Macroeconomic Resilience

Paul Krugman points out that since 1985, business investment has been purely a demand story i.e. “a depressed economy led to low business investment” and vice versa. As he explains “The Great Recession, in particular, was led by housing and consumption, with business investment clearly responding rather than leading”. But this does not imply that low business investment does not have a causal role to play in the conditions that led to the Great Recession, or that increased business investment does not have a role to play in the recovery.

As Steve Roth notes, business investment has been anaemic throughout the neo-liberal era. JW Mason reminds us that the neo-liberal transition also coincided with a dramatically increased financialisation of the real economy. Throughout my series of posts on crony capitalism, I have argued that the structural and cyclical problems of the developed world are inextricably intertwined. The anaemic trend in business investment is the reason why the developed world has been in a ‘great stagnation’ for so long. This ‘investment deficit’ manifests itself as the ‘corporate savings glut’ and an increasingly financialised economy. The cause of the investment deficit is an increasingly financialised, cronyist, demosclerotic system where incumbent corporates do not face competitive pressure to engage in risky exploratory investment.

Business investments can typically either operate upon the scale of operations (e.g. capacity,product mix) or they can change the fundamental character of operations (e.g. changes in process, product). Investments in scaling up operations are most easily influenced by monetary policy initiatives which reduce interest rates and raise asset prices or direct fiscal policy initiatives which operate via the multiplier effect. Investments in process innovation require the presence of price competition within the industry. Investments in exploratory product innovation require not only competition amongst incumbent firms but competition from a constant and robust stream of new entrants into the industry.

In an economy where new entrants are stymied by an ever-growing ‘License Raj’ that costs the US economy an estimated $100 billion per year, a web of regulations that exist primarily to protect incumbent large corporates and a dysfunctional patent regime, it is not surprising that exploratory business investment has fallen so dramatically. A less cronyist and more dynamically competitive economy without the implicit asset-price protection of the Greenpan/Bernanke put will have lesser profits in aggregate but more investment. Incumbents need to be compelled to take on risky ventures by the threat of extinction and obsolescence. Increased investments in risky exploratory ventures will not only drag the economy out of the ‘Great Stagnation’ but it will result in a reduced share of GDP flowing to corporate profits and an increased proportion of GDP flowing towards wages. In turn, this enables the economy to achieve a sustainable state of full employment and even a higher level of sustainable consumption without households having to resort to increased leverage as they had to during the Great Moderation.

Alexander Field has illustrated how even the growth of the Golden Age of the 50s and the 60s was built upon the foundations of Pre-WW2 innovation. If this thesis is correct, the ‘Great Stagnation’ was inevitable and in fact understates how long ago the innovation deficit started. The Great Moderation far from being the cure was simply a palliative that postponed the inevitable end-point of the evolution of the macroeconomy through successive cycles of Minskyian stabilisation. As I noted in a previous post:

The neoliberal transition unshackled the invisible hand (the carrot of the profit motive) without ensuring that all key sectors of the economy were equally subject to the invisible foot (the stick of failure and losses and new firm entry)….“Order for all” became “order for the classes and disorder for the masses”….In this increasingly financialised economy, the increased market-sensitivity combined with the macro-stabilisation commitment encourages low-risk process innovation and discourages uncertain and exploratory product innovation. This tilt towards exploitation/cost-reduction without exploration kept inflation in check but it also implied a prolonged period of sub-par wage growth and a constant inability to maintain full employment unless the consumer or the government levered up. For the neo-liberal revolution to sustain a ‘corporate welfare state’ in a democratic system, the absence of wage growth necessitated an increase in household leverage for consumption growth to be maintained. 

When commentators such as James Livingston claim that tax cuts for businesses will not solve our problems and that we need a redistribution of income away from profits towards wages to trigger increased aggregate demand via aggregate consumption, I agree with them. But I disagree with the conclusion that the secular decline in business investment is inevitable, acceptable and unrelated to the current cyclical downturn. The fact that business investment during the Great Moderation only increased when consumption demand went up is a symptom of the corporatist nature of the economy. When the household sector has reached a state of peak debt and the financial system has reached its point of peak elasticity, simply running increased fiscal deficits without permitting the corporatist superstructure to collapse simply takes us to the end-state that Minsky himself envisioned: an economy that attempts to achieve full employment will yo-yo uncontrollably between a state of debt-deflation and high,variable inflation – somewhat similar to a broken shower that only runs either too hot or too cold. The only way in which the corporatist status quo can postpone collapse is to abandon the goal of full employment which is exactly the path that the developed world has taken.  This only substitutes an economic fragility with a deeper social fragility.

Stability for all is synonymous with an environment of permanent innovative stagnation. The Schumpeterian solution is to transform the system into one of instability for all. Micro-fragility is the key to macro-resilience but this fragility must be felt by all economic agents, labour and capital alike. In order to end the stagnation and achieve sustainable full employment, we need to allow incumbent banks and financialised corporations to collapse and dismantle the barriers to entry of new firms that pervade the economy. The risk of a deflationary contraction from allowing such a collapse be prevented in a simple and effective manner with a system of direct transfers to individuals as Steve Waldman has outlined. This solution also reverses the flow of rents that have exacerbated inequality over the past few decades.

Note: I went through a much longer version of the same argument with an emphasis on the relationship between employment and technology adapted to US economic history in a previous post. The above logic explains my disagreements with conventional Keynesian theory and my affinity with Post-Keynesian theory. Minsky viewed his theory as a  ’investment theory of the cycle and a financial theory of investment’ and my views are simply a neo-Schumpeterian take on the same underlying framework.

In my posts on the subject of cronyism and rent-seeking, I have drawn heavily on the work of Mancur Olson. My views are also influenced by my experiences of cronyism in India and comparing it to the Olsonian competitive sclerosis that afflicts most developed economies today. Although there are significant differences between cronyism in the developing and developed world, there is also a very significant common ground. In some respects, the rent-extraction apparatus in the developed world is just a more sophisticated version of the open corruption and looting that is common in many developing economies. This post explores some of this common ground.

Mancur Olson predicted the inexorable rise of rent seeking in a stable economy. But he also thought that once rent-seeking activities extracted too high a proportion of a nation’s GDP, the normal course of democracy and public anger may rein them in. Small rent seekers can fly under the radar but big rent-seekers are ultimately cut back to size. But is this necessarily true? Although there is some truth to this assertion, Olson was likely too optimistic about the existence of such limits. This post tries to provide an argument as to why this is not necessarily the case. After all, it can easily be argued that rents extracted by banks already swallow up a significant proportion of GDP. And there is no shortage of corrupt public programs that swallow up significant proportions of the public budget in the developing world. In a nutshell, my argument is that rent-extraction can avoid these limits by aligning itself to the progressive agenda – the very programs that purport to help the masses become the source of rents for the classes.

