Reallocating labour - A Thought experiment in economists

Imagine one day economics dies off. We would naturally retrench all the professors of economics. According to their theories, their resources should be better utilized in some other work. The question is what work and how long will it take before they take up other jobs.

The point I am making is that reallocation of labour to other industries and other tasks is not easy. It is a painful process with a lot of stress and agony for the household involved. Economics professors, I am sorry to say, do not understand the problems involved. In a specialized work force these problems compound as set back to income and dignity is enormous. For example, if only jobs available were those of plumbers, and a less qualified economist is a better plumber, it will difficult for the better qualified economist to swallow the reality.

Keynesian approach makes jobs paramount because Keynes understood these problems. While I am not a Keynesian, as goes their definition, I do agree with focus on jobs during times of crisis.

Keynes, some say, likes to maintain status quo while Adam Smith actually hails the reallocation of resources. I believe Keynes and Adam Smith are at different end of the spectrum. If Adam Smith is looking at a car at rest, Keynes is looking at situation where car is speeding out of hand. Keynes' solution on maintaining jobs is akin to ABS braking in cars. In cars, as we know, it is better to have traction and hence brakes are applied and released repeatedly to achieve better braking. If we were to stomp on the brakes we will skid out of control. Similarly, maintain jobs in the times of crisis gives the economy traction to change course and ease into a new reality.

As far as I understand Keynes is a solution for crisis. The mistake Keynesians make is to apply Keynes' theories out of context.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

The question of Cities

Post the Economist debate on Cities, we have a series of fabulous articles on the topic. Let me quickly share a few of them right away. First article, Are mega-cities too big? comes Klaus Desmet and Esteban Rossi-Hansberg. The second article comes from Ryan Avent titled "Why we live in cities?". Other reading includes Richard Florida's book Who is your city? Another includes report from UN Research institute for Social Development titled "Development and Cities". Finally some of my thoughts are captured in the my ebook How Cities Develop.

There is a general agreement on cities being the drivers of economic growth. However, there is much debate about whether cities should be large or small, how they grow, etc. Let me highlight some important issues with respect to cities.

Cities are efficient providers of infrastructure
Investments make sense when they are used by more people. Cities have effective administration because they have piece-meal property - in other words they are dense. These piece-meal property affords economies of scales and better return on infrastructure like drainage, water supply, power etc. It is, therefore, clear why some cities like Detroit are encouraging people to shift out of far-flung suburbs into concentrated city center.

Cities help deploy capital efficiently
Cities allow for specialization and therefore interdependent service opportunities. Away from the city, multi-skilling is essential. City dwellers may get help if their car breaks down, away from the city you may need to know basic break-down procedures yourself. Same goes for food. Cities allow you to buy meals from restaurants etc. so that those expert in cooking and concentrate on cooking food. Thus a city, in effect, comprises core workforce, ancillary workforce and support services. Core workforce related to basic income generating opportunity - in Detroit -it would represent automobile company workers. Ancillary workforce represents those workers that feed into auto firms - like stationary provider, photo-copying machine providers and workers thereof. Further there are workers for support services like restaurants, hair-dressers, etc. This specialization creates far higher productivity and hence better returns on capital.

Cities as hotbed of ideas

On a social level, cities are breeding ground for ideas. The let diverse people mix and therefore create an environment where ideas can breed. The new knowledge economy, therefore, depends on efficient cities and thrives in such environments. Now we can see the conflict between efficient capital deployment and idea generation functions. One needs specialization and homogeneity while other needs generalization and diversity. It is here that cities are likely to break down.

Over past two decades, IT infrastructure has allowed idea-generation function to move online. As the next generation, the digital natives (1), take over, we will see cyber-cities forming for idea generation functions. Further, the capital efficiency too is driven by ideas and hence possibly moving towards cyber-space. 

DESIGN OF CITIES
Design of cities is more landmark-oriented rather than flow oriented. The word "settlement" connects better with access than with landmarks. However, we look at landmarks and try to connect them based on estimates of future population. Don't be fooled by what seems like flow-based design - it isn't the driver of design decisions.

