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Channeling Growth - Outside View by Nitin Gregory
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Channeling Growth
Nov 3, 2015

'I saw a hole in the man, deep like a hunger he will never fill.' - Apocalypto

We have been talking about the basic pieces of the growth puzzle. Capital and labour combine to generate economic growth. As many sectors compete for capital and labour, what are the mechanisms that channel these basic pieces into desirable sectors?

Developing countries have helpful 'hints' as to where to channel capital. They have a template of what works in developed countries and can emulate it. This has already been detailed in our discussion about catch-up growth

For developed countries at the technology frontier, the issue gets a little more complicated. How does capital find innovation? Is there a lot of waste in the process of discovery?

Tim Hartford highlights the concept of 'small experiments' in his book Adapt. Experiments on a scale small enough to allow failure are the most effective way to succeed in an increasingly complex environment. The experiments are then exposed to the environment. And based on the feedback, only a few will succeed.

This means that there is no straight-line path. Many options are permitted, but the weak ones die. Innovation is messy. Michael Mauboussin, in his book More Than You Know, likens it to the overproduction of synapses in a baby's brain. As the baby grows, the unused synapses die out (pruning). Evolution permits many species, but the ones that are unfit for the environment will die out.

In the economy, we see many options arising, but market forces cull the undesirable ones. The current herd of 'unicorns' is a familiar pattern. In time, only a few will remain.

How does the pruning happen? Are there any helpful markers along the way?

A simple model for visualizing the flow of capital is household savings a investment in economy a goods sold to consumer. The first leg channels capital to the economy through interest rates. Interest rates are the 'cost of delaying consumption'. A high interest rate means there are many high-return ideas in the economy, and they are competing for capital. A low interest rate implies that there are very few high-return ideas, and this can skew the incentive towards consumption. An idea that cannot generate returns in line with the prevailing interest rate will eventually die out.

The second leg is the feedback mechanism. It is directed by prices. Prices are like a 'thumbs up' from the consumer. A consumer will pay a fair price only if it satisfies a demand or need. Sectors where the price levels will allow investors to recover costs and profit will attract capital. Charlie Munger talks about businesses with 'pricing power'. The good or service has characteristics (like brand, intellectual property, etc) that allow prices to be increased without affecting the demand. These businesses can give impressive returns.

Any attempts to tamper with these feedback mechanisms can result in an 'anomaly'. Price subsidies force capital into unproductive sectors. Low interest rates encourage debt (leverage) and consumption today rather than investment in the future.

Is all growth a sign of progress? Keynes predicted that in the future (given our rate of growth), the wealthy countries would have a lot of leisure time. This is not the case today. We are more likely to hear about how life has become busier.

Economic progress can be viewed in two ways - the same output and choices but with considerably fewer work hours (Keynes' scenario: You still use a wired telephone but only work a three day week) or more output and choices with the same work hours. No prizes for guessing the path we have taken.

The distinction is purely philosophical, but it's interesting to note that we are on a quest for growth that will make our lives comfortable, exciting, and enjoyable. The journey has obstacles. And it's messy and unpredictable. Like all change, no matter what central planners tell you, it is difficult and requires sacrifice...

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "Channeling Growth"

Nita

Nov 5, 2015

Well explained

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Equitymaster requests your view! Post a comment on "Channeling Growth". Click here!

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