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Mobility, talent and capital

Wednesday 6 March 2013

By Reuven Brenner

Part four of a four-part series.

Part 1:Prosperity’s timeless sources

Part 2:The myth of government aid

Part 3:Uniqueness of the Scottish miracle

Human creative sparks are always there, probably randomly distributed around the world. Prosperity, though, is due not to new ideas but the commercialization of new ideas. And the incentives to commercialize ideas depend on accountable government and accountable, deep matchmaking in financial markets - call the latter "democratized" capital markets.

The great advantage of such markets is that they decentralize decision-making and prevent mistakes from lasting too long. Thus, when small-scale enterprises meet financial tests, they gain greater access to capital markets and expand. If they fail, the loss to society is much smaller than it is in the case of failed grandiose government-sponsored projects.

The latter must be grandiose to escape accountability, so that by the time they are finished, the politicians who started it are either dead or long out of office, calmly collecting extravagant pensions and other benefits.

Continued spending on such projects is justified by a large army of government-sponsored economists and statistical bureaus, parts of the priesthood of our times, who never fail to come up with half-baked theories of market failures to be remedied by - hold your breath - who else, but the smart, altruistic, government regulators and bureaucrats. The result of this myth-creation is that more good money is being thrown after bad.

Economists in the future may estimate exactly how much of the US economy since World War II can be attributed to the large movement to its shores of extremely skilled, ambitious, well-connected people from around the world, a world that until 10 years ago was hostile to initiative and hope.

Then we will know how much the transfer of this unmeasured human capital helped cover for many costly and mistaken US government policies. Whether or not recent observations, such as Robert Gordon’s on the pages of the Wall Street Journal, about the slowdown in rates of innovation in the US are already detecting the slowdown due to the diminished movement of the "vital few" to the US, or even reversing it (as recently documented by the outflow of the skilled of Asian origins back to their home countries), or the slowdown is happening due to the diminished incentives of financing start-ups - time will tell.

What should be clear from the historical evidence covered in the previous parts of this series is not that the declining innovations and entrepreneurship in the US is a predictable pattern, but that as the rest of the world retains its talents, and the US makes it harder to leverage vital talents in the US, it will become harder for the US to cover for its mistaken fiscal, regulatory and monetary policies.

Though for the moment the danger is not so immediate, since while some Asian governments in particular are changing their policies to accommodate entrepreneurial talents, many governments do the opposite - increase spending, raise taxes, regulate more. These countries continue to loose their "vital few", in part to the US. Washington’s present seriously mistaken policies notwithstanding, no other country sees for the moment so many people voting with their feet - or trying to - to get into the US. Perhaps this is happening because in contrast to other countries in the world, the US is still expected to correct its mistakes faster. Whether such expectations will continue to hold - time will tell.

Governments have a number of options to increase growth rates. One is to try and offer a package of taxes and benefits that would continue to attract talent and money to their shores. Because such policy discourages growth elsewhere, it can lead to retaliation.

A better alternative would be to encourage more domestic entrepreneurship. That can be done by lowering both income and capital gains taxes, and decentralizing and dispersing financial clout, while striving for accountability. These changes would bring about rebuilding equity more quickly - and this and nothing else can repay the debts that have accumulated due to compounding mistakes.

Politicians and economists argue that the present level of deficits and debts justify higher taxes. Not so: once fiscal and monetary policies lead to expectations of equity creation at a faster pace, paying down debts and deficits becomes easier. Government spending can be then cut, since companies would be expanding. The sequence in which changes in policies are carried out matter.

What is then the best way to infer from numbers whether the aforementioned policies are indeed working?

The answer is: not by looking at government statistics that reflect mismeasured, backward-looking aggregates. And nor is looking at statistical education indicators necessary useful. The production of high school and university diplomas, production of "research articles" (published in heavily subsidized journals and mainly never read outside mutual admiration societies), or for that matter even "patents" (which have turned into a trivialized compensation tool in some companies) - are no indicators of future performance.

It is true, statistically, that during the relatively good times when the dozen or so Western countries were far more distinctive in their political and financial features than now, the expansion of government bureaucracies allowed the hiring of many high school and university graduates, who managed to secure themselves high compensations. This short-term analyses created the illusion in too many thoughtless studies that staying longer on real estates called "schools" and "universities" brings higher incomes - an illusion coming now to a well-deserved end in the West.

The selection of smarter people for schools and universities will end up - once matched accountably with capital - with creating more knowledge and prosperity. Subsidizing mediocrity and below to stay in schools and universities for some 15 or 17 years - or more - is, at best, a waste of taxpayers money, and produces, at best, youngsters with pretensions with nothing to back them up. Unless an expanding bureaucracy absorbs them, they end up constituting a frustrated group, greatly disappointed in their expectations - a recipe for political venality.

The more reliable measure instead, as financial markets deepen, would be to look at significant changes in the value of market securitizations, measured in a relatively stable unit rather than a mismanaged floating paper unit.

That is because the opinions of a wide variety of people who back their opinions - accountably - with money have proven to be better predictor of where things are heading than the opinions of all those who do not so back their opinions.

Changes in the aforementioned measures are not a perfect indicator of things to come. Nothing is. But they are a better measure and more reliable measure of wealth creation than the alternatives.

