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Friday, June 28, 2013

Economic Development, Social Capital and Bankruptcy Processes

Michael Pettis is the blogger that many people seem to turn to for unbiased, high-quality analysis of  the economic situation in China.   He had a very long post recently entitled "How much investment is optimal?" that contained some very good observations about how a bankruptcy process can enhance an economy's functioning.  He wrote:

"the institutional framework around the writing down of overvalued assets, and the liquidation process itself, is an important part of how efficiently an economy is able to absorb the benefits of capital stock. A formalized bankruptcy process that takes assets away from inefficient users, writes them down to a fair market value, and reintroduces them into the economy, creates a much more efficient economic system than one in which bad loans are not recognized, effectively bankrupt companies are allowed to continue in value-destroying activity, and the use of assets is not systematically transferred from the less efficient to the more efficient user.

"In fact an efficient and relatively rapid bankruptcy process is, I would argue, of fundamental importance to the ability of an economy to exploit capital stock efficiently. Even very advanced countries without a formal process to transfer resources quickly can have a hard time exploiting its capital and labor factors, especially after a period in which a great deal of labor and capital were directed into unproductive uses. I think Japan’s twenty years of nearly zero growth may be explained in part by the very slow process in Japan by which resources were transferred from “losers” to “winners” after the investment orgy of the 1980s.

"In fact more generally the sophistication and flexibility of financial systems are an important component of social capital because these determine the capital allocation process. Financial system capable of taking risk and supporting new and disruptive technologies or organization structures tend to result in a greater ability by a society to absorb capital. In that light, and as an aside, I would suggest that the country that sees the most change in the list of its largest companies from decade to decade – because this list creates a simple way of determining how quickly companies can be created and destroyed as their level of efficiency changes – is probably better at absorbing capital than a country whose largest companies are the same decade after decade."

The overal thrust of his post does not have that much to do with bankruptcy, but rather is about the role of "social capital" in economic growth, which he defines as "the full range of legal, institutional, and economic relationships that can make an economy more or less productive. It is this complex mix of institutions, I would argue, and which I call social capital, that drives advanced economic growth, and not simply additional labor or capital."  His point is that pure physical capital investment is always and inherently productive, but optimizes only in the right environment, one that, in his words again:

"creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights),
encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses, and
"maximizes participation in economic activity by the whole population while minimizing distortions in that participation."
You can see how a good bankruptcy process falls under the second bullet.

By coincidence, along these same lines, Malcolm Gladwell had a nice essay in The New Yorker's June 24 issue that made a related point.  The essay reviews a biography of an economist/social scientist named Albert O. Hirschman who died last December (the book is entitled "Worldly Philosopher: The Odyssey of Albert O. Hirschman" by Jeremy Adelman).  Hirschman is best known for a beyond-brilliant work called "Exit, Voice  and Loyalty" which is about the three ways people tend to relate to badly managed organizations and institutions (including nations): exit (get out of it); voice (speak out and try to change it) and loyalty (conform so as to remain loyal notwithstanding its faults).  But he was also much respected for his academic work in economic development, where he held very much a "bottoms-up" as opposed to "top-down" perspective. In discussing Hirschman's work on economic development, Gladwell succinctly grasps the main point:

"Developing countries required more than capital.  They needed practice in making difficult economic decisions. Economic progress was the result of successful habits - and there is no better teacher, Hirschman felt, than a little adversity."

And this is exactly right. Tying it back to the bankruptcy process, for just one example, one can see that an economy is enhanced if it has a mechanism to deal with the difficult situation where an underachieving economic actor ceases to be able to provide a full return of capital, let alone on capital, and to do so in a way that mitigates the impact on the broader economy in both the short run (confining the depth, breadth and duration of the losses) and the long run (by operating in a way that does not deter capital from investing in future economic activity).  A mechanism that makes it possible for an economic actor to shed liabilities that are beyond its capacity to satisfy helps an economy regenerate itself, rather than be buried under the perpetual burden of insurmountable debt. claims. 

A lot of modern economies today unfortunately lack this kind of regenerating mechanism, with some tending to allow legacy liabilities to go unaddressed for years, and others tending to have highly politicized and otherwise ad hoc approaches that discriminate in favor of the interests of certain politically favored constituencies and thereby create a negative climate for capital allocation and economic growth.  The current US chapter 11 is not perfect but is probably as good as there is on the planet right now, especially when a company and its constituencies are able to go down the "prepack" or "prenegotiated" route to reorganization.

Another example of how social capital, as Pettis defines it, makes a difference in economic growth comes from a short article by Peter Hall in Harvard magazine, "Anatomy for the Euro Crisis".  Outlining some of  the differences between the northern European economies that have thrived, by comparison, under the euro, and the southern economies that haven't, Hall writes:

"Germany’s coordinated market economy exemplifies the northern model. That nation can hold down labor costs because its industrial-relations institutions encourage firms and unions to coordinate on modest wage increases. Its highly collaborative vocational training system, operated by strong employer associations and trade unions, provides firms with skilled labor that gives them comparative advantages in producing high-value-added goods and capacities for continuous innovation—enabling German enterprises to compete globally on quality as well as price. An economy organized in this way is ideally suited to mount the kind of export-led growth strategies that lead to success inside a monetary union.

By contrast, Spain, Portugal, Greece, and Italy entered EMU with political economies not well-suited to this type of growth strategy. They have fractious labor movements divided into competing confederations, and weak employer associations. As a result, they lack the capacities for collaborative skill formation and wage coordination central to northern European economic strategies. Instead, their governments have tended to rely on demand-led growth, in which governments increase spending to encourage domestic consumption and then use periodic depreciations of the exchange rate to offset the inflationary effects of this strategy on the competitiveness of their products. Depreciation lowers the price of a country’s exports in foreign markets and raises the price of imports that compete with domestically produced goods."

Germany's industrial relations model, in Hall's description, has productive social capital that leads to competitive success, while the southern economies have much less and instead historically have had to resort to the deficit-and-depreciate routine to get their economies out of first gear.  Which they can no longer repeat under the euro, hence the need for structural reforms if they want to escape their current predicament.

On a closing note, on the themes of habits, adversity and success, here is a quote in the current Sports Illustrated from James Jones, benchwarmer for the two-time NBA champion Miami Heat and evidently a nascent business school lecturer:

"James Jones, one of Miami's reserve forwards, read a book during the Finals called The Plateau Effect, in part because it pertained to the Heat. 'When you're the elite, the exception, the example, you get to a peak, and you try to maintain what got you there rather than growing it,' Jones explains. 'Complacency creeps in and by the time you realize it, you're regressing.  That's the plateau.  Getting past it requires stimuli, and oftentimes the best stimuli is failure.'"