Investment cycles

As many of my blog readers know, as a macroeconomist I am a maverick as I believe in cycles.  It seems to me (and a few others, although it should be noted we are definitely in a minority), that cyclical behavior is just part of what economists label the “business cycle” and denying its existence or stating that the cycles are caused by shocks simply put you in denial of the facts.  I would go beyond just the business cycle as a stylized fact – I believe there are other irregular cycles that also permeate the macroeconomy, most notably in the shorter term “growth cycles” that we can also observe just by looking at the growth rate.  These shorter term growth cycles originate from a variety of different sources, but most notably is investment ( - a previous blog posting covered the cycles in consumption expenditure), the reason for this being that investment is one of the most volatile components of aggregate spending.

First off, we need to just clarify what we mean by investment expenditures.  Investment as a concept has a very specific meaning in economics which is quite specific compared with the everyday use of the term “investment” in common language.  Investment in economics means spending on plant, machinery, equipment, new commercial property etc ( - what is known as gross fixed capital formation to an economist), but also included in this category in the national income accounts one also finds spending on new residential housing, computers (whether for households or firms) and changes in inventories.  Note that investment in an economic sense does not include purchases of stocks and shares or bonds or spending on education etc.  Although we might use the term investment to talk about these types of expenditures in everyday language, to an economist this is NOT investment spending.

So let’s look at the different cycles that I hypothesize one should find in investment spending and why.  There are 4 cycles that I would hypothesize exist in the data and each would be expected to have a different periodicity and to depend on different macroeconomic variables.  Let’s take each cycle from the cycle that I would expect to have the longest frequency to one that I would expect to have the shortest frequency. 

The longest cycle that I would anticipate one should find in the data is a “technology innovation investment cycle”.  If new technology is introduced then firms are likely to adopt this technology over time, but in more competitive industries this adoption could be quite rapid.  These are cycles that depend on hardware and often require dramatic changes in the workplace.  For example we have gone from labor being the major input in the production process of automobiles, to computers determining speed of the assembly line and ordering of parts but mostly labor involved in actual assembly to computer-controlled robots actually doing assembly.  In each wave of technological change (computers then computer-controlled robotics), there have been longer term costs savings from a lower labor requirement but a substantial upfront investment on plant machinery and equipment.  These cycles should be longer cycles than the business cycle ( - what some economists refer to as “medium-term cycles”), but they are intimately linked with the business cycle, as they can lead to booms in economic output as manufacturing costs fall, and costs elsewhere in the economy should also fall.  The point is that we shouldn’t expect every business cycle to be driven by these technological innovations, but of course the business cycle will be affected when these changes happen.

The next longest investment cycle has to do with the business cycle.  As consumption is cyclical, any downturn in the economy will result in a fall in consumption which will lead companies to pare back expansion plans, cancel those plans or indeed reduce production capacity.  This will result in a fall in investment as equipment wearing out will not be replaced and new equipment orders will be cancelled. This “demand-led investment cycle” should lag the business cycle.

The third investment cycle also has to do with the business cycle as well, but originates in Keynesian and Austrian thinking.  The real interest rate determines how costly it is to invest and determines the volume of investment according to a negative relationship between the cost of borrowing (the real interest rate) and the amount of investment undertaken.  This could happen through 2 different channels: i) the Austrian school channel which states that the interest rate is inversely proportional to the average length of the production process so that lower real interest rates lead to longer production times ( - and therefore a greater amount of capital required to produce the same amount of output at a given time in the future – a relationship known as the Hayekian triangle); and ii) the Keynesian school that simply states that lower real rates make it cheaper to borrow and thus more firms should borrow in order to expand.  Either way this implies that monetary policy will have an impact on investment and indeed exogenous shocks that lead to low or expectations of negative real rates would create incentives to increase investment.

The fourth investment cycle is of variable length but has to be with depreciation cycles.  If historically there were cycles in investment for whatever reason (“technology innovation” or “demand led” cycles) then these cycles will likely replicate themselves as this equipment will eventually wear out and need replacing.  Presumably the equipment would need replacing at roughly similar times given the fact that it was installed at roughly the same time, so this will lead to “upgrade” programs to replace old equipment and this tends to occur over a relatively short period of time relative to the business cycle.  This I will call “depreciation investment cycles”.  Obviously if we assume technology to be fixed, the depreciation investment cycles will depend on the quality of the capital and the availability of parts.  An obvious example of this would be aviation or transportation equipment that usually is used until it wears out and parts no longer exist or are prohibitively expensive.