The one important caveat is that financial markets must have the proper depth. That is, security markets must reflect expectations about government and central bank policies. When there are few sources of information in a society, information is controlled and the players’ hands are tied, then stock exchanges cannot fulfill their roles. Of course, the usual statistical measures are fiction in this case too - as all communist and other countries (where cash flows were centralized using other ideologies) have shown.

This brings us to China and its stock market, after a US historical reminder.

Recall that in the second half of the 19th century, the US stock markets saw spectacular booms and busts - for the aforementioned reasons. Channels of information were few; the few who had access to information did not always have the incentive to tell the truth, and they also had incentives to collude. Not surprisingly, people without privileged access to information withdrew from the markets.

However, the United States has been an open society, and people were allowed to try and overcome these problems. It was following the booms and busts a century ago that Charles Dow, Edward Jones and Charles Bergstresser were among the first to come up with the idea of publishing a financial newsletter in 1880; that the US stock exchange proposed in 1895 the radical innovation of publishing annual reports; that 100 years ago information started to be carried through New York’s streets from offices to banks - by couriers running through streets rather than as done today, flowing through satellites, cable and optical fibers.

It is not accidental that cities with developed stock exchanges also saw the emergence of a critical mass of people specializing in the information industry: newspapers, radio, broadcasting, Bloomberg, and financial and political analysts. It’s this information industry that allows stock exchanges to acquire the proper depth.

Societies that for political reasons, put impediments in the ways of information - as China did when Xinhua, the state-run central news agency, set restrictions on all aspects of Dow Jones’ business in the country - will see the same wild fluctuations on their stock exchanges as New York’s exchange saw a century ago, before the Dow Jones newsletter and the innovation of annual reports.

When that happens, neither security markets nor official statistics will tell us much about what is happening to growth and wealth creation. Recall one last time: on paper, countries were growing wonderfully under communism. But those of us who grew up under communism all knew that political statistics about growth were all one great lie.

Though the pseudo-science of macroeconomics was a myth and not a lie, its emphasis on national "aggregates" hid the reality that in one country things that people wanted were being measured, whereas elsewhere things that the rulers and the establishment wanted were being measured.

The fact that behind the aggregate counting there was, initially, a strong assumption that the relation between governments and citizens is, as in a private transaction, based on an exchange of services, was soon forgotten. The macroeconomic models, summarizing the working of the economy in a few simple-minded equations, have led to the same predictions whether "production" and "output" referred to something disastrous or something positive.

Since employment by governments and the governments’ "output" have been added, respectively, to employment and to whatever was produced in the non-government sector - and since there are good reasons, though not "macroeconomic ones", for governments to intervene and be able to do constructive things at times - it is no wonder that government expenditures were found to create both jobs and output from time to time.

By using these numbers unquestioned, economists, with the help of extensive government subsidies to bureaus of statistics and to academics, transformed a self-serving political idea into a neutral-sounding scientific debate about numbers and statistical methods, keeping political institutions out of sight.

Macroeconomics became thus a non-threatening theory that could be taught at universities around the world, and the numbers it relied on have been published with religious regularity and uncritically by all the international bodies, central banks and national statistical bureaus.

The fact that Greece was known to have a black market in the range of 50% relative to what was measured, or Italy in the 30% range - did not raise red flags. Myths do have blinding effects.

Chen Yun, a leading Communist Party figure under Mao Zedong before falling from grace, and whom Deng Xiaoping brought back to power, saw already back in 1953 that China needed a "private sector". Mao pushed Chen aside during his 1958 Great Leap Forward plan. Deng brought him back in 1978 with the explicit mandate for an economic reform plan. Chen believed that the aggregate statistics were meaningless, disguising - as Ronald Coase and Ning Wang put in a recent book - the "long structural imbalances: too much investment in heavy industry relative to light industry and agriculture, and state sectors and planning being emphasized at the exclusion of private sectors and markets."

The authors add though, that as much as observers put emphases on the reforms coming from the "center", "with the benefit of hindsight, we know that the economic forces that were really transforming the Chinese economy in the first decade of the reform were private farming, townships and village enterprises, private businesses in the cities, and the Special Economic Zones."

Briefly, dispersion of power, operating outside the state sector - and as long as they did not challenge the power of the Communist Party - created the independent sources of capital, which brought better matches with China’s diverse talents. Although these changes are still far from bringing about deep, accountable financial markets in China (as the state still controls the banks), the dispersion of power is eerily similar to what happened in Italy around the 10th and 11th centuries - where the sources of the rise of the West can be really found.

The competing trading cities in Italy of that time managed to play kings and the church one against the other - and extract the rights that brought about the gradual development and spread through Europe of the middle, commercial, trading and financial classes.

Perhaps this time it will take less than a few centuries for digesting more thoroughly what makes people and countries thrive.

This series of articles draw on Reuven Brenner’s recent speeches and on his Force of Finance, History - the Human Gamble, and other books.


Reuven Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management, and serves on the Board of the McGill Pension Fund, and is member of its investment committee. Professor Brenner this month was awarded the Queen Elizabeth II Diamond Jubilee Medal for his dedication to his peers, his community, and to Canada.

(Copyright 2013 Reuven Brenner)

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