Mean Markets and Lizard Brains Read online

  We may just be getting to the time when information technology is being understood well enough to make us richer. If so, it is possible that the recent high productivity will not only continue, but could even accelerate.

  Is the recent rise in productivity really a big deal? Yes, because of the magic of compound interest. My favorite example of compound interest comes from Charles Darwin. In Chapter 3 of the Origin of Species, he writes:9

  The elephant is reckoned to be the slowest breeder of all known animals, and I have taken some pains to estimate its probable minimum rate of natural increase: it will be under the mark to assume that it breeds when thirty years old, and goes on breeding till ninety years old, bringing forth three pairs of young in this interval; if this be so, at the end of the fifth century there would be alive fifteen million elephants, descended from the first pair.

  Darwin was calculating compound interest. If something grows at just over 2.3% a year, it doubles in 30 years. The magic of compound interest means that even with slow rates of growth, given enough time, the overall growth is stunning. The inability of the world to support so many elephants was an important step on Darwin’s intellectual road.

  To appreciate what different productivity rates mean, let’s take Keynes at his word. What are the economic possibilities of our grandchildren? In particular, let’s contrast the wealth of our grandchildren under two possible scenarios. In the high-growth scenario, productivity grows at the 3.62% average of this decade. In the lower-growth scenario, productivity grows at the 1.72% average of the period 1970 to 1999.

  Does it matter much for your grandchildren which of these two productivity rates exists for the next 40 years? Let’s test your intuition. How many hours per week will your grandchild work to have the same lifestyle as could be earned by working 40 hours now? Here are four possible answers:1. 29.3 hours per week

  2. 20.2 hours per week

  3. 15.9 hours per week

  4. 9.6 hours per week

  Pick an answer for each of the two productivity scenarios—high growth and lower growth. If the world turns out as in (2), your grandchildren will be roughly twice as rich as you for each hour that they work. That means twice as many cars, TVs, fridges, and vacations per hour of effort.

  Before we get to the correct answers, let’s take a step back and understand that even a productivity growth rate of 1% is remarkable and rare.

  What is the productivity growth rate for our closest living ancestor, the chimpanzee? This may seem like a strange question, but the answer is easy to calculate. Take a modern-day chimpanzee, and calculate the number of hours of work to obtain a fixed amount of food.

  To calculate change in productivity, compare the modern chimpanzee’s workload with the comparable figure for a chimpanzee from a thousand or a million years ago. Of course, we do not have any historical data on chimpanzees, but the answer is clear. The productivity growth rate for chimpanzees (and all other animals) is zero. Animals, even those with culture, show no progress across generations.

  The economic opportunities of the grandchildren of modern chimpanzees will be no higher than today’s chimpanzees (and probably far worse because of environmental destruction). Perhaps it is obvious that animals have zero productivity growth. Less obvious is the fact that the human rate of productivity growth throughout much of history has also been almost exactly zero! Through most eras, humans have done no better than chimpanzees or even bacteria for that matter. Keynes makes this point in his grandchildren essay, noting, “the absence of modern technical inventions between the prehistoric age and comparatively modern times is truly remarkable.”

  The archeological record reveals that Keynes’s observation applies to most periods. For most of human existence, the rate of technological change was essentially zero. Our modern ability to create more material goods per unit of effort is nothing short of amazing.

  Let’s return to our grandchildren. The answers are 20.2 hours per week for the lower-growth case and just 9.6 hours per week for the high-growth case. If the next 40 years look like the period 1970 to 1999, our grandchildren will have to work half as hard as we for the same material outcome. Alternatively, if productivity grows at the rate of the last few years, our grandchildren will only have to work one-quarter as hard as we do. If the high-productivity path happens, our grandchildren could work Keynes’s 15-hour weeks and be considerably richer than we. Note that productivity growth doesn’t just mean more TVs, it also allows for better medical care and education.

  In terms of economic wealth, small improvements in productivity translate into big improvements to our lives and those of our children and grandchildren. When it comes to economic wealth, productivity is the only thing. Thus, our economic wealth depends almost entirely on the rate of productivity growth.

  There are, of course, a number of important caveats to this productivity argument that go beyond the scope of this book. First, average economic wealth may mean very little if it comes in a world that is environmentally damaged. Second, the distribution of wealth may be more important than its total. Third, and most fundamentally, there is scant evidence that increases in wealth make people any happier. In fact, studies from around the world suggest that while most of us believe money will make us happier, wealth does not cause happiness.10 All of these are important topics, but not for this book, which is dedicated to the mission of helping investors make money.

  Conclusion: If the last few years of extremely high productivity are a sign of good times to come, we will be much richer, and our large debts will not be a problem.