A transparent example of this phenomenon is the experience of the Mahatma Gandhi National Rural Employment Guarantee – a public program that guarantees 100 days of work for unskilled rural labourers in India. In a little more than half a decade since inception, it accounts for 3% of public spending and economists estimate that anywhere from a quarter to two-thirds of the expenditure does not reach those whom it is intended to help. So how does a program such as this not only survive but thrive? The answer is simple – despite the corruption, the scheme does disburse significant benefits to a large rural electorate. When faced with the choice of either tolerating a corrupt program or cancelling the program, the rural poor clearly prefer the status quo.

A rather more sophisticated example of this phenomenon is the endless black hole of losses that are Freddie Mac and Fannie Mae – $175 billion and counting. The press focuses on the comparatively small bonus payments to Freddie and Fannie executives but ignores their much larger role in the back door bailout of the banking sector. Again the reason why this goes relatively uncriticised is simple – despite the significant contribution made by Fannie and Freddie to the rents extracted by the “1%”, their operations also put money into the pockets of a vast cross-section of homeowners. Simply shutting them down would almost certainly constitute an act of political suicide.

Source (h/t to David Ruccio)

The masses become the shield for the very programs that enable a select few to extract significant rents out of the system. The same programs that are supposed to be part of the liberal social agenda like Fannie/Freddie become the weapons through which the cronyist corporate structure perpetuates itself, while the broad-based support for these programs makes them incredibly resilient and hard to reform once they have taken root.

Those who cherish the progressive agenda tend to argue that better implementation and regulation can solve the problem of rent extraction. But there is another option – complex programs with egalitarian aims should be replaced with direct cash transfers wherever feasible. This case has been argued persuasively in a recent book as an effective way to help the poor in developing countries and is already being implemented in India. There is no reason why the same approach cannot be implemented in the developed world either.

All economists assert that wants are unlimited. From this follows the view that technological unemployment is impossible in the long run. Yet there are a growing number of commentators (such as Brian Arthur) who insist that increased productivity from automation and improvements in artificial intelligence has a part to play in the current unemployment crisis. At the same time, a growing chorus laments the absence of innovation – Tyler Cowen’s thesis that the recent past has been a ‘Great Stagnation’ is compelling.

But don’t the two assertions contradict each other? Can we have an increase in technological unemployment as well as an innovation deficit? Is the concept of technological unemployment itself valid? Is there anything about the current phase of labour-displacing technological innovation that is different from the past 150 years? To answer these questions, we need a deeper understanding of the dynamics of innovation in a capitalist economy i.e. how exactly has innovation and productivity growth proceeded in a manner consistent with full employment in the past? In the process, I also hope to connect the long-run structural dynamic with the Minskyian business cycle dynamic. It is common to view the structural dynamic of technological change as a sort of ‘deus ex machine’ – if not independent, certainly as a phenomenon that is unconnected with the business cycle. I hope to convince some of you that our choices regarding business cycle stabilisation have a direct bearing on the structural dynamic of innovation. I have touched upon many of these topics in a scattered fashion in previous posts but this post is an attempt to present many of these thoughts in a coherent fashion with all my assumptions explicitly laid out in relation to established macroeconomic theory.

Micro-Foundations

Imperfectly competitive markets are the norm in most modern economies. In instances where economies of scale or network effects dominate, a market may even be oligopolistic or monopolistic (e.g. Google, Microsoft) This assumption is of course nothing new to conventional macroeconomic theory. Where my analysis differs is in viewing the imperfectly competitive process as one that is permanently in disequilibrium. Rents or “abnormal” profits are a persistent feature of the economy at the level of the firm and are not competed away even in the long run. The primary objective of incumbent rent-earners is to build a moat around their existing rents whereas the primary objective of competition from new entrants is not to drive rents down to zero, but to displace the incumbent rent-earner. It is not the absence of rents but the continuous threat to the survival of the incumbent rent-earner that defines a truly vibrant capitalist economy i.e. each niche must be continually contested by new entrants. This does not imply, even if the market for labour is perfectly competitive, that an abnormal share of GDP goes to “capital”. Most new entrants fail and suffer economic losses in their bid to capture economic rents and even a dominant incumbent may lose a significant proportion of past earned rents in futile attempts to defend its competitive position before its eventual demise.

This emphasis on disequilibrium points to the fact that the “optimum” state for a dynamically competitive capitalist economy is one of constant competitive discomfort and disorder. This perspective leads to a dramatically different policy emphasis from conventional theory which universally focuses on increasing positive incentives to economic players and relying on the invisible hand to guide the economy to a better equilibrium. Both Schumpeter and Marx understood the importance of this competitive discomfort for the constant innovative dynamism of a capitalist economy – my point is simply that a universal discomfort of capital is also important to maintain the distributive justice in a capitalist economy. in fact it is the only way to do so without sacrificing the innovative dynamism of the economy.

Competition in monopolistically competitive markets manifests itself through two distinct forms of innovation: exploitation and exploration. Exploitation usually takes the form of what James Utterback identified as process innovation with an emphasis on “real or potential cost reduction, improved product quality, and wider availability, and movement towards more highly integrated and continuous production processes.” As Utterback noted, such innovation is almost always driven by the incumbent firms. Exploitation is an act of optimisation under a known distribution i.e. it falls under the domain of homo economicus. In the language of fitness landscapes, exploitative process innovation is best viewed as competition around a local peak. On the other hand, exploratory product innovation (analogous to what Utterback identified as product innovation) occurs under conditions of significant irreducible uncertainty. Exploration is aimed at finding a significantly higher peak on the fitness landscape and as Utterback noted, is almost always driven by new entrants (For a more detailed explanation of incumbent preference for exploitation and organisational rigidity, see my earlier post).

An Investment Theory of the Business Cycle

Soon after publishing the ‘General Theory’, Keynes summarised his thesis as follows: “given the psychology of the public, the level of output and employment as a whole depends on the amount of investment. I put it in this way, not because this is the only factor on which aggregate output depends, but because it is usual in a complex system to regard as the causa causans that factor which is most prone to sudden and wide fluctuation.” In Keynes‘ view, the investment decision was undertaken in a condition of irreducible uncertainty, “influenced by our views of the future about which we know so little”. Just how critical the level of investment is in maintaining full employment is highlighted by GLS Shackle in his interpretation of Keynes’ theory: “In a money-using society which wishes to save some of the income it receives in payment for its productive efforts, it is not possible for the whole (daily or annual) product to be sold unless some of it is sold to investors and not to consumers. Investors are people who put their money on time-to-come. But they do not have to be investors. They can instead be liquidity-preferrers; they can sweep up their chips from the table and withdraw. If they do, they will give no employment to those who (in face of society’s propensity to save) can only be employed in making investment goods, things whose stream of usefulness will only come out over the years to come.”

