Wednesday, January 30, 2013

Where Angels Fear to Tread

What about this strikes you as rational?
“Asps. Very dangerous. You go first.”

— Raiders of the Lost Ark

For a rapacious and unapologetic facilitator of the accumulation and redeployment of financial capital in the modern economy, I must admit in confidence to you, O Dearly Beloved, the perhaps surprising and somewhat disconcerting fact that I am an admirer of cogent Marxist analysis. While I remain unconvinced—and have been ever since some flaky antipodean professor/activist on sabbatical visited my college eons ago and completely failed to convince me his ideas had any practical political application whatsoever1—that Marxism has much useful to say about the practical organization of social and political institutions to reduce economic repression and increase socioeconomic justice, I do believe its focus on the interaction of capital and labor can offer interesting insights into economic and financial issues of perennial interest.

Marx thought capital was important. I think capital is important. Perhaps it is less surprising than a naive observer might otherwise think that I find Marxist analysis occasionally insightful.

All of which is typically verbose preamble to the observation that I find the work of C.J.F. Dillow almost always interesting, provocative, and insightful. I read his blog Stumbling and Mumbling regularly, and I recommend those of you who can absorb a Marxist analysis on an regular basis without blowing a physiological or psychological gasket do the same. His views are cogent, well-supported with copious references, and almost uniformly thought-provoking.

That being said, however, I must take issue in these pages with one of the points Mr. Dillow advanced in a recent post. While tying his remarks to some recent research which showed a correlation between stock market investment and business investment, Old C.J.F. asserted that

a correlation between investor sentiment and capital spending might exist simply because rational expectations of the future determine both. If so, then current weak sentiment and weak investment are a sign of weak future growth.

But Lee and Arif’s work suggests this might not be so. They estimate that, in most advanced countries, high investment leads to weaker GDP growth and falling profits. That’s exactly the opposite of what you’d expect if sentiment and investment were rationally determined.

This leaves us with another possibility - that it is irrational animal spirits that drive sentiment and capital spending. And herein lies the point that is not widely made. It’s that the economy is being depressed in part by company bosses being irrationally pessimistic. We’re paying the price for stupidity in boardrooms.

But this equation of businesses’ failure to invest now, when economic conditions are depressed and, presumably,2 opportunities for investment are particularly attractive, with irrationality, stupidity, and (thoughtless) “animal spirits” is cheap, sloppy, and simplistic. What Mr. Dillow seems to overlook is that business investment in any economy is characterized in large part as a collective action problem.

* * *

Businesses do not invest in existing or new business lines in a vacuum. In addition to exogenous factors over which they have no control and usually very little ability to predict, like customer demand, general economic conditions (including the exogenously determined market cost of the capital which it decides to invest), and competitive response, no business has the ability to predict with high confidence the actual financial or operational results of any investment. Businesses make investment decisions under often daunting conditions of significant uncertainty. When general economic conditions are weak or unsettled, as they are now, the uncertainties surrounding any investment decision are that much more worrisome.

Based upon my years of experience and interaction with senior business executives and company directors through both good and bad economic times, I can tell you with confidence business decisionmakers typically react to such conditions with the most natural, intelligent, and rational human response imaginable: caution. Failure to invest under conditions of economic malaise, recession, or disruption is not cowardly, stupid, or irrational. It’s often just plain common sense. Furthermore, executives and directors of corporations owe a fiduciary duty to their stakeholders to make rational and prudent decisions. If prudence dictates caution, who will gainsay a CEO’s or board’s decision to defer that new manufacturing line or acquisition until conditions become clearer? Who indeed, other than a central planner or politician who would like someone, anyone, to take the first step.

Now it is true that if every business in an economy exercises so much caution that they don’t invest, it will be difficult if not impossible for that economy to grow its way out of recession. This is well understood as the paradox of thrift. By the same token, when uncertainty decreases so much that every business feels comfortable investing in new capacity and new business lines, it is logical to expect the economy in total will suffer from overinvestment and subsequently sub-par returns. In aggregate, then, rational behavior on the part of individual businesses can lead to collective and individual outcomes that are suboptimal and, hence, in some fashion “irrational.” But this irrationality is a structural feature of the situation, not an individual failing of each independent actor.

We have an old riddle in the Colonies which may be unfamiliar to Mr. Dillow that captures the essence of my argument:

Q: How can you tell which settlers are the pioneers?

A: Simple. They’re the ones with arrows in their backs.

I am no apologist for the native intelligence of corporate executives or their directors. In this I agree with Mr. Dillow wholeheartedly. But let us not mistake the natural equilibrium outcome of independently derived rational decisions with individual irrationality or stupidity.

That is just dumb.

1 Which failure to convince me and my classmates drove the loopy bugger to foaming-at-the-mouth distraction and encouraged him to beat a hasty retreat to more amenable climes once the semester was over. It is perhaps not unfair to note that my college was not a seething hotbed of sympathetic vibrations to such worldviews.
2 Really? You want to bet your company on that (Warren Buffet-like) conventional wisdom? Be my guest. You go first.

© 2013 The Epicurean Dealmaker. All rights reserved.