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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