Nov

30

Allocation of capital on a macro, national scale is an important but under-studied subject, relevant to analysis of the cureent economic situation.

While the collapse of the Soviet economy seems multi-determined and very difficult to analyze, misallocation of capital (MAC) was a key, if not the key, ingredient. From the outset Soviet Communism was famous for its Five-Year Plans for investment and capital allocation. In the beginning the Plans emphasized catching up in major industrial areas where Western countries had obviously been successful — steel, machine tools, electric power — and the growth of the Soviet economy did well. There was even talk among US experts of the higher-growth-rate Soviet economy eventually surpassing that of the US.

But by the latter 20th century, US and other Western economies had become more subtle and technologically-oriented. Economic growth depended on research and fast-moving investment into high tech areas — inventions and products that initially seemed minor or almost invisible, discoverable only by haphazard groups of large corporate and tiny individual entrepreneurs, totally unpredictable to government bureaucrats.

In this environment Soviet Communism was hopelessly outclassed. Its top-down planning and traditional love of Five-Year Plans and machine tools could not keep up with Silicon Valley. Billions of dollars of Soviet capital were being allocated to projects with marginal or even negative returns, while growing billions of dollars of American capital were being allocated to the then unusually high returns of Silicon Valley and the like. Compounded over 30 or 40 years, this makes for an incredible difference in result, collapse for one and tremendous prosperity for the other.

What are the implications of this for present times?

First, we have a situation in the US where major portions of our very large economy are being shifted from allocation by entrepreneurs, who in the aggregate know where to allocate capital (not because they are so smart but because they are governed by highly diverse market forces), to allocation by Congress and government bureaucrats, who don't. (And "don't know" is charitable, since their political incentives of pork and saving failing constituencies make the government allocations even less economic.) That has to be far less favorable for long-term US economic growth.

Second, we have China. While the Chinese are probably smarter, or more uptodate, than the Soviets were in their allocations, and are dealing with an economy much more open to market forces (particularly in having to cater to US purchasing allocations), can the Chinese in their government-directed investment and capital allocations continue to escape the defects of the Soviet allocations?

And with the likelihood of the Chinese misallocations being covered up by phony statistics over many years (the same type of phony statistics that misled not only the Soviets themselves but sophisticated outside observers such as the CIA), isn't this a situation that will sometime lead to a pretty dramatic day of reckoning?

By the way, I have not read any academic or investment research on capital allocation/misallocation and the above is pretty much off the top of my head. Thus I would be grateful for good citations or sources to contradict or modify my views, or to better educate myself in this area.

Stefan Jovanovich comments:

I think Mr. Grossman exaggerates the extent to which American "capital" has been allocated by entrepreneurs in the years since 1925. Wealth has certainly been created by enterprising individuals; but the extent to which the national wealth has been allocated by the government should not be ignored. One statistic always comes to mind when I read praise for American "capitalism" — the amount of money spent on the Manhattan Project alone was more than the entire historical investment in the U.S. auto industry. Silicon Valley — which looks a good deal like Detroit in the mid-1930s these days — was very much the product of the military-industrial complex Eisenhower questioned. Mr. Hewlett and Mr. Packard got their start by selling oscilloscopes to the Army, and but for the need for control devices for ICBMs, they would still be growing fruit in the orchards around San Jose.

What defeated Soviet communism was the absence of private money, the inability of individuals to save their own wealth in a form that could be spent by them. Everything in the Soviet Union was rationed; it was the ultimate single payer system. The question for which none of us has an answer is will private money continue to exist in China when that country has its banking and credit crisis? (Of course, the cynics I know are asking the same question about the present banking system in the United States: "What do you think of the American system of private money, Mr. Gandhi?" "A most excellent idea.")

P.S. For the first 60 years the Soviets' allocation of capital was not greatly inferior to our own where military technology was concerned. Their ability to literally move their entire industrial base 500 to 1000 miles east while defending themselves against the Wehrmacht is a miracle of raw production that more than equals anything done by Kaiser's shipyards and Boeing's B-29 factories in Kansas. Imagine the German Army invading the United States through the Champlain valley and capturing Boston, Pittsburgh, Cleveland, Philadelphia and New York and the United States' moving its entire steel and auto industries by rail to Nebraska in the midst of winter.

P.P.S. The B-29 was built in Kansas because of the assumption that the United States might be subject to the same kind of sustained bomber offensive that the Allies had been conducting against Germany. The failure of the Germans to develop the significant heavy lift capacity for bombing and transport is probably the single top down command decision that doomed them; if they had invested the effort into development of a 4-engine bomber that they put into rocketry, they would have won. Instead, the Allies did, which allowed them to discover after the fact — thank you, Professor Galbraith — that bombing was a complete failure.