  America: The Talented Beggar

  We started this chapter by asking what path the United States will take. Will it be Keynes’s vision of examined leisure created by information technology, or will we stumble down a painful path similar to that taken by post-bubble Japan?

  Those who believe that these are the worst of times are right to recognize the U.S. financial hangover from the bubble years. The aftereffects of the 1990s are clearly visible in shaky consumer finances, idle factories, and large government deficits. However, those who believe these are the best of times are right to recognize the central importance of extremely high productivity growth.

  Thus, productivity is the key. If there is to be a happy financial ending for the United States, it must come through information technology and productivity growth. For investors, this converts to simple advice. Watch the productivity figures. If productivity can stay above 3% for the coming years, then like my talented running teammate, the United States should be able to work through its hangover. If productivity drops substantially, however, the pain of recovering from the excesses of the 1990s will be much greater.

  Update since the First Edition

  U.S. productivity growth has slowed dramatically. From an initial growth rate above 3% per year in the early part of the decade, productivity has slowed over the last three years to 1.5% (see Figure 4.6). This 1.5% level of productivity growth is lower than the rate from any post-World War II decade except for the 1980s. Overall, 2000-2007 productivity growth is solid, but not abnormally high (contrast Figures 4.7 and 4.5).

  FIGURE 4.6 U.S. Productivity Growth Has Slowed Dramatically

  Source: U.S. Bureau of Labor Statistics (nonfarm business output per hour)

  The United States continues to consume at an unsustainable pace, with U.S. consumers spending all their income (Figure 4.8). Beginning in the early 1980s, the personal savings rate began a persistent decline from around 10% to essentially zero.

  FIGURE 4.7 U.S. Productivity Growth Is Solid, but Not Spectacular

  Source: U.S. Bureau of Labor Statistics (nonfarm business output per hour)

  FIGURE 4.8 Americans Do Not Save

  Source: U.S. Department of Commerce

  What’s Next?

  In the battle between profligacy and productivity, profligacy has been winning. This is not a good trend. What are the prospects for the next rounds of the battle?

  Let us begin b
y asking how much people should save. As an example of an economy that saves more than the United States, we can look to Australia. Every worker in Australia is forced by government decree to save 9% of their income, and this is deposited in a form of private account called a superannuation fund. This forced saving has resulted in more than a trillion dollars of superannuation savings and for a relatively small population, the highest level of managed funds per person in the world.

  What do analysts say about this Australian saving system? The consensus view is that a 9% saving rate is too low! People who want to lead a retired life that is not too much worse than that of their working days should save something closer to 15%. This suggests that the U.S. savings rate is far too low.

  You don’t need to be an economist (it probably helps not to be one) to understand that zero savings leads to poverty. Eventually, as people approach retirement, they will realize that they will be extremely poor without savings, so they will begin to save more. The effects of this unavoidable shift from profligacy to frugality will be broad and persistent. To make up for the undersaving years, it does not seem crazy to think that the U.S. personal savings rate may exceed 20%.

  While the shift from debtor to saver will happen, productivity growth will help determine the level of pain from this adjustment. Productivity remains the only free lunch in economics, and the more productive we become, the more we’ll be able to fund savings out of growth and not out of belt tightening. Thus, productivity growth rate remains the single most important economic statistic.

  chapter five

  INFLATION Rising Prices and Shrinking Dollars

  Return of the Inflationary Monster?

  During the German hyperinflation of the early 1920s, banknotes had so little value that people had to carry money around in giant sacks. So worthless had the money become that one man who left a wheelbarrow full of money unattended for a moment returned to find that thieves had left his money but had stolen his wheelbarrow. While this story is funny, the hyperinflation itself was not; it wiped out the lifetime savings of millions of families.

  My first experiences as an investor came in the inflationary 1970s. In those days, inflation was a mysterious monster ravaging the U.S. and global economies. When I was in college in the 1970s, my friends and I used to retire to the student lounge after dinner each night to watch Mel Brooks’s classic comedy show, Get Smart. Because the lounge had just one shared TV, a form of adolescent democracy selected the channel. Other students who wanted to learn and not laugh sometimes outvoted my friends and me, and on some evenings we were forced to watch the nightly news.

  When it came to inflation in the 1970s, the TV news was bleak. Every month the government would announce the growing rate of inflation. We sat and feared that we would not have enough money to enjoy life. Even presidents seemed impotent to defeat the inflationary monster. In 1974, President Gerald Ford manufactured millions of “WIN” buttons to exhort the American public to “Whip Inflation Now” (although he never told us quite how we were supposed to accomplish this task). In sour economic times, President Ford lost to Jimmy Carter in the 1976 election. President Carter in turn lost his 1980 election to Ronald Reagan—a casualty, some say, in the Federal Reserve’s campaign to defeat inflation.