The fifth investment cycle relates to the relative price of capital, and this is usually measured by something called “Tobin’s q” theory.  If you think of companies as using factors of production labor and capital, then the valuation of a company is usually done based on it’s “assets” which, ignoring  labor force skills is calculated by the value of the physical assets (capital) which would remain if the company ceased to operate.  Comparing the value of the company (as measured by the cost of replacing its assets) versus how much the stockmarket currently values the company (how much the company is worth in terms of future profitability) gives a relative value of capital and is known as “Tobin’s q” theory after the Yale economist James Tobin.  Any calculation of “Tobin’s q” (Stockmarket value to replacement value) appears to move in cycles, and therefore implies that at certain points the stockmarket values capital more highly than the cost of capital and therefore there is an incentive to expand by increasing investment. 

The last investment cycle I will outline is a “competition-driven investment cycle”. In competitive economies with industry structures that resemble anything other than monopolies, there will be pressure to “keep up with the Jones’s” in order to maintain market share.  Although competition has a role to play in the “technology innovation investment cycle”, it also has a role to play in terms of offering a similar consumer experience as competitors do, and this might require software or equipment upgrades to meet consumer expectations in a competitive marketplace.  Examples of this type of investment may well take place by “third party” suppliers such as internet service providers for banks, modern décor in coffee shops or the look and feel of a supermarket.  This “competition-driven investment” is likely to occur over a discrete period of time between the different firms in the marketplace as firms attempt to differentiate themselves from one another. 

OK, enough theory.  The proof of this approach will clearly be in the pudding. More next time on the relationship between stockmarkets, economic growth and investment. 

Greece: the end-game nears

It is not surprising there are now riots in Athens.  It is now all too clear that even though Greek levels of debt are not yet at Japanese levels, Germany doesn't want Greece in the euro anymore.  If Greece doesn't leave the euro then not only will all political parties have to agree to institute the measures insisted on by the other euro area finance ministers, but also they will have to endure economic misery in the form of a depression for at least the next 5 years, if not longer.

As we say in economics, you have to evaluate the net benefits from doing this or from leaving the euro, because both are not going to be pleasant for Greece, and the possible choices facing Greece have potential ramifications for the rest of the world.  So let's look at this in terms of the choices facing Greece and then what the implications will be on the EU and on the rest of the world.

Scenario 1: Stay in the euro and Greek politicians behave. 

Greece has entered it's 5th year of recession, and unemployment is now at over 20%, and will undoubtedly approach Great depression levels of 25% this year if the austerity programme that the EU insists must be implemented goes ahead.  Now €130bn sounds like a lot of money, but in the context of the whole EU economy it is a relatively small amount.  The point here is that the Northern Europeans are tired of this never ending Greek bailout saga and they want this to be the last bailout so they are really tightening the screws. 

Staying in the euro would probably be the best solution for the rest of Europe and the rest of the world as long as this really is the last bailout and Greece accepts that it has to remain in depression for another 5 years.  Doing this though would likely see the Greek social order implode. As the Archbishop of Athens put it: "Homelessness and even hunger — phenomena seen during (World War Two) — have reached nightmare proportions. Patience among Greeks is running out, giving way to a sense of anger, and the danger of a social explosion cannot be ignored any longer. The medicine we are taking has proved fatal for the nation. More painful, and more unjust measures are now set to follow along the same, hopeless course."

So what's best for Europe and the rest of the world is probably worst for Greece, as it doesn't default, has it's hands tied and it's population have to endure more years of misery.
 
Scenario 2: Stay in the euro and Greek politicians misbehave.
 
This option essentially kicks the can down the road yet again, but still imposes misery on Greece and at the same time means that Greece will be back again for a further bailout in less than a year.  The Germans were right to suggest that someone from the Commission should be in Athens overseeing the Greek budget as historically it has been one of the most untrustworthy economic documents in terms of statistical reliability.  And the fact that the Greeks were affronted and said no means that if they take the bailout money this time around the rest of the EU has very little control in terms of what actually happens with the money and over the setting of future budgets.  This is despite the letters that have been signed by the current leaders of the political parties.  Add to that that political leaders are changing all the time in Greece right now, and you can see that the letters are only a commitment of one particular political leader, with the whole austerity package therefore having an automatic "loosening bias" as political leaders change through time.  The other point here is that politicians like to get re-elected - why would you vote for someone who is honestly going to impose austerity on you?  If I were a Greek I would much rather vote for a politician that says all the right things with a nod and a wink so that things are not nearly as bad as you expect. 
 