City is a flow of different variables. It is a flow of people to and from workplaces to and from houses. It is a flow of utilities across the sprawl. It is a flow of water, food and essential goods to different areas and evacuation of sewage, drainage and other effluents away from it. However we do not design cities based on efficiency of these parameters, rather we select a location and then try to service it with these amenities.

Rome v/s Las Vegas
The contrast between flow-based design and landmark based design is evident when you contrast Rome and Las Vegas in a simplified way.

Rome had a population of 1million around 10-3BC. At that time it still had a natural gravity driven water system that provided water no only to homes but also to street fountains and the like. There was also a well-designed drainage system. Though, Rome is not a purely flow-based design, it still comes close.

The old Las Vegas on the other hand is landmark based design. There is no business for it to exists in the middle of the desert and away from every amenity possible. Subsequent developments have tried to overcome its shortcomings. Yet, to date, its survival depends on the depleting Lake Mead created by the Hoover dam.

Balancing income and affordability determine the sprawl

Let us assume a person with a specific sum of money. She can, theoretically, buy large tracts of lands away from income generating opportunities. If she has to buy land in the city, in close proximity to income generating opportunities, she can buy very little even after leveraging future incomes. We can imagine a spectrum of affordability, from this maximum land without income opportunities to the minimum space purchasable by leveraging future income. Now the sprawl of the city depends on how geographically spread the affordability spectrum is. It is limited by time and not distance. Thus the geographical sprawl is equal to distance that can be travelled within acceptable commuting time. Hi-speed metros and maglev trains tend to increase the distance within alloted time.

The principles of Acceptable commute distance and acceptable commute time is essential in design of cities and development of sprawl.

Superimposing flow and landmarks measures real estate value
We can draw up monetary value of city's real estate by super-imposing flow and landmark characteristics. Landmarks with high flow are most valuable pieces of real estate in the city. I have distilled some of these thoughts in my "Affinity factor model" for cities.

Some of these ideas have been discussed in my free ebook How cities Develop. You can download it from Scribd by clicking on the link above.

Notes:

(1) Digital Natives refers to children born after 1990s who are far more comfortable with technology than current workers.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Wage growth and productivity increases

Mark Thoma points to a research paper by Lawrence Mishel and Heidi Shierholz titled "The sad but true story of wages in America". The study points to divergence between increase in productivity and increase in wages. 

First we must be clear with which productivity we are talking about. Increasing labour productivity must be complimented with increasing wages. However, higher productivity without any change in labour productivity need not be. Is this possible? Of course it is. 

At the risk of oversimplification, imagine a simple bread bakery. Its output is supported by various types of labour like bakers, sales staff, cleaning crew etc. Now imagine such a bakery buys an automatic bread making machine. All you do is put the dough in from one side and press a button. On the other side you get the most fabulous breads. In the new setup, the output supports sales staff, cleaning crew and a low-cost attendant. Now this machine needs maintenance which is on contract and there has been corresponding employment at the bread-machine manufacturing factory. But you can imagine the number of people supported by volume of bread produced is far lower. These people together take less percentage of sales price of bread but since their number is smaller they earn more. In a way, this is higher order of economies of scale in action. I agree that the knowledge provided by the bread-machine makers is high and deserves the monetary returns it gets. You can imagine this process running over and over again till gains accumulate with those that provide distinct knowledge. For example, the consulting baker at the bread-machine making factory would earn multiple times average baker.

So I would like to see change in capital intensity of production during the same time. An alternate, thus, would be that technology is resulting in polarization of incomes. On one side, it increases the scale that can be achieved by distinctive knowledge provider and hence scales up her returns / income, on the other it reduces the quality of labour required for the process and hence lowering the expected incomes of those still employed.

This change is structural shift from effort-based society to a knowledge-based society. Naturally, those without college degree, in other words ability to do knowledge work, have stagnant pay. In knowledge based society, the quality of effort is reduced and hence pay required to carry out the job reduces. 

