisitiveness itself in contempt. As if a person who is curious is having to come by knowledge in a substandard way, as if they had to buy the family silver, as it were. Worse, by claiming too much for his view of the economy, he has ended up wrong. Perhaps he should be just put in the dustbin of interesting, but passé, thinkers.

But I have found myself thinking about him often in the last few years. Because the “New Industrial Economy,” he discovered is with us still, with a vengeance. In developing countries it is most of the remaining story of their opportunities, their barriers, and their dilemmas.

Galbraith asserted, essentially, that companies could create demand, through advertising and other marketing processes. They could make people realize they want something they never considered wanting before.

All this is old news. Nor is it quite believable, in this bald form. But what is remarkable is that so much of the value of the products sold, and of the costs expended on creating these products, is entirely a matter of the psychology of the consumers, as recognized, exploited or manipulated by the companies who sell to them. Even in the Wal-Mart part of the economy, the manufacturing cost of the products is less than the distribution and marketing part. At the affluent end that Galbraith wrote about, the markup is enormous.

But here’s the tough part. That markup is mainly a function of the general affluence of the overall society. In Bangkok, only a relatively thin slice of the economy prices at foreigners’ levels. Most of the goods sold here are almost as good, but sold for much less. In the US, producers price higher and lose very few sales by doing so. But the same markup here in Thailand takes most customers out of the market.

We need to remember that pricing quandary when we discuss “productivity” or the amazing ingenuity of the market. We find it hard to absorb this quandary even after studying it and teaching it for years. The market produces the goods that are valued by consumers. This is almost axiomatic. So we then conclude, with the deep insight that gives economics its power, that the allocation of resources between different uses reflects the balance between the value consumers put on the good and the cost of making the good, where cost tells the alternative value that the resources might have produced elsewhere in the economy. This equation of value with cost, and cost with alternative production, is at the heart of our understanding of economics. And it leads quickly to the conclusion that large totals of value reflect large quantities of output per unit of inputs. But creating large amounts of value is no longer primarily a function of ability to turn out large amounts of goods.

That is not too hard to absorb as a notion, and our intuition then concludes that value is a function of quality, or perhaps of targeting specific preferences, since those are the aspects we shop for. But value as a measurable total amount is now heavily inflated by our psychology and the ability to price to take advantage of it. By vapor, essentially: the ability to charge a lot if you are in the lead in a marketing competition. Vapor, because the costs of being in the lead are not quantitatively related to the actual generation of value totals. The quantity of goods is virtually irrelevant to the value total, since it would not cost much to turn out twice as many of the same thing. And the competitive investment, the costs of being in the lead, face steeply diminishing returns once the nearest competitor is outdistanced. So twice as much of the same expenditure would add virtually nothing to value. The main source of vapor value is the market’s lack of interest in having goods provided at a lower price. That, in turn, is a function primarily of per capita income, or the relation between overall output capability and the number of empowered consumers. Our traditional understanding of the importance of the capital/labor ratio is almost stood on its head.

Galbraith discussed many of these themes, without necessarily relating it to positionality of lead competitors. He discussed the imbalance between capacity (in the aggregate) and demand, drawing on earlier researchers, actually. The beginning of a key chapter in “The Affluent Society,” for example, quotes Beckerman saying that society may suffer from the inability to generate enough wants to absorb the potential production. And he focused much of his discussion around the prominent “waste” of advertising, which will stand in well for my version of money spent on maintaining a lead position.

We would like it to be the case that those who produce “high value” goods have some intrinsic excellence that accounts for their high earnings. This may be true “at the margin” as we say. By working hard and building a small edge in performance, firms secure the position to harvest the vapor value. But in a macro sense, it is simply not so. The cumulative expenditure on securing high value would simply not achieve anywhere near the same results in a typical developing country.