Kim Zussman replies:

One could make the case that the tech bubble was partially the result of the collapse of USSR:

  1. The political stability risk-premium in the US went down post-Soviet threat (markets move in reverse to risk premium change)
  2. Defense spending went from 6% to 4% of GDP from 1990-2000 (see attached chart from this site). Some of that went toward tech investment (Note that defense spending went up post 911, and stocks/ROC 00-10 was not as good as 90-00).
  3. Check out what happened to Japan and Germany stocks post-defeat, and St. Petersburg post-Bolshevik.

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3 Comments so far

  1. Tim Richmond on November 30, 2009 2:51 am

    With all due respect to Mr. Jovanovich, comments regarding B-29 manufacture and the German loss in 1945 are not entirely correct.

    1) Four separate plants located in Renton (Washington), Marietta (Georgia), Wichita and Omaha were needed to manufacture the B-29. A study of armament manufacturing during 1942-45 will reveal wide distribution across the United States, with no specific concentration at the geographic center of the country.

    2) The single characteristic that doomed the Third Reich was overconfidence (following successive blitzkriegs against ill-equipped opponents) which led to taking on Great Britain, the United States and the Soviet Union at the same time. Manufacture (in quantity) of a heavy bomber by Germany would have had little effect against such odds, especially when considering that such a bomber would not have had sufficient range to hit the industrial infrastructure of the United States and Soviet Union.

  2. Nick Pribus on November 30, 2009 1:58 pm

    My first trip to Russia was in 1992 working for Honeywell with the primary responsibility to install accounting discipline in the Eastern European region of 9 newly opened Honeywell affiliates. Honeywell had the strategy of on the ground presence and after decades of servicing the region from Austria could now go directly through 100% affiliates.
    In more than 100 trips to the region in the 18 years since then, I have answered and then re-answered this question. Layering experience upon relationships built over the years, I am only an infant in the understanding of the causes of Soviet downfall, but can add these comments:
    1. Stefan hits the nail squarely on the head in his P.S. premise about Soviet response to the German invasion. But he doesn’t point out that the invasion set Russia back by a generation and a half. The staggering war losses in the Soviet Union crippled the economic potential of the country, entire villages wiped out by direct war, entire villages not on the front line finishing the war with no men in them. Visiting Tbilisi I had a friend tell me 1 in 3 Georgian men died in the war. Staggering, and how fully can a country recover from that, and how quickly, especially with the cold war right on the heels? Ask Dan Carlin and listen to the 4 part hardcore history “Ghost of the Ostfront.” http://www.dancarlin.com/disp.php/hharchive It is a less sanitized version of the war than we hear in America, and a horrifying thing to happen to any country, how great would America’s “greatest” generation have been if upon coming home the country was completely destroyed, and their friends were mostly dead.
    2. “Misallocation” of capital is a given when the government controls the purse strings, because then outcomes are not necessarily designed to be economic. They may be designed for fairness and equity, and in setting minimum levels of sustenance, in fact maximum levels are instituted. As an example, I put myself through school doing room service in a Union hotel shop. While everyone around me talked about the “minimum” wage we were paid, I always called it the “maximum” wage, because no matter how hard I worked, how dedicated creative and excellent in service I was, I still got paid the same low wage as everyone else. It is not a “misallocation” since return on investment (or proper incentive) is not the primary measurement of success. If you can’t jump high enough, lower the bar.
    3. In a Honeywell Poland training session in 1993, about a year after the affiliate was opened, the entire staff turned out for my lecture on financial statements and management accounting. The fundamental question from the crowd was “what is the proper level of profit?” In a cost plus mentality, the idea that a product would be sold for a loss in a capitalist system was incomprehensible. Capitalism is all about profits; therefore, profit exists in every sale. And again, how much is the correct amount. I spent a couple hours, and they were still just baffled, and these were smart people, the Honeywell Poland affiliate was among the brightest and hardest working of any in Eastern Europe at the time. In a Western sense, profit is the essence of capitalism in that it is a signal, when divided by capital deployed, the return and therefore usefulness of the capital deployment. There really was no sense of profit, and no sense of capital, and really, a general inability to properly distinguish a loan from a gift.
    Now 18 years later, they have moved, and the streets in Moscow are no longer dull, but as cosmopolitan as any major city in the world, and the capitalism not just capitalist, but brutally capitalist.

  3. douglas roberts dimick on December 2, 2009 3:32 am

    Dan, most perceptive about the MAC a la Communist China…

    For the past several months, I am reading these propaganda-like articles to include in the Times. They seem to be generated by some Times(?) writer(s) in Beijing with a contributor in Hong Kong.

    No facts. No statistics. No reports.

    Just headlines and dogma as to how the recovery is proceeding and it is “happy thoughts” every day — after 60 years of glory from “a fool’s errand” (Sum of All Fears).