To understand real productivity and incomes, we need new concepts such as "wage content of a job" or its reverse "job content of a wage". The former would refer to wage change of specified standard set of jobs, sort of a job basket similar to consumption basket for inflation. The later would refer to the value of work that we can get done at a particular wage. If we measure this over time we will get better understanding of changes taking place in the economy. At the end, the job-profile, income profile and knowledge profile of a country should match and if it does, we can say capitalism is working fine.

I discuss some of these concepts in my book "Subverting Capitalism and Democracy". 

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Want me to work with you?

I am looking for opportunities on the buy-side. Essentially, doing what I currently do but with added benefit of working with the best minds. If you are looking for someone to work with you please read below.

As an analyst employee, I tend to conform to fund manager's style. I believe a fund manager needs to get all the analysis that makes him or her comfortable about their view. In many cases it means stopping short of my comfort levels. In other cases it means working with specific formats (some fund managers I know respond to font color). 

I may, often, have divergent views than my fund manager. Whether I tell you upfront depends on two things, my relationship with you and how divergent are my views. I will tell you up front without being asked if we have a good equation or if the divergence is too large to be left unflagged. Else, I will wait till you ask for my view. 

I love to meet managements, sell-side analysts, make plant visits etc. If you let me go around a production facility I can tell you how good the management is (are they really doing things they say in MDA). In meetings I want to listen to everything the person has to say (sometimes people ramble on and I don't stop them). I don't check or fidget with my blackberry during meetings. I like to make notes on paper and I discard them later, I file things mentally.

I work with my own projections but I love to unscramble sell-side models. In my assumptions I am more conservative. In a way I deliberate a little more than people like and I doubt every model, every forecast and every assumption. However, I do not change my opinions unless the data changes. 

As an investor, I rely more on management quality than on sell-side projections. I have certain bias against few companies. Some I like to go long whenever opportunity permits (Bharti, L&T etc) and others I love as shorts (ADAG group). In some cases there is logic behind the reasoning (Bharti, L&T etc) while in others (ADAG group) it is more intuitive. 

As an investor, I am terribly risk averse, though the fact that I invest in equities implies some risk-taking. If I smell a rat, I don't want to wait for confirmation about what is wrong with the company. I am happy to close the position. Also, I like positions where there is an easy exit - so I do not invest in small and mid-caps.

I must highlight that I do not understand pharma and insurance. I believe these sectors are more about law-suits and legal skills than about science and finance. But, as I said, I do not understand these sectors.

I love to learn and understand new things. I can listen to new ideas without fatigue for days. These could be in any field from science to religion to cooking - I have varied interests. I follow reasonably advanced mathematics well, so if someone wants to explain calculus, I am game.

I like to go into depth, so I want to know how are oil rigs constructed, how are they anchored, how oil is drilled, why gas is vented off at the rigs, etc in detail. Often I know more about these things than many oil analysts. For metals, the other chemical reactions that can yield the metal and why the current method is preferred over others.

Very many years ago, a fund manager friend highlighted the importance of knowing global history in understanding any industry. What he referred to was the chronology itself. So, oil analyst must know where we struck oil first, how the production centers moved to other countries, how parallel development of technology was critical to such developments. Since then, I read up on general history more than job requires.

People say I am easy to get along with. I don't mind interruptions and am happy to explain things in detail. I am generally patient with people. 

But I know I am quirky person. I like a clean desk. Barring the computer and the phone, there is just a pen and paper on my desk. I hate printouts and like to read on-screen. I prefer iPad. I like to get tea delivered on my desk. I believe admin and HR departments often get tangled up in their own policies. I believe we must fight to retain the best employees.

In sum

I work best with gentle people though I have very high resistance to people who throw tantrums. The best people I know are all very well behaved. I am soft-spoken person. So if you want me to work with you please call me. You can find my CV here. You can reach me at rahuldeodhar [at] gmail [dot] com or call me at +91 -98 20 21 38 13.

Higher oil prices, inflation and what matters

David Beckworth quotes Caroline Baum and Mark Thoma about oil price increases, its impact on inflation and whether Fed should respond. 

