God is a Capitalist

Sunday, April 9, 2017

Creative destruction becoming less destructive

Investors should worry about productivity growth of the firms they invest in because it is one of the major determinants of profits and market share. Innovation should drive old technology firms out of business and improve productivity but that hasn’t been the case for half a century.

Productivity growth has been falling since about 1970 for many companies according to Andrew Haldane, Bank of England Chief Economist, in his speech “Productivity puzzles” at the London School of Economics last month in which he reported what’s happening to productivity in the UK and globally.

Haldane said the future is already here — it’s just not very evenly distributed. Some companies are highly innovative with rapidly growing productivity, but most lag far behind. There are broad differences in productivity growth between advanced economies and emerging market economies, between the US and other advanced economies, across industries and within industries. After providing the fruits of excellent research, however, Haldane offered an anticlimactic solution:
The Mayfield Commission aims to create an app which enables companies to measure their productivity and benchmark themselves against other companies operating in similar sectors and regions. By shining a light on companies’ relative performance, the aim is that this would serve as a catalyst for remedial action by company management.”

Economists should be able immediately to identify the problem with the line of thinking by the commission: if technology exists that would improve the profits of firms, entrepreneurs would jump on it and run the low productivity companies out of business. That has been the model of productivity growth for centuries. So why aren’t they? Haldane hinted at the problem:
Stifled competition in certain sectors and for certain products may have prevented the trickle-down of innovation. For example, restrictions on patents and intellectual property (IP) might restrict new entrants and retard replication.
Economists need to step away from the math models for a minute and consider larger, institutional factors. If entrepreneurs are not doing what we would expect of them in a free market, then either the entrepreneurs have all died or institutional barriers exist to them performing their role.

One such barrier might be state favoritism for larger corporations. In the “Baptists and bootleggers” school of political economy, large corporations capture the regulatory agencies and create regulations that favor them over smaller, nimbler, more innovative businesses. By shutting out smaller competitors, the large corporations can form oligopolies that guarantee them large profits without the need to innovate.

One result of the research will give the left a rash: 
A one standard deviation improvement in the quality of management raises productivity by, on average, around 10%.
This suggests potentially high returns to policies which improve the quality of management within companies.” In other words, the quality of the manager makes a great difference: better managed companies have much higher productivity and that justifies their higher pay. But don’t think the solution is simply better training, or as Haldane suggested a benchmarking app. Good CEO’s are as rare as professional athletes. They will always be in short supply.

The slowdown in productivity has been much worse for emerging market economies. The benchmark is still the US, but productivity growth here is stuck at one percent. This suggests the problem is institutions. A lot of growth can be had just by buying the technology of leading countries like the US. But eventually emerging economies hit an institutional ceiling. Native collectivism recovers from the initial shock and reasserts itself. The institutions won’t let the economy grow more than it has. Institutions that promote innovation require a culture that values it and business in general, but changing the culture requires changing religions and that is a very difficult thing to do.

Interesting research for investors would be a comparison of listed companies by productivity and productivity growth. Investing in the highest productivity companies would be smart. According to Haldane, only a few companies in any industry are innovative. On the macro level, the US is still the best place to invest.

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