If we accept this thesis, then it is no surprise that the post–2008 recovery has been quite so anaemic. Investment spending has remained low throughout the developed world, nowhere more so than in the United Kingdom. What makes this low level of investment even more surprising is the strength of the rebound in corporate profits and balance sheets – corporate leverage in the United States is as low as it has been for two decades and the proportion of cash in total assets as high as it has been for almost half a century. Specifically, the United States has also experienced an unusual increase in labour productivity during the recession which has exacerbated the disconnect between the recovery in GDP and employment. Some of these unusual patterns have been with us for a much longer time than the 2008 financial crisis. For example, the disconnect between GDP and employment in the United States has been obvious since atleast 1990, and the 2003 recession too saw an unusual rise in labour productivity. The labour market has been slack for at least a decade. It is hard to differ from Paul Krugman’s intuition that the character of post–1980 business cycles has changed. Europe and Japan are not immune from these “structural” patterns either – the ‘corporate savings glut’ has been a problem in the United Kingdom since atleast 2002, and Post-Keynesian economists have been pointing out the relationship between ‘capital accumulation’ and unemployment for a while, even attributing the persistently high unemployment in Europe to a lack of investment. Japan’s condition for the last decade is better described as a ‘corporate savings trap’ rather than a ‘liquidity trap’. Even in Greece, that poster child for fiscal profligacy, the recession is accompanied by a collapse in private sector investment.

A Theory of Business Investment

Business investments can typically either operate upon the scale of operations (e.g. capacity,product mix) or they can change the fundamental character of operations (e.g. changes in process, product). The degree of irreducible uncertainty in capacity and product mix decisions has reduced dramatically in the last half-century. The ability of firms to react quickly and effectively to changes in market conditions has improved dramatically with improvements in production processes and information technology – Zara being a well-researched example. Investments that change the very nature of business operations are what we typically identify as innovations. However, not all innovation decisions are subject to irreducible uncertainty either. In a seminal article, James March distinguished between “the exploration of new possibilities and the exploitation of old certainties. Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” Exploratory innovation operates under conditions of irreducible uncertainty whereas exploitation is an act of optimisation under a known distribution.

Investments in scaling up operations are most easily influenced by monetary policy initiatives which reduce interest rates and raise asset prices or direct fiscal policy initiatives which operate via the multiplier effect. In recent times, especially in the United States and United Kingdom, the reduction in rates has also directly facilitated the levering up of the consumer balance sheet and a reduction in the interest servicing burden of past consumer debt taken on. The resulting boost to consumer spending and demand also stimulates businesses to invest in expanding capacity. Exploitative innovation requires the presence of price competition within the industry i.e. monopolies or oligopolies have little incentive to make their operations more efficient beyond the price point where demand for their product is essentially inelastic. This sounds like an exceptional case but is in fact very common in critical industries such as finance and healthcare. Exploratory innovation requires not only competition amongst incumbent firms but competition from a constant and robust stream of new entrants into the industry. I outlined the rationale for this in a previous post:

Let us assume a scenario where the entry of new firms has slowed to a trickle, the sector is dominated by a few dominant incumbents and the S-curve of growth is about to enter its maturity/decline phase. To trigger off a new S-curve of growth, the incumbents need to explore. However, almost by definition, the odds that any given act of exploration will be successful is small. Moreover, the positive payoff from any exploratory search almost certainly lies far in the future. For an improbable shot at moving from a position of comfort to one of dominance in the distant future, an incumbent firm needs to divert resources from optimising and efficiency-increasing initiatives that will deliver predictable profits in the near future. Of course if a significant proportion of its competitors adopt an exploratory strategy, even an incumbent firm will be forced to follow suit for fear of loss of market share. But this critical mass of exploratory incumbents never comes about. In essence, the state where almost all incumbents are content to focus their energies on exploitation is a Nash equilibrium.
On the other hand, the incentives of any new entrant are almost entirely skewed in favour of exploratory strategies. Even an improbable shot at glory is enough to outweigh the minor consequences of failure. It cannot be emphasised enough that this argument does not depend upon the irrationality of the entrant. The same incremental payoff that represents a minor improvement for the incumbent is a life-changing event for the entrepreneur. When there exists a critical mass of exploratory new entrants, the dominant incumbents are compelled to follow suit and the Nash equilibrium of the industry shifts towards the appropriate mix of exploitation and exploration.

A Theory of Employment

My fundamental assertion is that a constant and high level of uncertain, exploratory investment is required to maintain a sustainable and resilient state of full employment. And as I mentioned earlier, exploratory investment driven by product innovation requires a constant threat from new entrants.

Long-run increases in aggregate demand require product innovation. As Rick Szostak notes:

While in the short run government spending and investment have a role to play, in the long run it is per capita consumption that must rise in order for increases in per capita output to be sustained…..the reason that we consume many times more than our great-grandparents is not to be found for the most part in our consumption of greater quantities of the same items which they purchased…The bulk of the increase in consumption expenditures, however, has gone towards goods and services those not-too-distant forebears had never heard of, or could not dream of affording….Would we as a society of consumers/workers have striven as hard to achieve our present incomes if our consumption bundle had only deepened rather than widened? Hardly. It should be clear to all that the tremendous increase in per capita consumption in the past century would not have been possible if not for the introduction of a wide range of different products. Consumers do not consume a composite good X. Rather, they consume a variety of goods, and at some point run into a steeply declining marginal utility from each. As writers as diverse as Galbraith and Marshall have noted, if declining marginal utility exists with respect to each good it holds over the whole basket of goods as well…..The simple fact is that, in the absence of the creation of new goods, aggregate demand can be highly inelastic, and thus falling prices will have little effect on output.

Therefore, when cost-cutting and process optimisation in an industry enables a product to be sold at a lower cost, the economy may not be able to reorganise back to full employment with simply an increased demand for that particular product. In the early stages of a product when demand is sufficiently elastic, process innovation can increase employment. But as the product ages, process improvements have a steadily negative effect on employment.