Caroline points out some mistakes when we interpret the metaphors too seriously. Few weeks ago I would have thought that Caroline is unnecessarily critical, that people understand these are metaphors (oil prices are a tax) used for better understanding the impact. However, people are definitely taking these metaphors very seriously. There is a danger of policy response (QE??) being blinded because of such blindness. So in a way we must thank Caroline for the article. 

The fundamental explanation on this topic comes from Mark Thoma. He details a very elaborate explanation. According to him, if central bank is responsible for price rises then it should respond. If the price rise, however, is based on changing fundamentals then central banks have no reason to respond. Such price rise is relative rather than absolute, prices of some goods increase higher than others. 

Hmm!

While I agree with overall analysis, I must put some pointers out. 

Firstly, Oil is different commodity. Oil is embedded within our economic system. This is a result of substantial capital investments over nearly a century. Hence any improvement in alternate technology requires far longer gestation than commonly assumed. Further, the quantum of investments required is also higher. In the intermediate time, oil can fuel general price rise (not just a relative price rise) through cost pressures. If the ability to pass on higher prices is limited, it results in shutting down of unprofitable production facilities leading to job losses. thus, in this sense, oil is inflationary and crimps consumer demand. 

But David is right to mention that such change is a spike and does not indicate a trend change. However, from a layman's perspective, price level is more important in relation to income level than rate of inflation itself. Let us assume prices rise to level of 3X and stay there thereafter. In such case there is immense pain for the lay person in the first year and thereafter as the incomes adjust, things get easier. But what if incomes do not adjust? Then the pain stays on for longer and ruthlessly drags household after household into poverty.

In such a scenario, it is policy response may be warranted. But it is not simply a monetary policy response that will do the trick. Monetary policy action will create a window of opportunity during which investments must be made in alternate technology and improve it. However, after monetary policy action when we see lower oil prices we forget the "improve the alternate technology" part. Meanwhile oil companies continue to invest more into status quo shifting the goal post further.

As an aside, I do believe we are improving technology to reduce oil dependence. However, it is more incidental than deliberate. The development of source independent power grids, energy efficiency norms etc are a step in the right direction.

Principle Reduction in mortgages

Some of the Fed economists have interesting post about principle reduction in the mortgage modification program. The post titled The Seductive But Flawed Logic of Principal Reduction | The Big Picture is available at the big picture blog. I have a few reservations about the logic expressed by the economists.

Some reservations about the article

First and foremost, the article refers to principle reduction as mechanism to create a win-win alternative. I must disagree. Principle reduction is a mechanism for loss sharing and there is no "win" in this.

When a lender and borrower together buy a property (by its economic definition referring to any asset), they are investing in it. This is understood when lender takes to same asset as collateral in lieu of the loan extended to the borrower. The borrower, by paying the interest on the loan, gets the right of ownership of the asset. Thus ideally, the lender will have a capped upside and a capped downside while the borrower will have unlimited upside and limited downside. This is the normal situation. 

However, during the current crisis, the situation took numerous forms all radically different from the normal situation. In most of these cases borrowers or lenders or both are seen to be speculating on house prices. In such cases, the upside and downside of the speculative bet should be equally shared.

Secondly, in specific cases of lender induced speculation, downside should be specifically and singularly borne by the lender. This is particularly true of the sub-prime loan category. Here all the losses should be borne by the lender and not the borrower.

Similarly, if borrowers are alone found to be speculating then they should bear the downside of the deal. Second home purchases are indicative of speculative behavior. Thus second homes should not have principle reduction.

Consequently, a first-home buyer at the mercy of lenders should be allowed principle reduction option.

The big picture story

The main factor in the decision about principle reduction lies away from this discussion. Principle reduction may create a buffer within the household balance sheets. This buffer, it is believed, may be the solution to the current crisis. There are a lot of arguments that agree with this hypothesis.

The resolution of the mortgage side, keeping an eye on the possible macro benefits, may not be fair. But it may work to revive the economy. Keeping this in mind, the financial industry may bite its own tail to save itself and agree with the principle reduction program. In a way, this is a question of bargaining power of government with respect to banks.