Jaylen Brown (7) (left) of the Boston Celtics and Stephen Curry of the Marcus Smart Guard Warriors. (Photo by … [+]
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 of Game 5, when the Celtics poured all their defensive resources into stopping Curry, the best shooter who ever played.
The Celtics won that close battle. Curry scored just 16 points and for the first time ever in a playoff game he did not make a single triple. But they still lost the game. Why? Unintended consequences. Other players, considered minor threats, were released and their touchdown handed Boston a devastating loss.
Andrew Smithers, a well-known financial analyst and author of a new book The economics of the stock market, thinks economists are making the same mistake as the Celtics. Specifically, they focus on one thing, the balance between expected saving and expected investment, and ignore other threats.
His book is complete and challenging. Market professionals prepared to roll up their sleeves and think that they will get a lot out of it. If that’s not for you, read on for the key insights and listen to our conversation on the latest ones. Top Traders Offline Podcast.
The stock market matters too
When people see an economic downturn coming, they worry. When they worry, they decide to save more. Companies, which are after all run by these same people, also change their intentions to save more, which they achieve by reducing investment. Both changes lead to a reduction in activity, which reinforces the economic recession. The Fed counteracts these intentions by lowering interest rates, making saving less attractive, and (theoretically) making investing more profitable.
But lowering interest rates, especially if done through quantitative easing, has other effects, notably driving up stock prices. By focusing primarily on anticipated savings and investment, and using interest rates to balance them, central banks disrupt other relationships.
One such key relationship is called “q” – the value of the companies assigned by the stock market relative to the replacement cost of the net assets owned by those companies. These two things should be united; There should be a close relationship between the value of an entity (its stock market price) and the value of the things it owns, after settling what it owes to others.
That is not controversial. However, conventional economics assumes that if what is unbalanced is investment that adjusts to put things back in order. Imagine a company that has a stock valued at $10 and owns one thing: an asset worth $5 at current replacement value. That may seem strange. The market is saying, “This company can do something unique with that $5 asset that generates additional profit. When they own it, it really is worth $10.”
That’s not entirely crazy, at least temporarily. The theory is 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 must come to an end, and competition will ensure that the company makes less and less extra profit as it invests in more assets. In other words, as investment increases, what it starts to fall and eventually the market value of the company and the assets it owns will come back into line.
Good but for the wrong reason
Smithers demonstrates that market value and replacement cost are actually linked: what it rotates slowly around a medium level. But it doesn’t mean revert in the way I described. When what upload companies No invest more The ratio goes down again due to a drop in share prices. And, as we are experiencing this year, stock prices tend to fall much faster than they rise. These sharp declines can trigger financial crises, destabilizing the economy and causing lasting damage.
US Stock Market Market Value relative to Equity at Replacement Cost.
pay me now
A big reason companies don’t invest more is what Smithers calls “the culture of bonuses.” Top corporate managers get much of their compensation from stock and stock options. Investing is a trade-off: lower profits now versus higher profits in the future. But lower earnings now mean a lower share price and a smaller bonus.
The alternative is to invest less, which increases reported earnings, and then use those earnings to buy shares in your own company. Both of these things drive up stock prices and lead to higher bonuses.
One doesn’t need a psychology degree 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 a slowdown in both productivity and economic growth. And, as I wrote last week, we need all the growth we can get to manage the rising health and pension costs as our society ages. Therefore, changing managers’ incentives to generate more investment is very important.
Unmasking the investment
Smithers believes that classifying intangibles like R&D as an investment masks what is going on. The point of it: R&D is a source of competitive advantage; if it is successful, it takes market share from a rival company. For every winner, there is a loser. It does not add to the productive capital base in the same way as investment in fixed assets and is therefore less important for economic growth.
The chart below shows that while total investment appears to be holding up, investment in productivity-enhancing tangible assets continues to fall. The high value of what in the last 30 years it has not led to an increase in tangible investment.
Investment relative to GDP. Source: Bureau of Economic Analysis
How to increase growth and reduce instability
What can we do? Perhaps I am exaggerating the analogy, but Smithers suggests both tangible and intangible change. The tangible change is to modify taxes to encourage business investment and pay for it by increasing taxes on current consumption.
Increased investment should bring two concrete benefits: in the long run, it will increase the rate of economic growth and gradually bring share prices in line with asset values, reducing the risk of financial crises. The hard part is ensuring that this happens without increasing the budget deficit.
If taxes are cut to encourage businesses to invest, that will reduce government revenue, and if nothing else changes, the budget deficit will rise. To offset this, Smithers says we need to raise excise taxes; For you and me, that means a higher income or sales tax.
His “intangible” goal is also ambitious: to change the economic consensus so that the importance of the stock market is widely understood and recognized. If this were the case, central bankers facing recessions in the future would be in a position to say, “We’ve lowered rates as far as we can, if we do more, the stock market will become dangerously unbalanced and another crisis will ensue.” “. happen”.
It is an ambitious agenda with obvious political challenges. It may take another financial crisis before we muster the will to make the changes you suggest. Still, his work is giving us a clearer understanding of how the economy really works and how it can work better. That is a good first step.