Eventually, a successful reorganisation back to full employment entails creating demand for new products. If such new products were simply an addition to the set of products that we consumed, disruption would be minimal. But almost any significant new product that arises from exploratory investment also destroys an old product. The tablet cannibalises the netbook, the smartphone cannibalises the camera etc. This of course is the destruction in Schumpeter’s creative destruction. It is precisely because of this cannibalistic nature of exploratory innovation that established incumbents rarely engage in it, unless compelled to do so by the force of new entrants. Burton Klein put it well: “ firms involved in such competition must compare two risks: the risk of being unsuccessful when promoting a discovery or bringing about an innovation versus the risk of having a market stolen away by a competitor: the greater the risk that a firm’s rivals take, the greater must be the risks to which must subject itself for its own survival.” Even when new firms enter a market at a healthy pace, it is rare that incumbent firms are successful at bringing about disruptive exploratory changes. When the pace of dynamic competition is slow, incumbents can choose to simply maintain slack and wait for any promising new technology to emerge which it can buy up rather than risking investment in some uncertain new technology.

We need exploratory investment because this expansion of the economy into its ‘adjacent possible’ does not derive its thrust from the consumer but from the entrepreneur. In other words, new wants are not demanded by the consumers but are instead created by entrepreneurs such as Steve Jobs. In the absence of dynamic competition from new entrants, wants remain limited.

In essence, this framework incorporates technological innovation into a distinctly “Chapter 12” Keynesian view of the business cycle. Although my views are far removed from macroeconomic orthodoxy, they are not quite so radical that they have no precedents whatsoever. My views can be seen as a simple extension of Burton Klein’s seminal work outlined in his books ‘Dynamic Economics’ and ‘Prices, wages, and business cycles: a dynamic theory’. But the closest parallels to this explanation can be found in Rick Szostak’s book ‘Technological innovation and the Great Depression’. Szostak uses an almost identical rationale to explain unemployment during the Great Depression, “how an abundance of labor-saving production technology coupled with a virtual absence of new product innovation could affect consumption, investment and the functioning of the labor market in such a way that a large and sustained contraction in employment would result.”

As I have hinted at in a previous post, this is not a conventional “structural” explanation of unemployment. Szostak explains the difference: “An alternative technological argument would be that the skills required of the workforce changed more rapidly in the interwar period than did the skills possessed by the workforce. Thus, there were enough jobs to go around; workers simply were not suited to them, and a painful decade of adjustment was required…I argue that in fact there simply were not enough jobs of any kind available.” In other words, this is a partly technological explanation for the shortfall in aggregate demand.

The Invisible Foot and New Firm Entry

The concept of the “Invisible Foot” was introduced by Joseph Berliner as a counterpoint to Adam Smith’s “Invisible Hand” to explain why innovation was so hard in the centrally planned Soviet economy:

Adam Smith taught us to think of competition as an “invisible hand” that guides production into the socially desirable channels….But if Adam Smith had taken as his point of departure not the coordinating mechanism but the innovation mechanism of capitalism, he may well have designated competition not as an invisible hand but as an invisible foot. For the effect of competition is not only to motivate profit-seeking entrepreneurs to seek yet more profit but to jolt conservative enterprises into the adoption of new technology and the search for improved processes and products. From the point of view of the static efficiency of resource allocation, the evil of monopoly is that it prevents resources from flowing into those lines of production in which their social value would be greatest. But from the point of view of innovation, the evil of monopoly is that it enables producers to enjoy high rates of profit without having to undertake the exacting and risky activities associated with technological change. A world of monopolies, socialist or capitalist, would be a world with very little technological change.” 

For disruptive innovation to persist, the invisible foot needs to be “applied vigorously to the backsides of enterprises that would otherwise have been quite content to go on producing the same products in the same ways, and at a reasonable profit, if they could only be protected from the intrusion of competition”. Burton Klein’s great contribution along with Gunnar Eliasson was to highlight the critical importance of entry of new firms in maintaining the efficacy of the invisible foot. Klein believed that

the degree of risk taking is determined by the robustness of dynamic competition, which mainly depends on the rate of entry of new firms. If entry into an industry is fairly steady, the game is likely to have the flavour of a highly competitive sport. When some firms in an industry concentrate on making significant advances that will bear fruit within several years, others must be concerned with making their long-run profits as large as possible, if they hope to survive. But after entry has been closed for a number of years, a tightly organised oligopoly will probably emerge in which firms will endeavour to make their environments highly predictable in order to make their environments highly predictable in order to make their short-run profits as large as possible….Because of new entries, a relatively concentrated industry can remain highly dynamic. But, when entry is absent for some years, and expectations are premised on the future absence of entry, a relatively concentrated industry is likely to evolve into a tight oligopoly. In particular, when entry is long absent, managers are likely to be more and more narrowly selected; and they will probably engage in such parallel behaviour with respect to products and prices that it might seem that the entire industry is commanded by a single general!

This argument does not depend on incumbent firms leaving money on the table – on the contrary, they may redouble their attempts at cost reduction via process innovation in times of deficient demand. Rick Szostak documents how “despite the availability of a massive amount of inexpensive labour, process innovation would continue in the 1930s. Output per man-hour in manufacturing rose by 25% in the 1930s…..national output was higher in 1939 than in 1929, while employment was over two million less.”

Macroeconomic Policy and Exploratory Product Innovation

Monetary policy has been the preferred cure for insufficient aggregate demand throughout and since the Great Moderation. The argument goes that lower real rates, inflation and higher asset prices will increase investment via Tobin’s Q and increase consumption via the wealth effect and reduction in rewards to savings, all bound together in the virtuous cycle of the multiplier. If monetary policy is insufficient, fiscal policy may be deployed with a focus on either directly increasing aggregate demand or providing businesses with supply-side incentives such as tax cuts.

There is a common underlying theme to all of the above policy options – they focus on the question “how do we make businesses want to invest?” i.e. on positively incentivising incumbent business and startups and trusting that the invisible hand will do the rest. In the context of exploratory investments, the appropriate question is instead “how do we make businesses have to invest?” i.e. on compelling incumbent firms to invest in speculative projects in order to defend their rents or lose out to new entrants if they fail to do so. But the problem isn’t just that these policies are ineffectual. Many of the policies that focus on positive incentives weaken the competitive discomfort from the invisible foot by helping to entrench the competitive position of incumbent corporates and reducing their incentive to engage in exploratory investment. It is in this context that interventions such as central bank purchase of assets and fiscal stimulus measures that dole out contracts to the favoured do permanent harm to the economy.