The equations relating value here to value there are comparing high vapor value to low vapor value. This means even that productivity is to a surprising extent not transferable. This is not because their production of “value” is any less, it is because there is simply very little vapor to harvest for that value.

In a very real sense it is not the opportunity cost of resources that determines value anymore, it is the opportunity cost of consumers’ time (that they could spend on price comparisons, and on time spent enjoying yet additional stuff), and even more bizarrely, it is their attitude that price comparison makes little or no difference – and that it is not an intrinsically rewarding activity that helps them feel good about themselves. Vapor indeed. And Galbraith saw it coming, out of his profound disrespect for orthodoxy and the plodding conclusions of standard analysis. And out of the excitement of being on the forefront of the wave of Keynesian economics that was sweeping all before it. Bliss was it in that hour to be an economist.

Speaking of Keynesian analysis, there is a deep coordination problem inherent in this vapor analysis. And any coordination problem begs for a multiplier analysis. But the levers seem to be limited – there is no overall mechanism for adjusting an entire market up to higher profit if people are not able to afford the higher markups. Maybe the problem with Keynesianism is that it grafted a similarly diffuse logic, which works in coordinating investment decisions in any situation, onto the multiplier that only works when there is a lot of excess supply.

Still, I find understanding the role of vapor to have some quantitative implications. For example, it seems to me that if all of those first world producers were willing to offer their products for lower prices at the same time, the developing countries would have more “real” income, and thus be able to expand purchases of those vapor-filled products at a faster rate. But no individual producer has an incentive to do that, since the result would simply be a loss of profit without much increase in sales. Is it possible that the simultaneous price reduction by many producers could give each an increase in profit, due to the accumulation of many tiny increases in vapor value? Maybe, but not necessarily.

Furthermore, by increasing incomes in the formal sector by employing more sales people, distributors, marketers, etc., (and possibly decreasing the amount going back to the home country in profit repatriation) the amount of vapor power in developing countries would increase on the earning side, and the demand would be yet further increased.

It is as if the struggle for the profits of position makes a sort of teeter-totter for the industrialized world firm and the developing world market. If one goes up, the other goes down. Quantity (as fact, not just strategy) vs. exclusivity. But the concentration of vapor that drives the difference between national markets means that the public sector could reduce the value of position by driving an acceleration of industrialization.

Of course, finding the right lever with which to multiply multi-national downscaling might be tough. Perhaps South-South Free Trade Agreements would be a good start, though. The ability to manufacture for local markets could be scaled up by the most efficient firms, while charging an amount that is aimed at the general market of a developing country, so with less markup than a typical multinational. Some of the insights of those who study marketing to the poor suggest that a partnership of first world marketing skills with developing country local understanding can be very productive at the low (and large) end of the market. It seems there might be scope for a general infusion of vapor into developing country markets, but not simply by “free trade” or “off-shoring of production”. The locally oriented approach moves the fulcrum of the teeter-totter. Moving a bit upscale from their typical location should be profitable for many local firms, allowing volume to increase even while capturing some vapor. The result is rapid expansion of productivity with, if the teeter-totter analogy holds, some erosion of the multi-national part of the market. But if they try to move far upscale to compete directly, the result has too many volume losses for companies not already engaged in producing for, effectively, the carriage trade.

There may be a missing connector between productivity and the addition of vapor to low-end economies, which is the price of capital goods. If machines without six sigma quality can be turned out cheaply and run on relatively cheap power (a bigger if, I think) then many developing countries could expand output at rates comparable to China’s. The Washington Consensus, by insisting on rationalist institutions, put the first stage in place. But without cheap capital, (and energy?) the general expansion may be held back in a modern version of the Poverty Trap. This trap is a diffuse externality that implies that rapid productivity advances in quantity terms, at the low end of the market, would rapidly breathe vapor into the economy, reaping additional gains to quantitatively measured productivity (if not entirely drained off by multinationals). Interesting that Galbraith, who chose to be ambassador to India during the Kennedy administration, would have identified forces offering particular hope for such countries.

