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'

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

stephen.king@hsbcib.com

Start your day with The Independent, sign up for daily news emails
PROMOTED VIDEO
Arts and Entertainment
Kara Tointon and Jeremy Piven star in Mr Selfridge
tvActress Kara Tointon on what to expect from Series 3
Voices
Winston Churchill, then prime minister, outside No 10 in June 1943
voicesA C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
News
i100
Sport
footballBrighton vs Arsenal match report
Arts and Entertainment
Benedict Cumberbatch has spoken about the lack of opportunities for black British actors in the UK
film
News
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Tax Assistant

Negotiable: Recruitment Genius: A Tax Assistant is required to join a leading ...

Recruitment Genius: Outbound Sales Executive - OTE £25,000

£16000 - £25000 per annum: Recruitment Genius: This is an exciting opportunity...

Ashdown Group: Java Developer / J2EE Developer - Watford - £45,000 - £47,000

£45000 - £47000 per annum + bonus + benefits: Ashdown Group: Java Developer / ...

Ashdown Group: Marketing Product Manager - (Financial Services) - SW London

£35000 - £38000 per annum + Benefits: Ashdown Group: Marketing Manager - Marke...

Day In a Page

Iraq invasion 2003: The bloody warnings six wise men gave to Tony Blair as he prepared to launch poorly planned campaign

What the six wise men told Tony Blair

Months before the invasion of Iraq in 2003, experts sought to warn the PM about his plans. Here, four of them recall that day
25 years of The Independent on Sunday: The stories, the writers and the changes over the last quarter of a century

25 years of The Independent on Sunday

The stories, the writers and the changes over the last quarter of a century
Homeless Veterans appeal: 'Really caring is a dangerous emotion in this kind of work'

Homeless Veterans appeal

As head of The Soldiers' Charity, Martin Rutledge has to temper compassion with realism. He tells Chris Green how his Army career prepared him
Wu-Tang Clan and The Sexual Objects offer fans a chance to own the only copies of their latest albums

Smash hit go under the hammer

It's nice to pick up a new record once in a while, but the purchasers of two latest releases can go a step further - by buying the only copy
Geeks who rocked the world: Documentary looks back at origins of the computer-games industry

The geeks who rocked the world

A new documentary looks back at origins of the computer-games industry
Belle & Sebastian interview: Stuart Murdoch reveals how the band is taking a new direction

Belle & Sebastian is taking a new direction

Twenty years ago, Belle & Sebastian was a fey indie band from Glasgow. It still is – except today, as prime mover Stuart Murdoch admits, it has a global cult following, from Hollywood to South Korea
America: Land of the free, home of the political dynasty

America: Land of the free, home of the political dynasty

These days in the US things are pretty much stuck where they are, both in politics and society at large, says Rupert Cornwell
A graphic history of US civil rights – in comic book form

A graphic history of US civil rights – in comic book form

A veteran of the Fifties campaigns is inspiring a new generation of activists
Winston Churchill: the enigma of a British hero

Winston Churchill: the enigma of a British hero

A C Benson called him 'a horrid little fellow', George Orwell would have shot him, but what a giant he seems now, says DJ Taylor
Growing mussels: Precious freshwater shellfish are thriving in a unique green project

Growing mussels

Precious freshwater shellfish are thriving in a unique green project
Diana Krall: The jazz singer on being friends with Elton John, outer space and skiing in Dubai

Diana Krall interview

The jazz singer on being friends with Elton John, outer space and skiing in Dubai
Pinstriped for action: A glimpse of what the very rich man will be wearing this winter

Pinstriped for action

A glimpse of what the very rich man will be wearing this winter
Russell T Davies & Ben Cook: 'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'

Russell T Davies & Ben Cook: How we met

'Our friendship flourished online. You can share some very revelatory moments at four in the morning…'
Bill Granger recipes: Our chef serves up his favourite Japanese dishes

Bill Granger's Japanese recipes

Stock up on mirin, soy and miso and you have the makings of everyday Japanese cuisine
Michael Calvin: How we need more Eric Cantonas to knock some sense into us

Michael Calvin's Last Word

How we need more Eric Cantonas to knock some sense into us