The division that matters from the perspective of maintaining the appropriate level of exploratory investment and product innovation is not monetary vs fiscal but the division between existing assets and economic interests and new firms/entrepreneurs. Almost all monetary policy initiatives focus on purchasing existing assets from incumbent firms or reducing real rates for incumbent banks and their clients. A significant proportion of fiscal policy does the same. The implicit assumption is, as Nick Rowe notes, that there is “high substitutability between old and new investment projects, so the previous owners of the old investment projects will go looking for new ones with their new cash”. This assumption does not hold in the case of exploratory investments – asset-holders will likely chase after a replacement asset but this asset will likely be an existing investment project, not a new one. The result of the intervention will be an increase in prices of such assets but it will not feed into any “real” new investment activity. In other words, the Tobin’s q effect is negligible for exploratory investments in the short run and in fact negative in the long run as the accumulated effect of rents derived from monetary and fiscal intervention reduces the need for incumbent firms to engage in such speculative investment.

A Brief History of the Post-WW2 United States Macroeconomy

In this section, I’m going to use the above framework to make sense of the evolution of the macroeconomy in the United States after WW2. The framework is relevant for post–70s Europe and Japan as well which is why the ‘investment deficit problem’ afflicts almost the entire developed world today. But the details differ quite significantly especially with regards to the distributional choices made in different countries.

The Golden Age

The 50s and the 60s are best characterised as a period of “order for all” characterised by as Bill Lazonick put it, “oligopolistic competition, career employment with one company, and regulated financial markets”. The ‘Golden Age’ delivered prosperity for a few reasons:

• As Minsky noted, the financial sector had only just begun the process of adapting to and circumventing regulations designed to constrain and control it. As a result, the Fed had as much control over credit creation and bank policies as it would ever have.
• The pace of both product and process innovation had slowed down significantly in the real economy, especially in manufacturing. Much of the productivity growth came from product innovations that had already been made prior to WW2. As Alexander Field explains (on the slowdown in manufacturing TFP): “Through marketing and planned obsolescence, the disruptive force of technological change – what Joseph Schumpeter called creative destruction – had largely been domesticated, at least for a time. Whereas large corporations had funded research leading to a large number of important innovations during the 1930s, many critics now argued that these behemoths had become obstacles to transformative innovation, too concerned about the prospect of devaluing rent-yielding income streams from existing technologies. Disruptions to the rank order of the largest U.S. industrial corporations during this quarter century were remarkably few. And the overall rate of TFP growth within manufacturing fell by more than a percentage point compared with the 1930s and more than 3.5 percentage points compared with the 1920s.”
• Apart from the fact that the economy had to catch up to earlier product innovation, the dominant position of the US in the global economy post WW2 limited the impact from foreign competition.

It was this peculiar confluence of factors that enabled a system of “order and stability for all” without triggering a complete collapse in productivity or financial instability – a system where both labour and capital were equally strong and protected and shared in the rents available to all.

Stagflation

The 70s are best described as the time when this ordered, stabilised system could not be sustained any longer.

• By the late 60s, the financial sector had adapted to the regulatory environment. Innovations such as Fed Funds market and the Eurodollar market gradually came into being such that by the late 60s, credit creation and bank lending were increasingly difficult for the Fed to control. Reserves were no longer a binding constraint on bank operations.
• The absence of real competition either on the basis of price or from new entrants meant that both process and product innovation were low just like during the Golden Age but the difference was that there were no more low-hanging fruit to pick from past product innovations. Therefore, a secular slowdown in productivity took hold.
• The rest of world had caught up and foreign competition began to intensify.

As Burton Klein noted, “competition provides a deterrent to wage and price increases because firms that allow wages to increase more rapidly than productivity face penalties in the form of reduced profits and reduced employment”. In the absence of adequate competition, demand is inelastic and there is little pressure to reduce costs. As the level of price/cost competition reduces, more and more unemployment is required to keep inflation under control. Even worse, as Klein noted, it only takes the absence of competition in a few key sectors for the disease to afflict the entire economy. Controlling overall inflation in the macroeconomy when a few key sectors are sheltered from competitive discomfort requires monetary action that will extract a disproportionate amount of pain from the remainder of the economy. Stagflation is the inevitable consequence in a stabilised economy suffering from progressive competitive sclerosis.

The “Solution”

By the late 70s, the pressures and conflicts of the system of “order for all” meant that change was inevitable. The result was what is commonly known as the neoliberal revolution. There are many different interpretations of this transition. To right-wing commentators, neoliberalism signified a much-needed transition towards a free-market economy. Most left-wing commentators lament the resultant supremacy of capital over labour and rising inequality. For some, the neoliberal era started with Paul Volcker having the courage to inflict the required pain to break the back of inflationary forces and continued with central banks learning the lessons of the past which gave us the Great Moderation.

All these explanations are relevant but in my opinion, they are simply a subset of a larger and simpler explanation. The prior economic regime was a system where both the invisible hand and the invisible foot were shackled – firms were protected but their profit motive was also shackled by the protection provided to labour. The neoliberal transition unshackled the invisible hand (the carrot of the profit motive) without ensuring that all key sectors of the economy were equally subject to the invisible foot (the stick of failure and losses and new firm entry). Instead of tackling the root problem of progressive competitive and democratic sclerosis and cronyism, the neoliberal era provided a stop-gap solution. “Order for all” became “order for the classes and disorder for the masses”. As many commentators have noted, the reality of neoliberalism is not consistent with the theory of classical liberalism. Minsky captured the hypocrisy well: “Conservatives call for the freeing of markets even as their corporate clients lobby for legislation that would institutionalize and legitimize their market power; businessmen and bankers recoil in horror at the prospect of easing entry into their various domains even as technological changes and institutional evolution make the traditional demarcations of types of business obsolete. In truth, corporate America pays lip service to free enterprise and extols the tenets of Adam Smith, while striving to sustain and legitimize the very thing that Smith abhorred – state-mandated market power.”

The critical component of this doctrine is the emphasis on macroeconomic and financial sector stabilisation implemented primarily through monetary policy focused on the banking and asset price channels of policy transmission:
Any significant fall in asset prices (especially equity prices) has been met with a strong stimulus from the Fed i.e. the ‘Greenspan Put’. In his plea for increased quantitative easing via purchase of agency MBS, Joe Gagnon captured the logic of this policy: ““This avalanche of money would surely push up stock prices, push down bond yields, support real estate prices, and push up the value of foreign currencies. All of these financial developments would stimulate US economic activity.” In other words, prop up asset prices and the real economy will mend itself.
Similarly, Fed and Treasury policy has ensured that none of the large banks can fail. In particular, bank creditors have been shielded from any losses. The argument is that allowing banks to fail will cripple the flow of credit to the real economy and result in a deflationary collapse that cannot be offset by conventional monetary policy alone. This is the logic for why banks were allowed access to a panoply of Federal Reserve liquidity facilities at the height of the crisis. In other words, prop up the banks and the real economy will mend itself.

