Big Problems Need Big Solutions

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Includes: DIA, IWM, QQQ, SPY
by: CrossBorder Capital

Summary

Conventional economics muddles two basic concepts: (1) the difference between the marginal return on new capital and the average return on existing.

(2) the size of the gross rather than the net private sector balance sheet.

New thinking now required on what constitutes productive versus unproductive capital and how we use QE investment productively to raise the marginal return on capital.

For another year running, the lengths of delegates attending the annual Davos gathering will fall short of a conclusion.

Despite the ritual congratulatory back-slapping, policy makers are no nearer solving the world's Economic problems. If anything they seem more confused.

Sitting behind this failure lies the fact that conventional economics muddles two basic concepts: 1) the difference between the marginal return on new capital and the average return on existing capital, and 2) the size of the gross rather than the net private sector balance sheet. The former explains that the economic growth requires a high marginal return on capital and not simply a high average return.

Financial markets will thrive on high average return, but this is neither sustainable in the long term, nor does it promote economic expansion. The latter tells us that flows of liquidity, not just savings, are critical to funding in a monetary economy, and that deficits are secondary to this funding question.

A quick heads up example comes from the 1930s when the two largest surplus economies - France and America - were the hardest hit by the Depression.

market analysis The focus on central bank QE (quantitative easing) in some way acknowledges that liquidity is important. However, it seems to have come at the cost of less attention being paid towards encouraging the recovery of still fragile private sector sources of credit supply and suppressing volatile cross-border flows. Moreover, recent debate about QE also seems to be the wrong answer to the wrong question, namely whether capital returns (R) exceed the cost of finance , R>r or vice versa R<r.

The real issue here is whether the R under discussion refers to the average or the marginal returns on capital? Policy makers need to focus on the marginal return and although compelling evidence points to R>r, many proponents of Wicksell's teachings dangerously proclaim that r>R. In financial markets alone that may be true, but it is a consequence and not a cause of our economic problems.

QE policies should be seen as trying to reduce the risk premia component of r. However, to interpret that R>r and then conclude that QE is bad, confuses the true problem. R is separately established in the economic sphere and r in the financial markets.

Pushing down r is unlikely to raise the marginal return on capital and may only slightly nudge the average return higher. What is needed is QE funded productive investment that can directly raise the marginal return on capital. Some might see this as the Keynesian recipe for big government, larger state handouts and more inflation, but this misses the point. Keynes may have understood that the underlying problem was a lack of industrial profits, but the pre-Keynes, Classical economics spent a lot more time debating the productive versus the unproductive labor question. This is what is missing.

Brought up to date the question today is what constitutes productive versus unproductive capital? We need more productive capital and less unproductive capital. This means better roads, more housing, less spent on share buy backs and fewer hedge funds! QE is part of the solution, and not part of the problem, but it does need to be directed.

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