By James H. Nolt
You may read that China, or biotech, or some other sector or country is the engine of growth in the world economy. I hear that argument often in meetings of investors that I attend regularly, such as the World Economic Roundtable. Recently, several participants agreed that China and the U.S. are the only remaining engines of the world economy. If either falters, a global recession might ensue.
You might wonder what exactly is meant by such talk. In the case of U.S. and China, you might think they are “engines” because they are the number one and two largest economies in the world. That is not it. That is not what confers the “engine” status.
Engines are drivers of bull sentiment. That is an unfortunate mixed metaphor that sounds like putting the cart before the horse: having an engine drive a bull. But the idea is that investors need some hopeful story somewhere in the economy so that there is some class of assets they can believe in.
As I said before, there are four components of GDP: consumption, investment, government spending on current goods and services, and net exports. The most volatile of these is perhaps net exports, since its value can range from positive to negative quickly with fluctuations in exchange rates. Despite this, for big countries it is usually a relatively small part of GDP, so let’s put it aside for now. As I argued in a previous blog, the perennial driver of economic instability among these four is investment.
Investment spending represents purchases of new productive equipment and buildings. Much of that category includes durable things expected to last a few decades, such as a new blast furnace, shipyard, or hotel. Although the investment spending falls within a short period of time, perhaps within one year, it increases a society’s productive capacity for decades to come.
Thus, investment spending is necessarily forward looking and hopeful. It requires bullish sentiment. Whereas consumption and government spending are typically slow and steady (Government spending typically only shoots up during a large war), investment expands rapidly during a boom, when investors expect the future will require ever-greater productive capacity, and falls rapidly when bullish expectations evaporate.
There are two major reasons why investment spending often reverses dramatically when growth slows: (1) if demand ceases to rise rapidly, existing productive capacity may suffice for years to come. New capacity is not needed. (2) Most investment spending is financed. That is, the new construction is bought with borrowed money. When investors are less confident of future growth, they will be more wary about financing new projects. If they do, they may discount bonds more, i.e., charge a higher interest rate, reflecting their estimate of increased risk. So investment spending falters on the closing scissors of falling expectation of future sales and rising cost of financing investment purchases.
That’s why every investor is scanning the world to find the engine that can drive rising asset values. The engine might be a particular fast growing country, like China has been in recent decades, or it might be a particular sector of the economy that has massive growth potential. Some booms are indeed named after the sector that drives them, such as the “dot-com” boom of the later 1990s. What all engines of growth have in common is investor excitement great enough to induce a frenzy of debt-leveraged investment. They are bullish dreams.
You know the fable of the tortoise and the hare. The lesson is that slow and steady wins the race. But that is not how capitalism works. Capitalism feeds on frenzy. Without a compelling story about the hottest new engine of growth, productive investment tanks.
In recent years, the environmental movement has popularized the notion of “sustainability.” Sustainability is a wonderful ethos for ecology, but it is impossible to inspire bullish investors with it, so it will never catch on as long as capitalist investors determine where and how much to invest. At the very least, transition to a “sustainable” capitalist economy, if such a thing is not an oxymoron, would require a big crash first as investors adjust to the idea that the economy may have no more frenetic engine to drive new investment and bloated asset prices collapse following that melancholy news.
In a previous column, I exposed the myth of the money supply. I said it is more apt, in understanding the business cycle, to focus on the credit supply. A burst of debt-leveraged investment provides an extra boost to demand, analogous to Keynesian fiscal pump priming, for those of you with a conventional macroeconomic education. Another way of considering the credit supply is to consider the supply of capital, since capital is wealth invested for profit. Capital seeking investment is the source of credit. But to understand this you need to understand this key term “capital” much better than the textbooks teach.
Capital, I remind you, has two broadly different meanings. Economics textbooks argue that capital is productive equipment and services (such as useful software or business consulting). Mainstream economic textbooks say that capital is productive stuff, but they also insist it has alternative uses. This is necessary because it fits their one and only paradigm: that economics is the study of choice under a scarcity constraint. Therefore, to economists, what entrepreneurs do is choose what to produce by allocating their capital to the most productive industry, following price signals from consumers about what they want to buy more of.
Business people, on the other hand, often speak of capital as their investable wealth, including all their assets: cash, stocks, bonds, real estate, and physical productive capital. Anything that can be invested to earn more profit is capital to an investor. It need not be invested to produce real stuff as long as it produces real profits.
Some people, including me in some instances, have used the shorthand “physical capital” for the textbook definition and “money capital” for the business savvy one. However, these are both misnomers. Physical capital may include non-physical things, such as software, design, or process improvements. Money capital includes many asset classes that are not counted as “money” in anybody’s definition of that term.
Two better terms would be “productive capital” and “investment capital.” Productive capital is used to produce the current GDP. It fits the economists’ definition. Investment capital includes productive capital plus investments in assets, real and financial. Whereas productive capital can increase only gradually as new productive equipment is produced in the economy, the portion of investment capital that is not manufactured equipment includes capital invested in natural resources, plus the most “magical” portion of capital, the part that is created as financial assets, including stocks, bonds and derivatives. It is this portion that we must examine more closely to understand the bull magic that creates engines of growth.
Economists’ confusion of these two important senses of “capital” lay at the heart of their failure to understand economic dynamics and crises. I shall give a better account of the frenzy of capital next week, and in the process solve the question of why the world economy needs an engine and why China today may not be up to that exalted role.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.