In this increasingly financialised economy, “the increased market-sensitivity combined with the macro-stabilisation commitment encourages low-risk process innovation and discourages uncertain and exploratory product innovation.” This tilt towards exploitation/cost-reduction without exploration kept inflation in check but it also implied a prolonged period of sub-par wage growth and a constant inability to maintain full employment unless the consumer or the government levered up. For the neo-liberal revolution to sustain a ‘corporate welfare state’ in a democratic system, the absence of wage growth necessitated an increase in household leverage for consumption growth to be maintained. The monetary policy doctrine of the Great Moderation exacerbated the problem of competitive sclerosis and the investment deficit but it also provided the palliative medicine that postponed the day of reckoning. The unshackling of the financial sector was a necessary condition for this cure to work its way through the economy for as long as it did.

It is this focus on the carrot of higher profits that also triggered the widespread adoption of high-powered incentives such as stock options and bonuses to align manager and stockholder incentives. When the risk of being displaced by innovative new entrants is low, high-powered managerial incentives help to tilt the focus of the firm towards a focus on process innovation and cost reduction, optimisation of leverage etc. From the stockholders and the managers’ perspective, the focus on short-term profits is a feature, not a bug.

The Dénouement

So long as unemployment and consumption could be propped up by increasing leverage from the consumer and/or the state, the long-run shortage in exploratory product innovation and the stagnation in wages could be swept under the rug and economic growth could be maintained. But there is every sign that the household sector has reached a state of peak debt and the financial system has reached its point of peak elasticity. The policy that worked so well during the Great Moderation is now simply focused on preventing the collapse of the cronyist and financialised economy. The system has become so fragile that Minsky’s vision is more correct than ever – an economy at full employment will yo-yo uncontrollably between a state of debt-deflation and high,variable inflation. Instead the goal of full employment seems to have been abandoned in order to postpone the inevitable collapse. This only substitutes an economic fragility with a deeper social fragility.

The aim of full employment is made even harder with the acceleration of process innovation due to advances in artificial intelligence and computerisation. Process innovation gives us technological unemployment while at the same time the absence of exploratory product innovation leaves us stuck in the Great Stagnation.

The solution preferred by the left is to somehow recreate the golden age of the 50s and the 60s i.e. order for all. Apart from the impossibility of retrieving the docile financial system of that age (which Minsky understood), the solution of micro-stability for all is an environment of permanent innovative stagnation. The Schumpeterian solution is to transform the system into one of disorder for all, masses and classes alike. Micro-fragility is the key to macro-resilience but this fragility must be felt by all economic agents, labour and capital alike. In order to end the stagnation and achieve sustainable full employment, we need to allow incumbent banks and financialised corporations to collapse and dismantle the barriers to entry of new firms that pervade the economy (e.g. occupational licensing, the patent system). But this does not imply that the macroeconomy should suffer from a deflationary contraction. Deflation can be prevented in a simple and effective manner with a system of direct transfers to individuals as Steve Waldman has outlined. This solution reverses the flow of rents that have exacerbated inequality over the past few decades, as well as tackling the cronyism and demosclerosis that is crippling innovation and preventing full employment.

Triggered by Robert Kuttner’s column in the American Prospect, the explanation du jour of our current economic malaise blames the ‘rentier class’ i.e. owners of financial assets – the thesis being that wealthy Americans do not want any more inflationary policies to be enacted and may even prefer deflation instead. Paul Krugman argues that wealthy Americans do not want inflation because financial securities are overwhelmingly held by the richest 10% of the population. But what matters for the incentives of rich households is what proportion of their balance sheet is made up of nominal financial securities. And Edward Wolff’s paper shows us that a significant proportion of the balance sheet of wealthy Americans is made up of real assets – real estate, stock and business holdings.

Similarly, a return to deflation will result in a fall in demand for products and services sold by businesses and a deterioration in bank balance sheets with increased and disruptive bankruptcies. As Brad DeLong noted, no one benefits from a deflationary collapse in the economy. A much better explanation is offered by Matthew Yglesias when he observes that “the Fed has hardly been indifferent to the potential for monetary expansion. It’s just that the goal of monetary expansion has been to do just enough to stabilize financial asset prices without going far enough to produce catch-up growth in the labor market.” What wealthy Americans, businesses and banks share is a common interest in supporting asset prices (real and nominal), a lack of interest in seeking full employment unless it is a prerequisite for supporting asset prices, and an aversion to any policies that can trigger wage inflation.

This bias towards asset price inflation doesn’t just impact the amount of stimulus. It has an influence on the type of stimulus that is preferred in this class conflict. The goal of asset price inflation without wage inflation is best achieved by an exclusive reliance on monetary policy – as I discussed in a previous post, a combination of “liquidity” facilities to prevent a collapse in shadow money supply and open market operations/QE to reduce real rates across the risk-free curve. Given the anaemic state of household balance sheets and insensitivity of corporate investment to interest rates due to a cronyist corporate sector, lower rates will not trigger sufficient real economic activity to trigger wage inflation but they will support real asset prices. Even within the ambit of fiscal policy, supply-side incentives for businesses are preferred. Given a less than competitive corporate sector, these will feed through to business profits more than they will feed through to wage inflation and employment.

Some of you may have noticed the distinctly Marxist tone of this debate – an emphasis on class conflict that rarely permeates economic discussion in mainstream circles. This is not a coincidence – as I observed in an earlier post, the dynamics of a crony capitalist economy resemble a zero-sum Marxian class struggle. Rather than expanding the size of the economic pie, economic agents focus their energies on trying to capture a larger slice of a static, stagnant output.

In previous posts (1,2), I explained how crony capitalism and rent-seeking can explain many of our current economic problems. Although I drew parallels with the experiences with cronyism in developing economies, there are some important differences that I neglected to mention.

Financing Constraints and Cronyism

Earlier, I highlighted the role that financing constraints faced by new firms can play in inhibiting exploratory investment. As Raghuram Rajan and Luigi Zingales have explained in great detail, financing constraints have caused and helped support cronyism throughout economic history. Incumbent corporates feel especially threatened by free financial markets “because they provide resources to newcomers, who then can make other markets competitive.”