This scenario is bad, but not quite as bad as scenario 1 for Greece - I would expect that the economic outlook is not quite as bad for Greece in the short term, but of course will likely lead to another crisis in the future and therefore we could be back at this crossroads again.  It is definitely not good for the rest of Europe, and likely not so wonderful for the rest of the world either.  The reason for this is that kicking the can down the road clearly involves a future decision about whether to kick Greece out of the euro because the next time around there will likely be a disorderly default, and then the rest of the EU will not want the contagion connected with this and will want Greece out of the euro.  The trouble is there is nothing in the Maastricht Treaties that specifies under what circumstances a country is forced to leave the euro.  This would be a real headache for the rest of the EU and would hence threaten the whole "harmony" within the euro and the consensus decision-making at the ECB.  Spain, Portugal, Ireland and Belgium would obviously all be watching the events that unfold around this scenario very carefully.


Scenario 3: Greece leaves the euro and returns to the drachma
This is, I now think, the most likely scenario. The immediate effect on Greece would be cataclysmic as money flows out of the country.  Exactly what happened in Argentina when they left the currency board will likely happen in Greece.  Anyone holding euros in a Greek bank would see these frozen and then converted into Drachmas at the official exchange rate that Greece entered the euro at, and then once the drachma is floated the accounts are unfrozen.  That means that savings are now converted into drachmas and then the drachma will obviously collapse against the euro meaning that savings will immediately be devalued by a huge amount making everyone a lot poorer in international terms and causing a severe bout of inflation as all imports are priced in non-drachma terms.  Of course the way to avoid this is to get your money out of the country now, so I'm sure there are huge capital flows happening right now to safeguard savings and other assets against this particular scenario.

The immediate effect would be horrible for Greece, as it was in Argentina, but the pain in these "almost instantaneous" adjustments is usually short-lived, and once the drachma gets into equilibrium with other currencies again, things usually quickly improve.  Obviously there is absolutely no way that Greece could repay any loans made in euros, so a disorderly default is inevitable. 

The pain here is on the Greeks, as well as private creditors in the rest of the euro area and on the credibility of the euro area, as it has it's first casualty as a country voluntarily leaves the euro.  Note that Greece would not be leaving the EU, and it's exports should improve dramatically as the national currency sinks to a new equilibrium level, and it would lead to a surge in inflation and therefore an automatic adjustment to real wages.  The credibility of the euro and the EU officials here would be badly hit, as would private banks that hold Greek debt.  Also if Greece does come out of the euro and quickly turns things around other countries might also be tempted to do the same, which could prompt a partial unravelling of the euro as well.  The effects on the rest of the world would be negligible, but could impact the banking sector as a domino effect occurs through European banks.

Scenario 3: Greece returns to the drachma and sets up a currency board

This is a variation on scenario 4 above.  Here though Greece leaves the euro area but reintroduces the drachma and allows the drachma to circulate alongside the euro at fixed rates, which presumably it would determine in such a way to take into account inflation differentials with the rest of the euro area over the past 9 years, and then some.  This way some of the pain for the Greek public associated with scenario 4 could be overcome, but at the same time the Greek government would likely have to default on its debt.  This would be an attempt at an "orderly exit" from the euro rather than the usual "disorderly exit" that happens when fixed exchange rate regimes collapse.  The big question here is how would Greece come up with the euro assets to fund the currency board?  Part of that might lie in persuading creditors to agree to a swap of a Greek euro denominated debt into Greek drachma debt and favorable rates and then use this Greek euro debt as an asset to fund the currency board.  This would be akin to asking investors to take a stake in the "new" Greece, in exchange for giving up old "soon to be worthless" assets.

I think this is a viable option for Greece, and probably is the best option in terms of Greece leaving the euro from an economics perpective.  Of course whether Greek politicians have the nouse or the will to think something like this through is another matter.  We shall see.