    Here at Shanghai University, Agricultural Bank’s branch office just closed. Wires hang from the inoperable ATM. This development is odd… seeing how the school required me to open the account just 3 months ago. Still, perhaps not strange given the central government’s recent cap-call on the big four state-owned, technically bankrupt pillars of capitalism with Chinese characteristics… ah-hem.

    More to the point, the university is getting screwed, as it requires staff and faculty and students to use this bank. I have yet to find another branch nearby. Guess the university isn’t the one getting screwed… just the students, faculty, staff – as long as school leaders are not inconvenienced, Confucian thinking dictates no speaking.

    So much for top-down-to-tickle-down-to-keep-95%-down-so-long-as-20%-not-demostrating-to-incite-80%-that-costs-5%-money economic policies (i.e., this would be the Chinese characteristics).

    You follow the Chinese math and logic here?

    Took me three years… Had I learned Mandarin, I would never had got it.

    Anyway, the Bank of China branch office at the Yanchang (Line 1) shopping mall, across the street from our lovely city campus, has one ATM and three teller stations for a locale that traffics tens of thousands of people per day.

    Right, you guessed it: the ATM does not have money a fair amount of the time.

    How about the line(s) for a teller?

    Forget about it. The mothers and grandparents line up in the morning before the doors open. Note, there is a VIP window upstairs for the Communists, as they are about the only ones with enough money to qualify.

    So yesterday, I took my dentist and his colleague to lunch at Sal’s (or Salzinaria’s, I think), an Italian food franchise (so quantified as [OliveGarden – PizzaHut = Sals]). Though, true to holism, albeit the parts sum total, the food and pricing and quality are the best that I have seen here in China as far as restaurant ecology may be observed.

    Anyway, I needed cash – this restaurant does not take cards, any kind of cards accept a pre-paid Sal’s Card. Smart – Sal’s does not seem to trust Chinese bankers either.

    Right, you guessed correct again. Being within sight of the restaurant, the Bank of China ATM has no money at a key time of the day (lunchtime).

    Being a barbarian, the foreigner, I do the unthinkable and complain.

    The nice lady, whom I presume to be the manager (or maybe the only one who speaks English), says that the ATM is waiting for cash to be “put in” but I can go to the ATM at the shopping store two buildings down. In summary, I cannot get cash from my own bank.

    Kim, your USSR theory on “our” tech-bubb is interesting. My study then of that phenomenon was less ecometrics and more social-economic with regard to civilian-commercialization of the Internet.

    Stephan, concur albeit causation. Clinton’s repeal of Glass-Steagall in 1999, whereby rules-based doctrines and paradigms — that had been developed since the last Great Depression — became (to varying degrees of obfuscated to obliterated) then fundamentally altered within a brief time-period.

    Nick, you hit the nail on the head of that which Dan hammered… ditto (in a Non-Rush context) here in Red China. They still don’t get it at the central government level, because they are afraid – which means, translated to Chinese Thinking, is that they do get it but do not want to do it because it will cost “them” too much money. This accounting scares the Communists, who ironically are afraid, because that is how they rule – with fear.

    When does the servant become the master?

    Thus, until US-EU policy mongers and corporate opportunists are replaced with some frontline veterans of trade and finance, who can draw lines instead of circles, whereby social-economic systematics absent of fundamental (First Amendment) human rights are opposed with economic-trade defenses, thereby replacing current free but for unfair trade concoctions of diplomatic, currency-swapped, palm pressing (albeit politically correct) ballyhoo… Communist states will be allowed to linger within if not fester among corruptive, party-centric domains of dysfunction.

    Ronald Regean had it right… trust with verification.

    In terms of legal and accounting compliance, I have seen little of that here, as US-EU state leadership cow-tow to their election-campaign-cuffed, well-lobbied finance streamed (MNC) corporate interests, who prefer non-bargaining labor pools and focused (noncompetitive) consumer segments.

    As Regean knew, if you force a communist state to perform based on verification, the system itself will deteriorate from within – until there is internal/external political demand for reform – due to the nontransparent nature of the political ethic.

    The system is reliant on lying. Stop the lying, stop the system.

    I do not mean Republic and Democratic lies. They do not have an army standing behind them – just a bunch of lawyers and spinsters… The Chinese government simply hangs or shoots them.

    As appealing as this approach to conflict-resolution may appear to those of us who hail from the most litigious society in the history of mankind, the point is not quite so absolute in terms of outcome-oriented disposition. The point is that rule of law prevails and is so required for even social-capitalistic constructs as practiced by most neo-communists these days, albeit Cuba and North Korea… stellar examples of how economic justice is reliant upon social justice – NOT.

    In conclusion, as we may garner from V, focus on your game, practice the shot to a point of mastery, and be patient. Eventually, the Chinese Communists will either do an economic-trade-like Peal Harbor and we will snap out of it or they will be eaten by their own kind. 5,000 years of history tells us so…

    Enough said.

    dr

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