  As shown in Figure 5.1, the 1970s’ U.S. inflationary monster was tamed, and for the last two decades, the United States has enjoyed a low inflation rate. Stories of inflationary problems might therefore seem to apply only to those living in Latin American countries or those with a long memory. Recently, however, gold prices have risen dramatically, and the value of the U.S. dollar has declined substantially. These are classic signs that inflation might be building. What are the prospects for inflation, and what sorts of financial investments are likely to prosper?

  FIGURE 5.1 The United States Has Enjoyed Low Inflation for Many Years

  Source: Bureau of Labor Statistics

  As in most areas to do with money, the best insights on inflation come from Professor Milton Friedman. Winner of the 1976 Nobel Prize in Economics, Professor Friedman is the leader of the monetarist school that seeks to understand the financial world through the creation and removal of money from the economy.

  The seminal work, A Monetary History of the United States, 1867- 1960, written by Professors Friedman and Anna Schwarz, states, “Money is a fascinating subject of study because it is so full of mystery and paradox. The piece of green paper with printing on it is little different, as paper, from a piece of the same size torn from a newspaper or magazine, yet the one will enable its bearer to command some measure of food, drink, clothing, and the remaining goods of life: The other is fit only to light the fire. Whence the difference?”1

  As Professor Friedman suggests, to understand inflation we must remove some of the monetary mystery. Accordingly, our investigation into inflation starts with an analysis of the reason we use money in its current form. In this journey, we begin by examining a modern market that does not use money at all.

  The Creation of Money: This Kidney Is Not for Sale!

  Kidney transplantation is a potentially lifesaving surgery that transfers a kidney from one person to another. Sometimes the kidney comes from a donor who has recently died, while many others come from living donors. Most people are born with two kidneys but can live quite well with just one.

  My Harvard Business School colleague, Professor Al Roth, has become involved in improving the kidney transplantation system. At first glance, the situation seems quite simple and not applicable to the tools of economics. People in need seek a relative or friend willing to donate a kidney. Those needy patients who do not find a willing donor wait in line for kidneys from cadavers. Why is Professor Roth, an economist, involved in a medical process?

  There are special circumstances that make the kidney market particularly problematic and appeal to an economist’s special skills. Kidney donors and recipients need to match on a number of physiological measures. So while a needy patient might find a willing donor in, for example, his or her spouse, tissue incompatibility may preclude a transplant. In these cases, a willing donor cannot help his or her loved one because of biological mismatch.

  A potential solution for couples suffering from this mismatch is to find a complementary couple in a similar situation. In the simplest case, two such couples might find that they can swap organs. So, for example, Mrs. Smith wants to donate a kidney to Mr. Smith, but they are biologically incompatible. Similarly, Mr. Jones wants to donate a kidney to Mrs. Jones, but cannot. If, by chance, they are mutually compatible, the solution is to have Mrs. Smith donate to Mrs. Jones, and Mr. Jones to Mr. Smith. Thus, both patients get the kidneys they need.

  This sort of “matching” problem is well understood by economists and is a particular area of expertise of my colleague Al Roth. In some of his previous work, Professor Roth helped reform the system of matching medical residents to positions at teaching hospitals.2 Thus, the kidney transplantation system, which appears at first to be purely medical, has an underlying “matching” problem that has been studied by economists.

  Such organ-swapping is legal, and it is beginning to happen. Here is a summary of a news story about one such arrangement (The Reporter, Vanderbilt University Medical Center, November 21, 2003):

  The lives of two West Tennessee families have been changed forever by the generous act of organ donation, but not in the way they had originally planned. Kay Morris, 53, was to receive a kidney from her daughter, Melissa Floyd, and Tom Duncan, from his friend and neighbor, Patricia Dempsey. But, there was a positive cross match within each couple so the transplants couldn’t take place. Debbie Crowe, Ph.D., an astute Nashville immunologist, discovered that by swapping kidneys between the two pairs, the transplants would work.

  In this case, Melissa donated her kidney to Tom, a man she had not previously met, while Tom’s friend Patricia donated her kidney to Melissa’s mother. These organ-swapping arrangements allowed transplants that could not take place otherwise. I
n this case, two recipients received new kidneys that they could not have had without involving the other pair. Fantastic.

  There are, however, some difficulties with kidney swaps. First, sometimes it takes more than two pairs to find compatible matches. For example, Johns Hopkins recently performed a three-way swap. Involving more couples makes the matching process more difficult, particularly since donor and recipient need to be in the same hospital for the surgery. Second, surgeons who do swaps have a rule that all the surgeries must take place simultaneously. In the West Tennessee case, that meant four simultaneous operations (two donors, two recipients) and the Johns Hopkins triple swap involved six operating teams working on the three donors and the three recipients at the same time.