Saved by the markets

Hmm. Time to admit I was wrong, again? Maybe. And maybe not.

Since the Fed surprisingly announced a rate increase, surprising because of a flat yield curve, long term rates rose along with the short term. This is not exactly in line with expectations. The implication is as ambiguous as the rest of the economic news this week.

Economic growth last quarter was the strongest in three years (but in the previous quarter, was anemic.) Unemployment is down (4.7%). Housing starts were down to the lowest rate in three years also, and median price of housing down. Perhaps it is not surprising that Bernanke has been giving mixed signals about “pausing” in the increase in interest rates, but not being “soft” on inflation.

I had predicted that the higher rates would exert too much drag on the economy, and the economy would slow substantially this year. Could still happen. But like Bernanke, I have to pause and think carefully. The latest long-term interest rate increases may be indicating that the economy is just fine and the Fed’s increase was at least not a problem.

First, there is good reason to believe that long-term rates rose because of a coincidence, that foreigners slowed their stampede to park money in the U.S. in the same week as the interest rate increase. Theory would have predicted the opposite: interest rates rising would attract finance. All other things equal, of course. The monetary tightening should have raised short-term rates, but by thereby attracting foreign capital, it would raise the exchange rate (the dollar would rise.) The actual fall in the dollar, therefore, tells us plainly that a shift in motivation to invest in the U.S. was responsible.

But be a little careful. Evidently there was a similar fall in January, but a big increase in the inflows in February. So even if these signs are genuinely pointing to a slowdown in inflows in March, it does not appear to be part of a strong or gathering trend.

The depreciation, however unconnected to the monetary tightening, may inspire further withdrawal, say of Arab money suddenly facing the prospect of a 10% fall in the value of money they were just parking short-term anyway. If so, then as they say, panic could turn into a rout. A 30% fall in the dollar this year is not at all out of the realm of possibility, but I would not expect it, for reasons to be discussed below.

Theory would have predicted little rise in the long-term rate for another reason. Once upon a time we taught that long and short-term rates moved together because long and short-term loans are substitutes, so that higher short-term rates push borrowers toward longer-term loans and cause long-term rates to rise from the new demand. However, the short-term rates are much more volatile, and long term rates are determined much more by the inflation rate and the availability of private funds. Unless the Fed is ordering a truly massive reduction in funds, their tightening would not have raised the long-term rates by as much as the short-term. Yet they did rise as much. And if most economists were predicting the effect on long term rates they would have guessed that the expectation of lower inflation from monetary tightening would have caused long term rates to fall. This has been the effect of higher short term rates with growing frequency over the last decade.

So long term rates probably rose due to foreign money slowing its supply, at least in part. Might it also be due to a growth spurt? It is certainly possible. The most reasonable interpretation of the connection is that faster growth is inspiring investment activity, and that is raising demand for credit. We should look closely at the housing market, though, if only because it has been so overheated so recently.

Housing results have also been mixed. Permits are down from February, but up 2% from last March. Starts are in the same position, but up 7% from last March. Sales of existing homes, however, were up 14% from February but down 7% from March. Interpreting very liberally, new home construction is catching up to demand, after a delay due to worries of a bubble. Add to this that the decline in median price from February was almost 7%, the largest in a series of declines since last October, and average prices dropped 7% month-on-month, for the first real decline in years. It appears that the growth has been at the high end, but is now easing there and the medium and low price segments are filling in.

From a macroeconomic view the news is that quantity of housing is increasing, but not price. This is clearly a supply increase. (Although, we do not know that the price of a given property was falling, but mainly that more were transacting in the lower portions of the distribution.)