Banks may be reluctant to lend to new entrants for entirely rational reasons such as lack of collateral or uncertainty-aversion. Moreover, many developing economies are capital-poor at the early stages of their economic development and their governments often choose to play an active part in allocating scarce capital to chosen industries and firms. In his book on the origins of cronyism in Japan, Richard Katz laid out the extent to which Japanese capital-intensive firms were dependent upon state patronage and approval for their financing needs in the 50s and 60s. Katz takes the example of Kawasaki Steel which struggled to raise capital for Japan’s first modern integrated steel facility due to the objections of the BoJ and only succeeded due to the patronage of another government agency, the Japan Development bank (JDB).

Inefficient Crony Capitalism vs Efficient Crony Capitalism

Although there are some similarities (e.g. collateral constraints), it is a stretch to compare the cronyism of capital-poor developing economies with financing constraints faced by new firms in the developed world (especially the United States) today. There are fundamental differences between the crony capitalism faced by the United States and the experience of economies such as India or Japan. As I have highlighted before, our malaise is caused by insufficiently exploratory incumbent firms. However, our economy is sufficiently internally competitive that incumbent corporates are efficient. Crony capitalism in most developing economies and in Japan has been characterised by a distinctly inefficient and uncompetitive corporate sector. Katz describes the high costs and overemployment that are endemic to many of Japan’s domestic industries which can only remain solvent due to a myriad of implicit and explicit collusive and protectionist measures. In other words, the protected incumbents in most developing economies not only fail to explore but are exploitatively inefficient.

The exploitatively inefficient crony capitalism of most developing economies is easy to identify. For example, Katz documents the abysmal productivity of Japan’s protected domestic sectors. On the other hand, a systemic failure to explore and innovate is more subtle and harder to detect – in fact, the drive towards exploitative efficiency is likely to increase measured productivity in the short run. When Katz argues that America’s problems have few similarities to the problems of Japan’s dual economy he is only half right.

The most significant difference between inefficient and efficient crony capitalism is in its impact on unemployment and prices. Paradoxically, efficient crony capitalism goes hand in hand with higher unemployment and lower prices. Incumbent corporates are efficient enough to shed workers during the inevitable deleveraging cycle but are unwilling to explore and create the new jobs that will take their place. Intense exploitative competition between the incumbents also reduces price levels in the short run. On the other hand, inefficient crony economies have lower unemployment at the cost of lower economic output and higher prices. Richard Katz’s observations on Japan’s hidden social safety net are worth repeating in full: “Whereas in Europe, the social safety net is woven out of overt government programs, in Japan it occurs in hidden form. Anticompetitive activities allow moribund companies and flagging companies to sustain themselves so that unemployment is disguised….”Japan is organized so that society’s losers don’t feel like losers,” is how it is described by Takashi Kiuchi, chief economist at the Long-Term Credit Bank.”

In this post, I apply the framework outlined previously to some empirical patterns in the financial markets and the broader economy. The objective is not to posit crony capitalism as the sole explanation of the below patterns, but merely to argue that the below patterns are consistent with an increasingly crony capitalist economy.

The Paradox of Low Volatility and High Correlation

As many commentators have pointed out [1,2,3], the spike in volatility experienced during the depths of the financial crisis has largely reversed itself but correlation within equities and between various risky asset classes has kept on moving higher. The combination of high volatility and high correlation is associated with the process of collapse and typical of the Minsky moment when the system undergoes a rapid delevering. However the combination of high correlation and low volatility post the Minsky moment is unusual. In the absence of bailouts or protectionism, the economy should undergo a process of creative destruction and intense exploratory activity which by its diffuse nature results in low correlation. The combination of high correlation and low volatility instead signifies stasis and the absence of sufficient exploration in the economy, alongwith the presence of significant slack at firm level (micro-resilience).

As I mentioned in a previous post, financing constraints faced by small businesses hinder new firm entry across industries. Expanding lending to new firms is an act of exploration and incumbent banks are almost certainly content with exploiting their known and low-risk sources of income instead.

The Paradox of High Corporate Profitability, Rising Productivity and High Unemployment and The Paradox of High Cash Balances and High Debt Issuance

Although corporate profitability is not at an all-time high, it has recovered at an unusually rapid pace compared to the nonexistent recovery in employment and wages. The recovery in corporate profits has been driven by a rise in worker productivity and increased efficiency but the lag between an output recovery and an employment recovery seems to have increased dramatically. So far, this increased profitability has led not to increased business investment but to increased cash holdings by corporates. Big corporates with easy access to debt markets have even chosen to tap the debt markets simply for the purpose of increasing cash holdings.

Again, incumbent corporates are eager to squeeze efficiencies out of their current operations including downsizing the labour force but instead of channeling the savings from this increased efficiency into exploratory investment, they choose to increase holdings of liquid assets. In an environment where incumbents are under limited threat of being superceded by exploratory new entrants, holding cash is an extremely effective way to retain optionality (a strategy that is much less effective if the pace of exploratory innovation is high as an extended period of standing on the sidelines of exploratory activity can degrade the ability of the incumbent to rejoin the fray). Old jobs are being destroyed by the optimising activities of incumbents but the exploration required to create new jobs does not take place.

This discussion of profitability and unemployment echoes many of the common concerns of the far left. This is not a coincidence – one of the most damaging effects of Olsonian cronyism is its malformation of the economy from a positive-sum game into an increasingly zero-sum game. The dynamics of a predominantly crony capitalist economy are closer to a Marxian class struggle than they are to a competitive free-market economy. However, where I differ significantly from the left is in the proposed cure for the disease. For example, incumbent investment can be triggered by an increase in leverage by another sector – given the indebted state of the consumer, the government is the most likely candidate. But such a policy does nothing to tackle the reduced evolvability of the economy or the dominance of the incumbent special interest groups. Moreover, increased taxation and transfers of wealth to other organised groups such as labour only aggravate the ossification of the economic system into an increasingly zero-sum game. A sustainable solution must restore the positive-sum dynamics that are the essence of Schumpeterian capitalism. Such a solution involves reducing the power of the incumbent corporates and transferring wealth from incumbent corporates towards households not by taxation or protectionism but by restoring the invisible foot of new firm entry.

STABILITY AS THE PRIMARY CAUSE OF CRONY CAPITALISM

The core insight of the Minsky-Holling resilience framework is that stability and stabilisation breed fragility and loss of system resilience . TBTF protection and the moral hazard problem is best seen as a subset of the broader policy of stabilisation, of which policies such as the Greenspan Put are much more pervasive and dangerous.

