Stephen King: Proof that entrepreneurs are alive and well despite what the economists may believe
'Policymakers may not be able to rely on economic models, we have to make judgements'
Tuesday 30 May 2006
To many economists particularly those who have also studied accountancy profits are no more than a residual. They are the gap between total revenues and total costs. Revenues and costs reflect, in turn, economy-wide demand conditions and the occasional external shock. The majority of macroeconomic models have no room for entrepreneurial abilities. For those business people who are reading this column, I can only apologise: there are those in the economics profession who basically assume you don't exist.
Entrepreneurial activities do, however, matter. Sometimes they matter for all the wrong reasons, a conclusion that Kenneth Lay and Jeffrey Skilling, erstwhile top dogs at Enron, have plenty of time to contemplate. They also matter, though, for our understanding of what makes economies tick. I'm thinking not so much of the textbook theory of the firm but, rather, how economies behave in aggregate. Entrepreneurial behaviour influences the things that policymakers worry about, namely growth, unemployment and inflation. Ignoring this facet of economic performance can easily lead to the wrong policy conclusions.
At the moment, central bankers are, understandably, fretting about inflation. Oil prices are higher than they were, wage growth has picked up a bit in the US, and markets have been looking rather jumpy. Suddenly, policymakers feel they have to re-assert their anti-inflation credibility. As Paul Tucker, a member of the Bank of England's Monetary Policy Committee, put it last week, "we have to make judgements about whether medium-term inflation expectations are ... securely anchored. We need to resist falling into the trap of thinking that the nominal side is now, and forever, nicely looked after by some miracle of credibility".
Mr Tucker is, of course, absolutely right to emphasise that inflation expectations may sometimes drift off in undesirable directions. Indeed, only three years ago, many central bankers were becoming worried about deflation. As Mr Tucker recognises, though, the key difficulty lies in knowing when inflation drift is happening. In his words: "Policymakers may well not be able to rely on their models ... we have to make judgements."
This is where profits and corporate behaviour more generally come into the equation. Because economic models assume that entrepreneurs don't exist, they typically make only limited claims about the relationship between costs and revenues. If costs rise, there's a good chance that companies will try to pass these costs on in the form of higher prices and, hence, higher revenues. If companies fail in this strategy, they're likely to face weakening profits and, in stock market terms, see their share prices heading downwards. In this world view, companies either have pricing power in which case inflation is always waiting to pounce or they face huge profits volatility: either way, it's not good news for long-term economic performance.
Recent corporate behaviour, though, casts a huge amount of doubt over this simplistic approach to profits and suggests that, in the real world, the relationship between costs, prices and profits is a lot more complicated. Faced with an energy price increase, for example, companies have three broad alternatives to ensure that they meet their shareholders' expectations. They can raise prices, cut wages or raise their productivity levels.
Few companies take the pricing option seriously these days: the alternatives have become more attractive. First, firms recognise that central banks are independent and are unlikely to tolerate persistent price increases. This is no miracle but, rather, a recognition that the world has changed: independent central banks have fewer incentives to debauch the currency than governments had in the past and, therefore, companies have to think carefully before they attempt to pursue a strategy of price increases.
Second, companies are facing a more competitive world than before, largely a reflection of the effects of information technology. In the old days, companies lived the life of luxury, ensconced in domestic oligopolies, and were able, collectively, to push prices up in the event of an unwelcome cost shock. The greater flow of information around the world means that companies now face much more actual and potential competition in the markets in which they operate. In this sense, we've seen a shift towards the perfectly-competitive world beloved of textbooks: company pricing power is competitively off limits.
Third, the speed with which new technologies are coming through has enabled companies in some countries to extract productivity gains that have broadly offset the impact on costs of higher energy prices. This is particularly true in the US where company management has been swift to reorganise workplace practices. The left-hand chart shows this story very clearly. Over the past three years, the period in which energy prices have been rising swiftly, the US has experienced a remarkable surge in corporate productivity. Recent gains have been even faster than in the late-1990s, when the US was supposedly enjoying its productivity miracle.
To argue that this productivity surge is simply manna from heaven is, surely, to understate the role of management. It takes more than just new technologies to deliver productivity gains, as Europe with its poor productivity performance has discovered to its cost. For the US, though, the persistence of low inflation owes a huge amount to these productivity gains. Without them, unit labour costs would have been firmer, energy price increases would have been more difficult to absorb and markets would have had to cope with both higher inflation and falling profits. Put another way, entrepreneurial activity has prevented the dire inflationary outcomes of old from materialising.
And this brings me to my final point. The productivity story is impressive in the US but is rather dismal elsewhere, particularly in the UK. Does this mean that entrepreneurial skills are seriously lacking on this side of the pond? Not necessarily. Productivity gains are important but they're not the only way of controlling costs. Through enhanced labour and capital mobility, globalisation has increased the bargaining power of companies with respect to labour. Either this means the reorganisation of workplace practices, as we've seen in the US, or it means that wages don't rise in the light of energy price increases.
In the UK, and elsewhere in Europe, the absence of wage pressures, not productivity strength, has proved to be the main surprise. Increased labour supply in the UK, the result of both immigration and the return to work of the over-55s who've discovered their pensions aren't quite so impressive as they'd hoped, has surely contributed to the absence of wage pressures (see the right-hand chart). In Germany, the threat of capital exodus to central and eastern Europe has done much the same thing.
Mr Tucker is absolutely right to say that, for monetary policy, judgement is more important than the models that over-simplify economic relationships. The trouble with judgement, though, is that opinions differ, as the Monetary Policy Committee has demonstrated with its three-way vote on interest rates at the last meeting. For what it's worth, I'd judge that the risk of a sudden rise in inflation expectations may still be rather low because, unlike standard economic models, I'm happy to assume that entrepreneurs exist.
Stephen King is managing director of economics at HSBC
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