Does all of this mean the Fed read the trends better than I did? Momentum in the economy is strong – doesn’t it need to be restrained? Won’t the multiplier effects of the production increase create a demand overhang that might melt suddenly if not restrained beforehand? Well, first, let me note that that kind of talk is pretty Keynesian. Monetarists are supposed to believe that if the central bank is not actively creating credit, which they are not doing much of when there is a flat yield curve, then demand swings can take care of themselves. So if the Fed policymakers are taking an active approach with Keynesian consciousness feeding in, it may be worth the sacrifice of 50 basis points.

Second, even if they are reading the situation better than I am, I don’t mind very much. They have access to way more statistics and stuff than I have. My point would be, however, that the surge in demand doesn’t necessarily matter as much as the threat of the dollar decline. The first is short-term, and monetarists assure us it doesn’t matter in the long run. (It doesn’t even matter to the price level, if the Fed doesn’t accommodate the demand with extra money growth. M2 has been growing a bit fast, but who believes that the Fed is still fostering demand?) So we need to worry more about the supply side. I read the willingness of foreigners to buy American goods and American debt as supply, as I would capital inflow to a metropolitan area.

The huge financing of US trade deficits by foreigners will undoubtedly come to an end. It has to eventually, because the debt is growing faster than the real economy. The implications will be higher prices (but not sustained inflation) in the US. But also a shift back toward manufacturing, and thus an improvement in job prospects, especially for the less educated. It will also carry its own demand side drag. As a result real estate prices will undoubtedly fall in world terms, and may fall in dollar terms. Although this may seem like a threat, the idea of propping up interest rates to support the dollar doesn’t really look attractive by comparison. Rather, it might make more sense to nudge the markets in that direction by easing credit and thus decreasing the attractiveness of the dollar.

The fundamental question still seems to me to come back to whether there is any problem in the field of view that was created by excess credit creation by the Fed. Seeing none, I conclude that there is no justification for intentionally slowing down growth.

Might a drastic dollar fall (30%?) create a financial panic or depression? Of course it might. But the late 80s saw a bigger fall in the dollar (supposedly managed by Accords, but obviously not well if so,) and without any great adverse impact. (Although come to think of it, someone ought to look into its role in hitting the Japanese bubble economy.) In general, the effects aren’t likely to be so serious, and the likelihood isn’t that high anyway.

In fact, to portray a scenario in which a plummeting dollar creates a financial panic, you have to come up with institutions whose assets are heavily in dollars but whose liabilities are in foreign currencies. Lots of people hold dollars, but I don’t know any outside the US that are dependent on them for income, to meet domestic bills. Probably Japanese banks are beginning to hold enough dollar assets to be exposed to significant risk, but I would bet that now that the rest of their portfolio is performing again, they could absorb the hit pretty well. (Someone should check.)

The concern is more for the rest of those assets. If the dollar falls too fast, can Japanese firms handle the loss of competitiveness? Can Chinese? The answer depends a lot on domestic demand, and whether either one is at last becoming independent of US demand. My guess is that both can, for the unexpected reason that the rest of the world is finally sufficiently on track to want the goods, especially capital goods, and that the US can finally get off the dance floor and let someone else be their partner for awhile. Maybe even each other.

But we are unlikely ever to find out. Both governments got enough scare the last time the dollar dropped, a few years ago, that they will probably let it down only very easy, increasing their buying if necessary when others sell. Look for a steady (managed in East Asia) decline in the dollar of 2 to 5 percent per year for the next five years. It would be very interesting to plot the path of asset holdings implied by such a shift. Probably Tokyo already has.

Bottom line, the Fed did not screw up. Especially not on the scale I thought. They have already been vindicated by the news, to show that they didn’t add much to restraint. Not even enough to give an inverted yield curve. The question is whether they will somehow draw the wrong conclusion, that demand is out of hand and must be restrained even more, or whether they already knew what was happening and have already announced the steps they think are appropriate. If the latter, as Bernanke’s remarks would suggest, I gladly stand aside and salute them. But if they get all hyper about the latest growth, they could still wreck things.