By itself, stabilisation is not sufficient to cause cronyism and rent seeking. Once a system has undergone a period of stabilisation, the system manager is always tempted to prolong the stabilisation for fear of the short-term disruption or even collapse. However, not all crisis-mitigation strategies involve bailouts and transfers of wealth to the incumbent corporates. As Mancur Olson pointed out, society can confine its “distributional transfers to poor and unfortunate individuals” rather than bailing out incumbent firms and still hope to achieve the same results.

To fully explain the rise of crony capitalism, we need to combine the Minsky-Holling framework with Mancur Olson’s insight that extended periods of stability trigger a progressive increase in the power of special interests and rent-seeking activity. Olson also noted the self-preserving nature of this phenomenon.  Once rent-seeking has achieved sufficient scale, “distributional coalitions have the incentive and..the power to prevent changes that would deprive them of their enlarged share of the social output”.

SYSTEMIC IMPACT OF CRONY CAPITALISM

Crony capitalism results in a homogenous, tightly coupled and fragile macroeconomy. The key question is: Via which channels does this systemic malformation occur? As I have touched upon in some earlier posts [1,2], the systemic implications of crony capitalism arise from its negative impact on new firm entry. In the context of the exploration vs exploitation framework, absence of new firm entry tilts the system towards over-exploitation¹ .

Exploration vs Exploitation: The Importance of New Firm Entry in Sustaining Exploration

In a seminal article, James March distinguished between “the exploration of new possibilities and the exploitation of old certainties. Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” True innovation is an act of exploration under conditions of irreducible uncertainty whereas exploitation is an act of optimisation under a known distribution.

The assertion that dominant incumbent firms find it hard to sustain exploratory innovation is not a controversial one. I do not intend to reiterate the popular arguments in the management literature, many of which I explored in a previous post. Moreover, the argument presented here is more subtle: I do not claim that incumbents cannot explore effectively but simply that they can explore effectively only when pushed to do so by a constant stream of new entrants. This is of course the “invisible foot” argument of Joseph Berliner and Burton Klein for which the exploration-exploitation framework provides an intuitive and rigorous rationale.

Let us assume a scenario where the entry of new firms has slowed to a trickle, the sector is dominated by a few dominant incumbents and the S-curve of growth is about to enter its maturity/decline phase. To trigger off a new S-curve of growth, the incumbents need to explore. However, almost by definition, the odds that any given act of exploration will be successful is small. Moreover, the positive payoff from any exploratory search almost certainly lies far in the future. For an improbable shot at moving from a position of comfort to one of dominance in the distant future, an incumbent firm needs to divert resources from optimising and efficiency-increasing initiatives that will deliver predictable profits in the near future. Of course if a significant proportion of its competitors adopt an exploratory strategy, even an incumbent firm will be forced to follow suit for fear of loss of market share. But this critical mass of exploratory incumbents never comes about. In essence, the state where almost all incumbents are content to focus their energies on exploitation is a Nash equilibrium.

On the other hand, the incentives of any new entrant are almost entirely skewed in favour of exploratory strategies. Even an improbable shot at glory is enough to outweigh the minor consequences of failure² . It cannot be emphasised enough that this argument does not depend upon the irrationality of the entrant. The same incremental payoff that represents a minor improvement for the incumbent is a life-changing event for the entrepreneur. When there exists a critical mass of exploratory new entrants, the dominant incumbents are compelled to follow suit and the Nash equilibrium of the industry shifts towards the appropriate mix of exploitation and exploration.

The Crony Capitalist Boom-Bust Cycle: A Tradeoff between System Resilience and Full Employment

Due to insufficient exploratory innovation, a crony capitalist economy is not diverse enough. But this does not imply that the system is fragile either at firm/micro level or at the level of the macroeconomy. In the absence of any risk of being displaced by new entrants, incumbent firms can simply maintain significant financial slack³. If incumbents do maintain significant financial slack, sustainable full employment is impossible almost by definition.  However, full employment can be achieved temporarily in two ways: Either incumbent corporates can gradually give up their financial slack and lever up as the period of stability extends as Minsky’s Financial Instability Hypothesis (FIH) would predict, or the household or government sector can lever up to compensate for the slack held by the corporate sector.

Most developed economies went down the route of increased household and corporate leverage with the process aided and abetted by monetary and regulatory policy. But it is instructive that developing economies such as India faced exactly the same problem in their “crony socialist” days. In keeping with its ideological leanings pre-1990, India tackled the unemployment problem via increased government spending. Whatever the chosen solution, full employment is unsustainable in the long run unless the core problem of cronyism is tackled. The current over-leveraged state of the consumer in the developed world can be papered over by increased government spending but in the face of increased cronyism, it only kicks the can further down the road. Restoring corporate animal spirits depends upon corporate slack being utilised in exploratory investment, which as discussed above is inconsistent with a cronyist economy.

Micro-Fragility as the Key to a Resilient Macroeconomy and Sustainable Full Employment

At the appropriate mix of exploration and exploitation, individual incumbent and new entrant firms are both incredibly vulnerable. Most exploratory investments are destined to fail as are most firms, sooner or later. Yet due to the diversity of firm-level strategies, the macroeconomy of vulnerable firms is incredibly resilient. At the same time, the transfer of wealth from incumbent corporates to the household sector via reduced corporate slack and increased investment means that sustainable full employment can be achieved without undue leverage. The only question is whether we can break out of the Olsonian special interest trap without having to suffer a systemic collapse in the process.

1. It cannot be emphasized enough that absence of new firm entry is simply the channel through which crony capitalism malforms the macroeconomy. Therefore, attempts to artificially boost new firm entry are likely to fail unless they tackle the ultimate cause of the problem which is stabilisation [↩]
2. It is critical that the personal consequences of firm failure are minor for the entrepreneur – this is not the case for cultural and legal reasons in many countries around the world but is largely still true in the United States. [↩]
3. It could be argued that incumbents could follow this strategy even when new entrants threaten them. This strategy however has its limits – an extended period of standing on the sidelines of exploratory activity can degrade the ability of the incumbent to rejoin the fray. As Brian Loasby remarked : “For many years, Arnold Weinberg chose to build up GEC’s reserves against an uncertain technological future in the form of cash rather than by investing in the creation of technological capabilities of unknown value. This policy, one might suggest, appears much more attractive in a financial environment where technology can often be bought by buying companies than in one where the market for corporate control is more tightly constrained; but it must be remembered that some, perhaps substantial, technological capability is likely to be needed in order to judge what companies are worth acquiring, and to make effective use of the acquisitions. As so often, substitutes are also in part complements.” [↩]