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.”

Bank of England: mainstream econ is broken

It seems that the Bank of England has been feeling the heat from its forecast that Brexit would plunge the UK into a depression. Added to the failure of mainstream economists to predict the Great Recession, the public is losing confidence in its gurus, according to a story in the Guardian,

Haldane described the collapse of Lehman Brothers as the economics profession’s “Michael Fish moment” (a reference to when the BBC weather forecaster predicted in 1987 that the UK would avoid a hurricane that went on to devastate large parts of southern England). Speaking at the Institute for Government in central London, Haldane [Bank of England Chief Economist] said meteorological forecasting had improved markedly following that embarrassing mistake and that the economics profession could follow in its footsteps.

The bank has come under intense criticism for predicting a dramatic slowdown in the UK’s fortunes in the event of a vote for Brexit only for the economy to bounce back strongly and remain one of the best performing in the developed world.

Before the referendum on divorcing the EU, Bank of England governor Mark Carney had warned that that the split would cause a recession in the second half of 2016. Instead, the UK economy grew at an annual rate of 2.4% in the third quarter with no signs of a slowdown in the fourth.

The Mysterious Case of Missing Inflation

When the Fed dramatically expanded its balance sheet after the latest recession began, many economists expected to meet high inflation barreling down the road. Fear of inflation helped send the price of gold to $1,800 per ounce. Instead, inflation has been very mild and Europe is flirting with deflation. What happened?

Of course, Austrians needed Hayek and Mises to remind us that the quantity theory of money shouldn't be taken mechanically. Someone has to borrow money and spend it in order for lower interest rates or QE to increase the money supply. The state borrowed and spent in the hyperinflation in Germany during the 1920’s. And the US government borrowed and spent during the 1960’s and 1970’s to create high inflation.

Today, the government borrows to maintain spending while spending increases are relatively small due to high existing debt and political opposition to increasing debt. Businesses aren’t borrowing because high taxes and massive regulation raise the profit bar to pole vaulting levels. So people are borrowing to invest in assets such as real estate and the stock market or exporting newly created money by investing overseas or buying imported goods.

Julien Noizet at spontaneousfinance.com informs us that banking regulations are directing lending to real estate. In “A new regulatory-driven housing bubble?” Julien explains the effect of risk weighted assets (RWA) on lending:

Basel regulations are still incentivising banks to channel the flow of new lending towards property-related sectors. A repeat of what happened, again and again, since the end of the 1980s, when Basel was first introduced. I cannot be 100% certain, but I think this is the first time in history that so many housing markets in so many different countries experience such coordinated waves of booms and busts.

So far we’ve had two main waves: the first one started when Basel regulations were first implemented in the second half of the 1980s. It busted in the first half of the 1990s before growing so much that it would make too much damage. The second wave started at the very end of the 1990s, this time growing more rapidly thanks to the low interest rate environment, until it reached a tragic end in 2006-2008. It now looks like the third wave has started, mostly in countries where house prices haven’t collapsed ‘too much’ during the crisis.

The Basel regulations require banks to hold more reserves for riskier loans. The safest loans go to governments, which carry a zero risk according to Basel. Real estate carries the next lowest risk. Business loans are among the riskiest and force banks to keep more cash idle.

One of the latest casualties of the Basel regulations has been the Bank of England’s Funding for Lending Scheme. The scheme set aside funds for loan to small and medium enterprises, but as Julien writes,

Since the inception of the scheme, business lending has pretty much constantly fallen… According to the FT: Figures from the British Bankers’ Association showed net lending to companies fell by £2.3bn in April to £275bn, the biggest monthly decline since last July.

The Basel accords pretty much guarantee that lending in the future will go mainly to governments and real estate, not so much to businesses. Most governments in the West are trying to limit spending, so for the foreseeable future we can expect repeated real estate and stock market bubbles and little CPI price inflation. That makes bonds a better prospect when real estate and the stock market are in bubble territory, but it also makes gold less attractive.

Of course, I could be wrong, so always hedge.